S Corporation Distribution Rules

S Corporations are a favorite among small business owners thanks to their tax-saving structure and flexible profit-sharing. But when it comes to distributions—how you pay out profits to shareholders—the IRS enforces strict rules. Getting these rules right keeps you compliant, avoids audits, and ensures everyone gets their fair share.

What Are S Corporation Distributions?

S Corp distributions are simply the portions of a company’s after-tax profits that get paid out to shareholders.

Each distribution must mirror ownership percentages. If you own 25% of the company, you receive exactly 25% of the distribution. Your ownership stake lives on the cap table and guides every payout.

How Distributions Are Taxed

Pass-Through Taxation
S Corps themselves don’t pay corporate tax. Profits “pass through” directly to shareholders, who report the income on their personal returns.

Ordinary Income vs. Return of Capital

• Distributions up to your basis (your original investment plus retained earnings) are tax-free returns of capital.

• Anything beyond that basis is treated as a capital gain, taxed at preferential rates.

• Regardless of distribution, you still pay ordinary income tax on your share of S Corp earnings—so why not distribute the cash?

Salary vs. Distribution: Why the Distinction Matters

Reasonable Compensation
If you’re an active shareholder-employee, the IRS demands a “reasonable salary” for the work you perform. That salary is subject to Social Security and Medicare taxes.

Distributions
Leftover profits can be distributed tax-efficiently because these payments skip payroll taxes. But distributions must never replace a fair salary. Underpay yourself on payroll and over-distribute profits, and you'll draw an IRS audit like a magnet.

Reporting Your Distributions

• S Corps file Form 1120-S every year, detailing income, deductions, and credits.

• Each shareholder gets a Schedule K-1, which breaks down their share of those items—and shows the total distributions they received.

• On your personal return, use Schedule K-1 figures to report both income and distributions. Consistency between corporate and individual filings is crucial to avoid red flags.

Common Pitfalls and How to Avoid Them

• Misclassifying salary as a distribution (or vice versa) can trigger payroll-tax penalties.

• Exceeding your shareholder basis leads to unexpected capital gains.

• Poor documentation of salary determinations—or of basis calculations—leaves you vulnerable in an audit.

Tips to stay safe:

• Benchmark your salary using third-party industry data.

• Track basis changes after every distribution and capital contribution.

• Work with a qualified CPA to keep your numbers airtight.

Next Steps for Your S Corp

• Review your last three years of payroll and distributions.

• Update your cap table and recalculate each shareholder’s basis.

• Document your salary-setting methodology with industry reports.

• Schedule a quarterly check-in with your CPA to ensure ongoing compliance.

If you'd like help implementing these steps or need a custom distribution plan, let’s connect!

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