Owner’s Distribution

An owner’s distribution is a transfer of value out of a business to its owners in their capacity as owners. FASB defines it as exactly that: distributions to owners are decreases in equity of an entity resulting from transferring assets, rendering services or incurring liabilities by the entity to owners, and investments by owners and distributions to owners are transactions between an entity and its owners as owners (FASB Concepts Statement No. 8, Chapter 4, paragraphs E72 and E73).

Read the phrase “to owners” as the whole test. A distribution is made to someone because of what they own, never because of what they did. That single distinction is what separates it from wages, and it is where most of the trouble on a small business return begins.

A Distribution Is Not an Expense

Because a distribution decreases equity rather than reporting a use of resources in operations, it never appears on the income statement. It reduces equity directly, alongside the entity’s own capital accounts, and it never affects net income.

That is why an owner cannot lower the business’s profit by taking more money out, and it is a misunderstanding a preparer has to unwind on nearly every owner-managed file. Taking a distribution changes the balance sheet and the cash balance. It does not change the tax the business or its owners owe on the profit that was earned.

The residual it reduces is treated in owner’s equity, and the corporation’s version of the same transfer is in cash dividend.

The Wage Rule That Comes First

For an S corporation the sequence is not optional, and the IRS states it plainly. S corporations must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee (IRS, S Corporation Compensation and Medical Insurance Issues).

What the standard costs a shareholder-employee once salary runs through payroll, and the reclassification authority behind it, is worked through in c corp vs s corp.

A working shareholder taking everything as a distribution and nothing as salary is therefore not running an aggressive position, they are running a position the agency has already said it has the authority to unwind. The conversation a firm needs to have with that client is about what reasonable compensation is, not about whether the rule applies.

The Order the Tax Rules Apply

Once the wage question is settled, the distribution itself is taxed by a sequence rather than by a single rule, and which sequence depends on whether the corporation has accumulated earnings and profits.

A distribution made by an S corporation with no accumulated earnings and profits as of the end of the taxable year in which the distribution is made is treated in the manner provided in section 1368(b), and a distribution by an S corporation that does have accumulated earnings and profits is treated in the manner provided in section 1368(c) (26 CFR 1.1368-1).

The first of those is the ordinary case, an S corporation with no accumulated earnings and profits. The distribution is not included in gross income to the extent it does not exceed the adjusted basis of the stock, and the portion in excess of that basis is treated as gain from the sale or exchange of property (26 U.S.C. 1368(b)).

The basis the distribution is measured against is taken after the year’s income is added to it. In the case of any distribution made during a taxable year, the adjusted basis of the stock is determined with regard to the increases in basis provided in section 1367(a)(1) for that taxable year (26 U.S.C. 1368(d)).

Shareholder stock basis, start of year          85,000
Share of current-year income                    40,000
                                               -------
Basis before distributions                     125,000
Distributions taken                           (110,000)
                                               -------
Basis after distributions                       15,000     no gain on the distribution

Take one more dollar than basis supports and that excess is gain from the sale or exchange of property, reported by the shareholder, on money that felt like their own. Tracking basis through the year is therefore not a compliance formality, it is what tells an owner which dollars come out without tax.

Timing is fixed too. A distribution is taken into account on the date the corporation makes it, regardless of when it is treated as received by the shareholder (26 CFR 1.1368-1(b)), so a distribution made on the last day of the year runs against that year’s basis even though the shareholder is not treated as receiving it until later.

The Words Clients Use Interchangeably

Three terms get swapped, and they are not the same.

A draw is the sole proprietor’s and partner’s version, money taken out of a business that does not run its owner through payroll. A sole proprietor files the business’s income on Form 1040 with Schedule C and pays self-employment tax on Schedule SE rather than receiving wages (IRS, Sole proprietorships).

A distribution is the term for a payment out of an entity to its owners as owners, and it is what an S corporation makes, including an LLC that has elected to be taxed as one.

A dividend is the C corporation’s version, and it carries the second layer of tax that the S corporation election was made to avoid.

Using one word for all three is harmless in conversation and expensive on a return, because the payroll treatment and the basis rules differ across them. The entity that makes the distribution is classified in pass-through entities, and what the classification costs a shareholder-employee is in c corp vs s corp.

Common Questions

Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can grade that basis and distribution work on its own files through a trial task before a client engagement depends on it.