The Internal Revenue Service allows small businesses to organize as S Corporations. Profits from an S Corporation generally flow through to the owners rather than to the retained earnings of the business. Distributions of profits and losses to the owners constitute their income, and the IRS recognizes such for tax purposes.
Distributions of Profits
Many S Corporation shareholders or owners take a direct distribution of the profits rather than receiving wages. Owners report the profits on their individual tax returns. When a business makes a distribution to someone who performs duties for the company, the IRS refers to this amount as wages, subject to federal and state taxes.
Distribution of Assets
The company treats a distribution of appreciated assets as a sale. An asset is machinery, equipment, furniture or any other physical property. Rising market value equates to an appreciated asset. Therefore, the IRS assesses a capital gain in accordance with the shareholders' proportion of ownership, even if only one person receives the property.
Calculating the Percentage of Distribution
Distribution percentages depend on the proportion of shares a shareholder owns. If the person owns 60 percent of the S Corporation's shares, then he receives 60 percent of the profits and 60 percent of the capital gains on the distribution of an asset. The other 40 percent belongs to the other shareholders, based on their proportion of ownership.
The IRS refers to distributions beyond reasonable levels of compensation as dividends. The services provided and gross receipts of the company determine what compensation is reasonable. The IRS taxes dividends as income when earned, not when distributed. Therefore, receiving the dividends does not necessarily mean the shareholder owes income tax on them for the year of receipt.
- Internal Revenue Service: S-Corporation
- "Income Tax Planning for Financial Planners"; Thomas Langdon, E. Vance Grange, Michael Dalton; 2011
- Andrey Popov/iStock/Getty Images