Your S-Corp had $100,000 profit. You took $80,000 in distributions. How much tax on those distributions? Zero.
The tax was on the $100,000 of income, not the distributions.
This confuses a lot of S-Corp owners. Income gets taxed. Distributions don’t (up to basis). Understanding this distinction is key to S-Corp tax planning and avoiding costly mistakes.
Key Takeaways
- S-Corp distributions are generally tax-free to the extent of shareholder’s stock basis
- Distributions in excess of basis are taxed as capital gains
- S-Corp income is taxed when earned (via K-1), NOT when distributed
- No self-employment tax on S-Corp distributions (unlike partnership distributions)
- AAA (Accumulated Adjustments Account) tracks available tax-free distributions
- Distributions must be proportional to ownership percentage
- Timing matters: Take distributions before year-end to match K-1 income with cash
- Keep basis tracking records – you’ll need them for distributions and stock sales
Table of Contents
How S-Corp Distribution Taxation Works
The S-Corp distribution rules trip up even experienced business owners. Let’s clarify exactly how this works.
Pass-Through Taxation Explained
S-Corps are pass-through entities. This means:
- S-Corp income flows through to shareholders via Schedule K-1
- Shareholders report this income on their personal tax returns
- Tax is owed in the year income is earned
- The tax obligation exists whether or not cash is distributed
You could earn $100,000 in your S-Corp, take zero distributions, and still owe tax on the full $100,000. The income hit your K-1. The IRS wants their share.
The Distribution Itself is NOT the Taxable Event
This is the critical concept.
When you take a distribution from your S-Corp, you’re not triggering a new tax. You’re withdrawing money that’s already been taxed (or will be taxed via your K-1).
Think of it like a savings account. You deposit $1,000 (your after-tax S-Corp income). You withdraw $800. The withdrawal isn’t income. It’s accessing money you already have.
Distributions are a return of your investment and accumulated earnings that have already been subject to tax.
Contrast with C-Corp Dividends
C-Corporations work differently:
C-Corp:
- Corporation earns profit
- Corporation pays corporate tax (21%)
- Corporation distributes remaining profit as dividends
- Shareholders pay tax on dividends (0%, 15%, or 20%)
- Result: Double taxation
S-Corp:
- S-Corp earns profit
- Shareholders pay tax on profit via K-1 (personal rates)
- S-Corp distributes profit
- No additional tax on distribution
- Result: Single level of tax
Simple Example
| Event | Tax Treatment |
|---|---|
| S-Corp earns $100,000 | Shareholders taxed on $100,000 via K-1 |
| S-Corp distributes $75,000 | No additional tax (return of taxed income) |
| Shareholder’s total tax | Tax on $100,000 only |
S-Corp Distributions vs Dividends
Terminology matters in tax. Using the wrong word can signal misunderstanding of your own structure.
Terminology Matters
- S-Corps make “distributions”
- C-Corps pay “dividends”
These are not interchangeable terms. Dividends imply C-Corp double taxation. Distributions are returns of basis and already-taxed earnings.
If you’re telling people you “pay yourself dividends” from your S-Corp, you’re using the wrong term. It’s a distribution.
Tax Treatment Comparison
| Factor | S-Corp Distribution | C-Corp Dividend |
|---|---|---|
| Corporate-level tax | No | Yes (21%) |
| Shareholder tax | No (if basis exists) | Yes (0-20%) |
| Double taxation | No | Yes |
| Self-employment tax | No | No |
| Treatment | Return of capital | Taxable income |
Why This Matters
S-Corp distributions are significantly more tax-efficient than C-Corp dividends. You get one level of tax, not two. This is the core S-Corp advantage for small business owners who need to access their business profits.
Understanding Stock Basis
Stock basis is the foundation of S-Corp distribution taxation. If you don’t understand basis, you can’t properly plan distributions.
What is Stock Basis?
