How to Account for a Distribution From an S Corp When It Should Be a Dividend

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A corporation can make a Subchapter S election with the Internal Revenue Service (IRS) to change the way it is treated for tax purposes at any time. Once the election is made, the way the corporation accounts for distributions to shareholders is fundamentally altered. A regular corporation distributes dividends from retained earnings (RE) that are taxed at the corporate level. An S corporation does not accumulate retained earnings. Instead, it puts excess income into an accumulated adjustment account (AAA). Distributions from this account, whether called distributions or dividends, are not taxed at the corporate level. Any S corporation distribution from an old RE account must be accounted for and taxed as a dividend under regular corporation rules.

  • Verify that the S corporation has a retained earnings account with a positive balance on the books that is left over from a time when the company was taxed as a regular corporation. Any ordinary distribution to shareholders that an S corporation makes out of its AAA account, whether called distributions or dividends, would be treated the same way and recorded on Schedule K-1 for tax purposes. It is only when a distribution is supposed to be made out of a holdover RE account that it must be accounted for and taxed differently.

  • Obtain the consent of the S corporation's shareholders to treat the distribution as a dividend out of retained earnings. The IRS tax rules automatically take any distributions made by an S corporation out of AAA before considering any other account. If you want to treat a distribution as a true dividend paid out of RE, you will have to file an election. To request an election, the law requires the consent of shareholders, either in writing or by vote.

  • Prepare IRS Form 1099-DIV for each shareholder who received a distribution that you want to treat as a dividend. This is the tax form that regular corporations provide to shareholders to document dividends for tax purposes. Ordinarily, an S corporation would not use this form. S corporation distributions are recorded on Schedule K-1.

  • Make a tax election to distribute accumulated RE as dividends. Attach a statement to the corporation's 1120S tax return that indicates that the corporation is making the election, that all shareholders consent and the amount of the dividend distributed. The election is irrevocable but applies only to the tax year when it is made. This election will allow the corporation to account for a distribution that it wants to treat as a dividend.

  • Properly account for the dividend distribution on the books of the company for tax purposes. Make sure the corporation's accountant knows that the dividend should reduce the RE account and not AAA. The dividend is taxable to the corporation at the applicable tax rate for S corporation dividends, unlike distributions from AAA which are tax-free at the corporate level. Make sure the accountant records this transaction properly on the company's tax return on Form 1120S, Schedule K, Line 17c and that the company pays taxes on it.

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