How Are S Corporation Dividends Taxed?

This question is a really good one.

But to understand how S corporation dividends are taxed you first need to understand both what S corporation dividends are and what S corporation distributions are.

Dividends versus Distributions

Let us start by pointing out that, in general, the money that an S corporation pays to its shareholders isn't called a dividend.

Regular corporations, also known as C corporations, pay dividends. And those dividends are taxed.

But S corporations, in general, pay distributions.

The Usual Rule: Distributions Don't Get Taxed

In general the distributions paid by an S corporation to the S corporation shareholders are not taxable to the shareholders.

In other words, if you're an S corporation shareholder and you receive a $100,000 distribution check from an S corporation in which you own shares, you generally are not taxed on the $100,000.

Upon hearing this, some people become confused and say, "Well, that's crazy... does that mean that I don't pay taxes on S corporation profits?"

The answer to this related question is "no".

As a shareholder, you pay taxes on your proportionate share of the S corporation's profits. For example, if you and a buddy equally own an S corporation and the S corporation makes $250,000, you will each need to pay the income taxes on your $125,000 shares of the S corporation's profits.

Note that it won't matter whether or not this money is retained by the corporation. Even if the corporation keeps the profits, you will still be taxed on the profits.

The Exceptions to the Rule

Okay, so what we've described in the preceding paragraphs is the general rule. But note that two common exceptions exist to the general rule:

Exception #1: If an S corporation used to be a regular C corporation and the corporation retained some of its profits from the "C corporation" years and the corporation while an S corporation pays some of those old C corporation profits out to shareholders, that payment is a dividend. And that dividend (because it's paid out of the C corporation's old profits) is taxed to the shareholders. Under current tax law, the dividend is taxed at a preferential qualified dividends rate, which is 15% or less in most cases. (If you have a high income, you may pay a 20% dividend tax and the 3.8% net investment income tax, also  known as the Obamacare tax.)

Exception #2: If an S corporation shareholder receives a distribution that exceeds his or her basis in the S corporation, the in-excess-of-basis distribution gets treated as a long-term capital gain and, therefore, may be taxed. This business about a distribution in excess of basis gets tricky. But as a generalization, S corporations and their shareholders get into this situation when they retain very little of their profits inside the corporation and instead borrow money for items like fixtures and equipment. In effect, in this situation, and often without realizing it, the S corporation borrows money from someone like the bank and then directly or indirectly uses this borrowed money to pay distributions to shareholders.

Two Special S Corporation Dividend Rules

Because we're talking about S corporation dividend taxation, let me also tell you about a couple of other special rules connected to the way S corporation shareholders get taxed...

First special rule: Income retains its character as it passes through to the S corporation shareholders. For example, if an S corporation did allocate (per the earlier example) $125,000 of the S corporation profit to you because you're a shareholder, the character of that income matters.

If the income is ordinary income, you pay the ordinary income tax rates. But if the income is long-term capital gains or qualified dividends, you pay the lower preferential tax rates (sometimes 0%, usually 15%, and worst-case 20%).

Say, for example, that you get $125,000 of income from an S corporation:

  • $50,000 of ordinary business profits
  • $50,000 of long-term capital gains on some investments the S corporation sold
  • $25,000 of qualified dividends the S corporation receives because it owns shares in a C corporation.

In this case, you pay ordinary income tax rates on that first $50,000 and then the preferential tax rates on the $50,000 of long-term capital gains and the $25,000 of qualified dividends.

Second special rule:  The 3.8% net investment income tax, also known as the Obamacare tax, never hits the ordinary income that flows out of an S corporation if the shareholder is actively involved in the S corporation.

Note, however, that the 3.8% tax does potentially hit the ordinary income if the shareholder is not actively involved. And the Obamacare tax will also potentially hit long-term capital gains and dividends allocated to shareholders regardless of whether or not the shareholder is active.

For example, suppose that you and a partner each own half of an S corporation and each receive $125,000 allocation of profits.

Assume $75,000 of each partner's share represents long-term capital gains and qualified dividends. That leaves $50,000 as the amount of ordinary business profit.

If you're active in the business, you won't ever have to pay the 3.8% Obamacare tax on the $50,000 of ordinary business profit.

If your partner is not active, she may just have to pay the 3.8% Obamacare tax on the ordinary business profit.

Note that both of you might pay the 3.8% Obamacare tax on the long-term capital gains and dividends.

Note: The rules for determining whether you're active or not and when the net investment income tax applies (aka "Obamacare tax") are discussed in some detail in a blog post I did here.

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