Key Takeaways
Summary | |
Definition | Dividends and distributions are ways business owners receive profits from a corporation, depending on the business structure. |
Key Difference | C corporations pay dividends to shareholders, while S corporations pay distributions to owners. |
Tax Treatment | Dividends may be taxed twice at the corporate and individual levels, while S corp distributions generally avoid corporate tax. |
Reporting Requirements | Dividends are reported on Form 1099-DIV, while S corp distributions are reported on Schedule K-1 (Form 1120-S). |
Purpose | Helps business owners understand how profits are paid out and taxed to stay compliant and plan distributions effectively. |
Got questions on how you can disperse company profits to yourself and your fellow business owners? Well, we’ve got answers for you: one of the most common ways to do this for C corporation owners is through dividends, and for S corporation owners, it’s through distributions.
Read on for the difference between the two, and information about how distributions and dividends are taxed.
Dividends vs. distributions: what’s the difference?
Both dividends and distributions are considered a return of capital. In other words, dividends and distributions are both types of income, but they’re used in different contexts.
A dividend is a portion of a company’s profits, usually cash, but sometimes shares. A corporation may pay dividend income to its shareholders. Unlike a salary, though, dividend payments aren’t necessarily predictable. It’s generally considered a reward or bonus if your company does well financially. There are two types of dividends, which differ in how they’re taxed: ordinary dividends and qualified dividends.
A distribution is also a dispensation of company profits—generally in cash—but it goes to the shareholders of an S corporation, not a C corporation. Similar to a dividend, a distribution is a payment that differs from a salary.
How are dividends and distributions taxed?
Because C corps are subject to double taxation, you pay taxes at the corporate and individual levels. Your company will pay income tax on your profits; then, once you distribute the dividends as payment, the shareholders who receive them will pay tax on them. If you offer qualified dividends—which have to meet certain IRS criteria (more on that later)—they’ll be taxed at the lower long-term capital gains rate, instead of the regular income tax rate.
S corps, on the other hand, are pass-through tax entities (also known as disregarded entities), meaning that they operate like LLCs, partnerships, and sole proprietorships in terms of taxes. The company’s earnings are passed through to you as the owner, then taxed on your personal income tax return—so you don’t have to pay corporate taxes.
As the owner of an S corp, you can generally take distributions tax-free as long as you have sufficient basis in your company. Basis is a calculation of your financial contributions to the business, income, and distributions. If you receive distributions that exceed your basis, you may have to pay long-term capital gains tax on them.
How to report dividends and distributions
It’s critical to accurately report the dividends or distributions you receive as a business owner; if you don’t, the IRS may penalize you with a fee.
If you have a C corp, you’ll report dividends on Form 1099-DIV form. In an S corp, you report distributions on the Schedule K-1 (Form 1120-S) in Box 16. This form is specifically for S corps with shareholders, and it breaks down each shareholder’s income, gains, losses, tax deductions, and credits.
Before you fill out your forms, take the following steps:
Get prepared with paperwork: To streamline the reporting process, it’s helpful to have the right information on hand. Gather your most recent business tax return, your company’s financial statements, and your articles of incorporation.
Talk to your accountant: Reach out to your business accountant for financial advice and help with correctly reporting your dividends or distributions.
FAQ
What’s a shareholder?
A shareholder is an individual or entity that has ownership in a corporation. This ownership is usually in the form of shares of stock.
What is capital gains tax?
Capital gains tax is a tax on the profit made from selling an asset, like a share of stock. If you own an asset for less than a year, you’ll pay a short-term capital gains rate upon the sale; if you own the asset for more than a year, you’ll pay a long-term capital gains rate, which is generally lower. Short-term capital gains tax rates are the same as ordinary income tax rates, while long-term capital gains tax rates are either 0%, 15%, or 20%, depending on your total taxable income.
What are capital gains distributions?
Capital gains distributions are shareholder distributions made from mutual funds or Exchange-Traded Funds (ETFs). When fund managers gain profits from selling an item in an investment portfolio, that’s a capital gain; they then dispense these profits to shareholders in the form of capital gains distributions.
How do C corps and S corps differ?
Both C corps and S corps have shareholders and give business owners liability protection, but there are a few important differences:
C corps can have unlimited shareholders, while S corps can’t have more than 100.
C corps can have international owners, but S corps have to be owned by US citizens.
C corps can issue multiple classes of stock, while S corps can only issue one type.
C corps can offer dividends to shareholders; S corps can offer distributions.
What’s a qualified dividend?
A qualified dividend is a dividend that meets the below criteria from the IRS:
Paid by an eligible US corporation or qualified foreign corporation
Held by the investor/shareholder for more than 60 days within a 121-day window
Is not from a disqualified source, like a non-profit organization or real estate investment trust (REIT)
When should a business choose to pay a distribution instead of a dividend?
Businesses should pay a distribution instead of a dividend if they’re an S corp. An S corp can offer distributions to shareholders on a quarterly or annual basis to split profits, or spontaneously when the business hits a certain milestone or exceeds financial expectations.
If a business is considered a C corp, it can pay dividends to shareholders—but not distributions—to reward them when the company performs well financially.
Are distributions always tied to ownership percentage?
Yes, distributions in an S corp are always tied to ownership percentage. If an S corp shareholder/owner has a 25% stake in the company, they’ll get 25% of the distributions. If S corps don’t dole out distributions proportionally, they’re subject to IRS audits and could get their status as an S corp removed.
Can distributions be taken when a company has no profits?
Sometimes. Depending on how much cash or accumulated (aka past) profits a company has, they may be able to pay distributions even when they don’t have current profits—but it’s not necessarily advisable. Some states even have insolvency laws that prevent companies from offering distributions if doing so will result in the company’s liabilities exceeding its assets.