Stock basis is your tax investment in the S-Corp. It represents the amount you’ve put in plus income you’ve been taxed on, minus what you’ve taken out and losses you’ve claimed.
Basis determines:
- How much you can receive tax-free in distributions
- How much loss you can deduct
- Your gain or loss if you sell your S-Corp stock
How Basis is Calculated
Initial Basis:
Your starting basis includes:
- Cash you contributed to the S-Corp
- Property contributed (at your adjusted tax basis, not fair market value)
- Debt assumed by the S-Corp in certain circumstances
Annual Adjustments:
Each year, basis changes based on S-Corp activity:
| Item | Effect on Basis |
|---|---|
| S-Corp income (K-1) | + Increases basis |
| Additional capital contributions | + Increases basis |
| S-Corp losses (K-1) | – Decreases basis |
| Distributions taken | – Decreases basis |
| Non-deductible expenses | – Decreases basis |
Basis Tracking Example
Let’s follow a shareholder’s basis over three years:
| Year | Starting Basis | K-1 Income | Distributions | Ending Basis |
|---|---|---|---|---|
| Year 1 | $10,000 | $50,000 | $40,000 | $20,000 |
| Year 2 | $20,000 | $60,000 | $55,000 | $25,000 |
| Year 3 | $25,000 | $45,000 | $70,000 | $0 |
In Year 3, the shareholder took $70,000 in distributions but only had $70,000 available ($25,000 starting + $45,000 income). Basis drops to zero.
Why Basis Matters
- Distributions up to basis = tax-free
- Distributions over basis = capital gain
- Losses are limited to basis = can’t deduct more than you have “at risk”
- Sale of stock = gain or loss calculated against basis
Warning: Many S-Corp owners don’t track basis. This causes problems when selling the business or taking large distributions. Start tracking now. Our bookkeeping services for S-Corps include basis tracking.
Tax-Free Distributions (Up to Basis)
Here’s the good news about S-Corp distributions.
The General Rule
Distributions up to your stock basis are tax-free. They’re treated as a return of your investment and previously taxed earnings.
Each dollar you take reduces your basis by one dollar.
Example Scenarios
| Shareholder’s Basis | Distribution | Tax Treatment |
|---|---|---|
| $50,000 | $30,000 | $30,000 tax-free |
| $50,000 | $50,000 | $50,000 tax-free |
| $50,000 | $60,000 | $50,000 tax-free + $10,000 capital gain |
As long as you stay within basis, no additional tax.
Order of Operations
The timing of basis adjustments matters:
- K-1 income increases basis first
- Distributions reduce basis second
- K-1 losses reduce basis third (limited to remaining basis)
This order is favorable. You get credit for the year’s income before distributions reduce basis.
Planning Tip: If you expect a loss year, consider taking distributions early. Once losses reduce basis, less is available for tax-free distributions.
Distributions in Excess of Basis
What happens when you take more than your basis allows?
What Happens
The amount exceeding basis is taxed as capital gain.
- Long-term capital gain rates apply if you’ve held S-Corp stock over one year (most shareholders)
- Rates are 0%, 15%, or 20% depending on income
- Plus 3.8% Net Investment Income Tax (NIIT) for high earners
Long-Term vs Short-Term
Capital gain treatment depends on your holding period of the S-Corp stock:
- Held over 1 year: Long-term capital gain rates (0%, 15%, 20%)
- Held 1 year or less: Short-term capital gain (ordinary income rates)
Most S-Corp shareholders have held their stock for years, so long-term rates typically apply.
Example Calculation
Scenario: $30,000 basis, $50,000 distribution
| Amount | Treatment |
|---|---|
| $30,000 | Tax-free (return of basis) |
| $20,000 | Long-term capital gain |
| New basis | $0 |
If you’re in the 15% capital gains bracket, that $20,000 excess costs $3,000 in tax.
