If you’re the owner of an LLC, there’s a chance you’ve elected to have your business taxed as an S Corporation. As your S Corp turns a profit, there are two ways to have those profits paid back to you: 1) reasonable compensation and 2) owner’s distributions (sometimes referred to as draws). While we won’t dive deep into reasonable compensation, we will discuss everything you need to know about S Corporation distributions as a business owner.
Let’s explore owner’s distributions in greater detail.
What are owner’s distributions?
Owner’s distributions are non-payroll (i.e. reasonable compensation) funds that owners take from an S Corporation. Most commonly this is a distribution of an owner’s share of profits from the operations of the business.
How do I take an owner’s distribution?
This is a common question that we receive and there’s often a misconception that this is a complicated process. While there are some documentation and bookkeeping steps that need to happen, taking a distribution is as simple as transferring funds from the business bank account to your personal bank account.
Your business has a dedicated business bank account, right? See #2 here.
What are the reasons for taking owner’s distributions?
Here are three common reasons for taking owner’s distributions:
- Distributions for tax purposes. S Corporations are passthrough entities, meaning, the owner(s) generally pay tax on the income the business earns on their personal tax returns. This income does not have taxes withheld like a paycheck does, so owners should be making quarterly estimated tax payments for their share of the income to avoid penalties and interest. The timing and formula (usually net income x the owner’s ownership percentage x a set tax rate) for calculating tax distributions will usually be outlined in the operating agreement.
- Required distributions. For whatever reason, some operating agreements specify required distributions.
- “Just because.” I’ll lump everything else into “just because.” The owner needs to pay their mortgage. Their kid needs braces. It’s Tuesday. Whatever. The reality is, so long as the operating agreement allows it, owners can make distributions whenever they want.
How are distributions reported on my business tax return (Form 1120S)?
You’ll see the distributions reported in a few places on Form 1120S:
- Schedule K – Shareholder’s Pro Rata Share Items
- Schedule M-2 – Analysis of Accumulated Adjustments Account, Shareholders’ Undistributed Taxable Income Previously Taxed, Accumulated Earnings and Profits, and Other Adjustments Account
- Schedule K-1 – Shareholder’s Share of Income, Deducts, Credits, etc. This is the form that goes to each shareholder for their use in preparing their personal tax return. The place to look here is in Box 16, “Items affecting shareholder basis.”
How are distributions reported on my personal tax return (Form 1040)?
As mentioned above, the shareholder uses the K-1 they receive from the S Corp to prepare their personal tax return. The distributions will appear on Form 7203, which is usually prepared with the business return and then filed with your personal return, “S Corporation Shareholder Stock and Debt Basis Limitations.” Your distributions, or a portion of your distributions, may also appear on Schedule D and Form 8949 if you have distributions in excess of basis.
If your S Corporation distributions are distributions of earnings and profits, you will be taxed based on the income reported on your K-1, which then flows to various schedules in your personal tax return. Distributions aren’t separately stated as income except as noted below.
How are my S Corp distributions taxed?
In layman’s terms, they’re not but with a few exceptions. Earnings from the business are taxed at the personal level, whether the earnings are distributed or not. Distributing the earnings doesn’t create a taxable event unto itself, as you’ve already been or are being taxed on the earnings as S Corps are a passthrough entity.
The most common exception here is distributions in excess of basis. We most commonly see this when the business underperforms and/or takes on a lot of debt. In cases like this, a situation can occur when a business owner or owners are effectively financing their distributions with debt.
In (super) layman’s terms again, basis is simply the accumulated investment you’ve made in the company. If you take out more than you’ve put in, you have a gain. In tax law, generally, whenever you have a gain (you got more out than you put in) you’re going to pay tax on that gain.
What’s the difference between a distribution and a dividend as it relates to an S Corp?
Distributions are primarily concerned with S Corps and dividends are primarily concerned with C Corps. That said, we often have customers refer to distributions as dividends because it’s a term that’s more familiar to them.
If an S Corp was previously a C Corp, the business may issue dividends of its accumulated earnings and profits.
What are best practices for documenting distributions?
There are a couple of bases to cover here:
- Make sure they’re classified correctly in your accounting software. Distributions are a balance sheet-only transaction as they reduce cash and reduce equity. For the S Corps that we do bookkeeping for, we create two equity accounts for each owner: 1) FirstName LastName – Contributions and 2) FirstName LastName – Distributions. That way, it makes the accounting pretty clear and we can ascertain the amount of distributions fairly quickly.
- Document the distributions in your company’s monthly/quarterly/annual meeting minutes.
Again, make sure the distributions are consistent with and allowed by your company’s operating agreement.
How do I manage distributions during periods of low profitability?
The simplest and most prudent answer to this question is to reduce or stop making discretionary distributions. As a matter of fiscal responsibility, distributions should only be made from profits. If profitability is low and you’re accustomed to a certain level of distribution, it’s a good idea to work with your tax advisor first to understand your basis and at what point you may trigger a capital gain event.
How can I avoid common mistakes that might lead to penalties or audits?
There are two common mistakes that we see:
- Distributions in excess of basis. I can spend an entire blog post on this and it’s detailed above. First of all, you should pay attention to your basis when your tax return is prepared every year, and make sure your preparer is providing that information. Then, you should at least be mindful of that number throughout the course of the year as you consider making distributions. If you’re not sure, contact your tax advisor before you make a distribution.
- Distributions not in proportion to ownership. While this isn’t always an issue, it most certainly can be an issue. S Corps can only have one class of stock. Therefore, each owner needs to have the right to receive distributions in proportion to their ownership interest. This doesn’t mean distributions always need to be made at the same time or the same amount(s). However, if you fall behind it does mean you still have the right to the distributions in proportion to your ownership share. The same is also true for any other shareholders in the business.
Conclusion
Electing S Corp status for your LLC or corporation is a common tax strategy. While there is often a lot of confusion and consternation around the what, when, why and how of distributions, it’s really not that complicated so long as ownership proceeds diligently. My advice is to always lean on your tax advisor if you’re not sure of something.
Many of our customers are marketing agencies or in a service-based business, and many of them are S Corps. We deal with these issues a lot.
