Are distributions from an S corp taxable as long term capital gains?

Question

We have several shareholders. As needed, we will do a distribution for taxes. We are being told that these distributions are taxable as long term capital gains. Is that right?

Should shareholder salaries be paid as distributions vs. payroll?

Answer 1

If you have an S-Corp with several shareholders - you probably also have a tax adviser who suggested using S-Corp to begin with. You're probably best off asking that adviser about this issue.

If you decided to use S-Corp for multiple shareholders without a professional guiding you, you should probably start looking for such a professional, or you may get yourself into trouble.

That said, and reminding you that: 1. Free advice on the Internet is worth exactly what you paid for it, and 2. I'm not a tax professional or tax adviser, you should talk to a EA/CPA licensed in your state, here's this:

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Generally S-Corps are disregarded entities for tax purposes and their income flows to their shareholders individual tax returns through K-1 forms distributed by the S-Corp yearly. The shareholders don't have to actually withdraw the profits, but if not withdrawing - they're added to their cost bases in the shares.

I'm guessing your corp doesn't distribute the net income, but keeps it on the corporate account, only distributing enough to cover the shareholders' taxes on their respective income portion. In this case - the amount not distributed is added to their basis, the amount distributed has already been taxed through K-1.

If the corporation distributes more than the shareholder's portion of net income, then there can be several different choices, depending on the circumstances:

1. The extra distribution will be treated as salary to the shareholder and a deduction to the corporation (i.e.: increasing the net income for the rest of the shareholders).

2. The extra distribution will be treated as return of investment, reducing that shareholder's basis in the shares, but not affecting the other shareholders. If the basis is 0 then it is treated as income to the shareholder and taxed at ordinary rates.

3. The extra distribution will be treated as "buy-back" - reducing that shareholder's ownership stake in the company and reallocating the "bought-back" portion among the rest of the shareholders. In this case it is treated as a sale of stock, and the gain is calculated as with any other stock sale, including short-term vs. long-term taxation (there's also Sec. 1244 that can come in handy here).

4. The extra distribution will be treated as dividend. This is very rare for S-Corp, but can happen if it was a C-Corp before. In that case it will be taxed as dividends.

Note that options #2, #3 and #4 subject the shareholder to the NIIT, while option #1 subjects the shareholder to FICA/Self Employment tax (and subjects the company to payroll taxes).

There might be other options. Your licensed tax adviser will go with you through all the facts and circumstances and will suggest the best way to proceed.