How to Avoid This
- Track basis carefully throughout the year
- Don’t over-distribute beyond what basis supports
- Contribute capital if needed to increase basis
- Time distributions relative to income so K-1 income builds basis first
Red Flag: Taking distributions far exceeding K-1 income suggests basis may be exceeded. If you’re distributing $200,000 and your K-1 shows $50,000 income, check your basis calculation.
AAA: Accumulated Adjustments Account
AAA is a corporate-level tracking account that matters for distribution taxation.
What is AAA?
The Accumulated Adjustments Account tracks S-Corp earnings available for tax-free distribution. It’s maintained at the corporate level (not shareholder level).
Think of AAA as the S-Corp’s running total of earnings that have been taxed to shareholders but not yet distributed.
Why AAA Matters
AAA is particularly important when:
- The S-Corp was previously a C-Corp
- The S-Corp has earnings and profits (E&P) from C-Corp years
- Multiple shareholders need to track distribution sourcing
For pure S-Corps (never C-Corps), AAA and shareholder basis typically track similarly.
AAA vs Basis
| Concept | Level | Purpose |
|---|---|---|
| Stock Basis | Shareholder | Limits tax-free distributions per shareholder |
| AAA | Corporate | Tracks S-Corp-era earnings available for distribution |
| E&P | Corporate | Tracks C-Corp-era earnings (if applicable) |
Former C-Corp Considerations
If your S-Corp was previously a C-Corp, distribution ordering matters:
- AAA (tax-free): Distributions come from S-Corp earnings first
- E&P (taxable dividend): Then from accumulated C-Corp earnings
- Return of basis (tax-free): Then reducing shareholder basis
- Capital gain: Excess after basis is exhausted
This is why former C-Corps need careful tracking. Accidentally distributing E&P triggers dividend taxation.
Pure S-Corp (Never C-Corp)
If your S-Corp has always been an S-Corp:
- No E&P to worry about
- AAA tracks all earnings
- Distributions are generally tax-free up to basis
- Simpler situation overall
Self-Employment Tax Savings
This is the primary reason most small businesses elect S-Corp status.
The Big S-Corp Advantage
S-Corp distributions are NOT subject to self-employment tax.
Compare to:
- LLC (default): All profit subject to 15.3% SE tax
- Partnership distributions: Generally subject to SE tax for active partners
- S-Corp distributions: Zero SE tax
This is the whole point of S-Corp election.
The Math
LLC with $100,000 profit:
- SE tax: ~$14,130 (15.3% on adjusted amount)
S-Corp with $100,000 profit ($50K salary / $50K distribution):
- Payroll tax on salary: ~$7,650
- SE tax on distribution: $0
- Savings: ~$6,480
Why Distributions Are Different
S-Corp shareholders pay payroll tax on their salary. That satisfies the employment tax obligation for their labor.
Distributions above salary represent return on investment, not compensation for services. There’s no employment relationship involved in receiving distributions.
The Reasonable Salary Requirement
You can’t game this by taking only distributions:
- Must pay yourself reasonable salary first
- Salary is subject to payroll taxes
- THEN take distributions
The IRS monitors S-Corps taking large distributions with minimal salaries.
S-Corp Reasonable Compensation Guide
Distribution Timing Strategies
Strategic timing of distributions can improve your tax situation.
Match Distributions to K-1 Income
Remember: You’re taxed on K-1 income whether or not you take distributions.
If your K-1 shows $100,000 income but you left all the cash in the business, you still owe tax on $100,000. You need cash to pay that tax.
Strategy: Take distributions to have cash available for your personal tax payments.
