Among the rules governing S corporations is a requirement that the corporation issue only one class of shares. While it may divide a class of shares into voting and nonvoting stock, all shares of stock in an S corporation must be treated the same when it comes to issuing distributions. For this reason, S corporation distributions must be pro rata.
Pro Rata Distributions
Pro rata distribution refers to the practice of handling all earnings distributions equitably, among all the company shares in possession. If the company management distributes $1 dollar per share to a single investor, then all investors must receive that same $1 per share. Shareholders cannot elect to skip a distribution.
Consequence for Failing to Distribute Pro Rata
If the Internal Revenue Service learns that an S corporation has distributed earnings in violation of the pro rata requirement, it could disallow the company's status as an S corporation. The company would then become a C corporation, which would potentially trigger a number of tax consequences.
Conversion to C Corporation
If the IRS disallows your S corporation status and converts your company to a C corporation, all shareholder dividends will potentially become subject to double taxation. This is because while S corporations, as pass-through entities, are disregarded for the purposes of income tax collection, C corporations must pay a corporate income tax as high as 35 percent. Only after they pay federal income tax may C corporations distribute earnings to shareholders; dividend distributions to shareholders are not deductible to C corporations. The dividends are then taxed again at the shareholder level. The result is that the after tax income from C corporations may be significantly lower than from an S corporation posting comparable earnings.
Because S corporation dividend rules provide the S corporation ownership no flexibility in distributing earnings according to the owner's needs, many business owners choose to remain in partnerships or limited liability companies, which provide more options to the business owner about when and how to distribute earnings.