Many closely held businesses operate as S Corporation “pass-through” entities for federal income tax purposes. Some S Corps started out as C Corporations and converted to an S Corp.
Often, questions arise on the income taxation of distributions of cash or assets from S Corps to the shareholders of those S Corps personally. These S Corp shareholders will often need to use S Corp distributions to fund personal financial objectives. Among them: personally owned or trust-owned life insurance to finance personal protection, retirement income or estate planning objectives.
A specific sequence and protocol must be followed under IRC Section 1368 when S Corp cash and/or assets are distributed to S Corp shareholders. Each “tier” of distribution must be reduced to zero before moving into the next “tier” of distribution.
Here is the sequence of taxation that must be followed when these distributions take place. For simplicity, assume the S Corp shareholder owns 100 percent of the shares of the company. S Corps are “pass-through” tax entities wherein K-1 net profits are taxed to the S Corp shareholders personally on Schedule E of their Form 1040 U.S. Income Tax return.
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Distribution Tier #1
All S Corp Net Profit (business income minus business expenses) for the current tax year is “passed-through” as K-1 ordinary income to the S Corp shareholder.
For tax year 2013 and beyond, ordinary income may be taxed at a top federal rate of 39.6 percent for high income S Corp owners. Plus, an additional 3.8 percent tax on “passive” interest and rental income as a result of the Affordable Care Act went into effect in 2013 for certain high earners. The combined marginal tax rate on ordinary income for high income S Corp owners could be as high as 43.4 percent.
Distribution Tier #2
All S Corp “Accumulated Adjustments Account” (AAA) is distributed tax free to the S Corp shareholder.
This AAA account is a tax accounting entry for all previously taxed K-1 income that has been left in the S Corp and was not distributed to the shareholder in prior tax years. Some professionals refer to this AAA account for S Corps as “previously taxed profits” or “previously taxed income.” This AAA tier of distribution is important to verify because it can provide a tax-free technique to fund personal insurance needs. The most recent Form 1120S U.S. Income Tax Return for an S Corp would be a good source to verify the AAA account.
Distribution Tier #3