A. “Distributions” from a "Subchapter S" corporation are generally tax-free, as they usually represent a payment of “previously taxed income”.
Sub-S distributions are not considered to be dividends. For tax purposes they are treated as “drawings” from the shareholders’ “capital account” (called here an "Accumulated Adjustments Account”), similar to a way distributions from a partnership are treated.
The income and expenses of a Sub-S corporation are passed-through to the shareholders. Shareholders are taxed on the income of the corporation whether or not they actually receive a distribution. The income is taxed when it is earned by the corporation, and not when it is distributed to the shareholder. Again, this is basically the same tax treatment as a partnership.
The income and deductions passed through from a Sub-S corporation are reported on the Form 1040 of the shareholders, and are taxed based on the individual nature of the item. Ordinary business income is passed through as ordinary income on Schedule E and is taxed at ordinary “marginal” income tax rates. Interest, dividends, capital gains dividends and short and long term capital gains from the sale of assets that are received by a Sub-S corporation are taxed by the shareholder as interest, dividends and capital gains, and are reported on Schedule B or Schedule D.
Similarly, any charitable contributions, investment expenses and Section 179 expense from the corporation are “separately stated” on the appropriate 1040 schedule or form, as are “tax preference items” that affect the dreaded Alternative Minimum Tax.
The only possible way a distribution from a Sub-S corporation could be taxed as a qualified dividend, at the lower capital gain rate, is if the corporation had “earnings and profits” (E&P) from prior tax years during which it operated as a “C” corporation. For example, the corporation was formed in 2000, but did not elect Sub-S status until 2004, and it had accumulated net profits from the period of operation as a “regular” corporation. A distribution from E&P could be taxed as a “qualified dividend”.
The IRS has “ordering rules” to determine how a distribution made by a Sub-S corporation with E&P is taxed. Distributions are first considered to be from the “Accumulated Adjustments Account” (AAA) – income generated by the Sub-S corporation that has been previously taxed to the shareholders. These distributions are tax-free. Any distribution in excess of AAA is considered first to be from E&P and taxed as dividends.
Under IRC 1368(e)(3) you can make a special election to take distributions first from E&P instead of AAA. The election is made on a year-by-year basis.
The only time a distribution from a Sub-S corporation could be treated as a capital gain is if the distribution is in excess of the taxpayer’s "basis" in the Sub-S corp. This is last on the list in the “ordering rules”.
As mentioned above, qualified dividends earned by the Sub-S corporation that are passed through to the shareholder are taxed at the special capital gain rates, as are passed-through capital gain dividends and long-term capital gains.