Are my dividends that I pay myself as an S-Corp taxable? That depends…partly on your basis.
In financial matters, you basis is what something cost you. If you were to purchase ten shares of a stock at $10 each and you had a $50 broker’s fee, your total basis would be $150 or $15/share.
Similarly, if you start a business you typically invest money in the business. These initial startup funds are your basis; it is also known as member or partner capital. Funds you invest are member contributions. When you pay yourself as a sole-proprietor or LLC, you take member draws. Contributions increase you basis as does income that your business generates. Draws decrease your basis and so do deductions and losses.
Some rules to follow according to IRS regulations:
- Distributions are applied to the basis first, and then losses
- The distribution is tax free until the basis is reduced to $0
- Any remaining distribution (after the basis has been reduced to $0) is now taxed as a capital gain.
- For most intents and purposes, basis does not go below $0 because we’re not dealing with indebtedness and shareholder loans.
Let’s go through a case scenario. It is 2013; you had a windfall (say you inherited some money) and decide to follow your dream and start a business. You form an LLC and elect S-Corp status with the IRS. To get things going, you invest $30,000 for tools and equipment, legal fees, advertising, etc., all out of your own pocket. Your basis in the adventure is $30,000.
You do really well that first year and after expenses you allocate $50,000 of ordinary income, $30,000 of long-term capital losses, and $40,000 of distributions.
Where the money’s going:
In this example, all of the distributions are tax free.
Let’s take the same $30,000 basis but $20,000 of income, $60,000 of distributions, and $10,000 of losses
Because you had more distributions than basis, part of the distributions are now taxable. Also of note in this example is the large amount of distributions compared to the income. If you are an S-Corp, you are required to pay yourself a “reasonable salary”. Reasonable is not specifically defined; you are expected to pay yourself wages similar to other professionals in your career field. One of thumb is the 60/40 ratio. 60% of your net income should be paid out as wages, and 40% as distributions.
Distributions can be complicated but are still a good way to legitimately avoid some self-employment taxes.
Footnotes:
Note 1-I borrowed heavily from a very good article by Tony Nitti at http://www.thetaxadviser.com/issues/2014/jan/nitti-jan2014.html