The two types of ordinary disbursements of money an S corporation can make for accounting purposes are wages and shareholder distributions, sometimes imprecisely referred to as dividends. This type of corporation is a U.S. construct with special tax rules established by the country’s Internal Revenue Service (IRS). To keep its special status, an S corporation is only allowed to have 100 shareholders or less, but those shareholders can be owners and employees of the corporation at the same time.
If a shareholder in an S corporation decides to work for the company, he can draw a salary as an employee. The corporation would pay the shareholder for his services out of earnings, and both the employee and the corporation would pay applicable employment taxes on the wages. Paying shareholders who work for the corporation is an important part of an S corporation distributions policy because the IRS looks askance at owners who pull earnings out of an S corporation when no one is listed as employed by the company to pay employment taxes.
S corporation distributions also include the disbursement of excess profits to owners at year end. The corporation can make a lump sum distribution of profits to shareholders in proportion to the shareholder’s distributive interest as represented by their Accumulated Adjustments Account (AAA). An S corporation’s special tax status means that the corporation does not pay taxes on its earnings. Instead, it passes profits and losses through to the shareholders, who record their share on their personal income taxes and pay taxes on it at the individual tax rate.
The AAA is not necessarily tied to the amount of stock owned. An S corporation’s ownership, or percentage of stock allocated to shareholders, can be different from the way profits and losses are allocated for tax purposes. In short, a person can own 50 percent of an S corporation’s outstanding stock but be entitled to only 25 percent of the distributive profits or losses. For this reason, the policy on a S corporation distributions might call a distribution a dividend, but it is not a dividend in the traditional sense. A dividend is a disbursement of retained earnings on a per share basis, usually in very small amounts and at various times throughout the year.
If the S corporation was converted from a C corporation, it can also distribute a traditional dividend out of the C corporation’s holdover retained earnings account. These dividends are not technically treated as part of S corporation distributions for tax purposes since it comes out of retained earnings and not the AAA. This distinction is often confused by the layperson, but is very important for tax purposes.