Year-End Distribution Planning
Before year-end:
- Estimate full-year K-1 income
- Calculate your expected tax liability
- Distribute enough cash to cover taxes (plus living expenses)
- Don’t over-distribute beyond basis
Quarterly Distribution Patterns
Many S-Corp owners take regular quarterly distributions:
- Creates predictable cash flow
- Helps plan estimated tax payments
- Easier to manage than lump-sum year-end distributions
- Provides consistent income for personal budgeting
Estimated Tax Coordination
| Quarter | Estimated Payment Due | Consider Distribution |
|---|---|---|
| Q1 | April 15 | March |
| Q2 | June 15 | May |
| Q3 | September 15 | August |
| Q4 | January 15 | December |
Take distributions in time to fund estimated payments.
Distribution Proportionality Rules
S-Corps have strict rules about how distributions must be made.
Must Be Proportional
S-Corps can only have one class of stock. This means distributions must be proportional to ownership.
- Own 60%? You get 60% of distributions.
- Own 40%? You get 40% of distributions.
No exceptions based on who “needs” the money more.
What Happens If Disproportionate
Disproportionate distributions create serious problems:
- Could be treated as second class of stock
- Terminates S-Corp election
- Retroactive C-Corp taxation
This is not hypothetical. The IRS pursues these violations.
Handling Unequal Cash Needs
When shareholders have different cash needs:
What you CAN’T do:
- Give one shareholder larger distributions
What you CAN do:
- Loans to shareholders: Properly documented, with interest, treated as debt not equity
- Different salaries: If duties justify (but salaries must be reasonable for actual services)
Example
| Shareholder | Ownership | Distribution (of $100,000) |
|---|---|---|
| Owner A | 60% | $60,000 |
| Owner B | 40% | $40,000 |
Any other split violates the one-class-of-stock rule.
Warning: Even small disproportionate amounts can trigger problems. A $500 extra distribution to one shareholder could technically violate the rules. Be careful.
Frequently Asked Questions
Are S-Corp distributions taxable?
S-Corp distributions are generally tax-free up to your stock basis. The income was already taxed via your K-1. Distributions exceeding basis are taxed as capital gains.
What is the tax rate on S-Corp distributions?
Distributions up to basis: 0% (tax-free). Distributions exceeding basis: 0%, 15%, or 20% capital gains rate depending on your income level, plus potential 3.8% NIIT for high earners.
How do S-Corp distributions differ from C-Corp dividends?
S-Corp distributions are returns of already-taxed income (tax-free up to basis). C-Corp dividends are taxable to shareholders after the corporation already paid 21% tax. S-Corp = one tax level, C-Corp = two tax levels.
What is stock basis?
Stock basis is your tax investment in the S-Corp. It starts with your contributions, increases with K-1 income, and decreases with distributions and losses. It determines how much you can receive tax-free.
What happens if I take distributions in excess of basis?
The excess is taxed as capital gain. Most shareholders have long-term holding periods, so preferential capital gains rates (0%, 15%, or 20%) apply.
Do S-Corp distributions affect self-employment tax?
No. S-Corp distributions are not subject to self-employment tax. Only salary is subject to payroll taxes. This is the primary tax advantage of S-Corp status.
What is AAA?
Accumulated Adjustments Account tracks S-Corp earnings available for tax-free distribution. It’s a corporate-level account that parallels shareholder basis. It matters most for S-Corps that were previously C-Corps.
Do distributions have to be proportional?
Yes. S-Corp distributions must be proportional to ownership. Disproportionate distributions could be treated as a second class of stock, potentially terminating S-Corp status.
Next Steps
Manage Your Distributions Wisely:
- Track your basis: Know how much you can take tax-free
- Coordinate with K-1 income: Distribute to cover tax liability
- Stay proportional: Equal percentages to all shareholders
- Document everything: Keep annual basis calculations
We help S-Corp owners track basis, plan distributions, and avoid capital gain surprises. Your K-1 tells you the income. Understanding what you can actually take home tax-free requires basis tracking and proper planning.
If you’re unsure about your current basis position, need help planning distributions, or want to ensure you’re maximizing the S-Corp tax advantage, professional guidance pays for itself in tax savings and avoided penalties.