What are excess distributions and how do you handle them?
A common question from business owners is “How much money can I take out of the business?” We like to make sure business owners know what they are allowed to take out by educating them. After all, it is their hard-earned money.
Before we get into the nitty-gritty of this, I would like to point out that if you are an S Corporation shareholder there is one thing to keep in mind: salary. The IRS requires that a shareholder providing services to the S Corporation must take a reasonable salary. If you were ever to be audited by the IRS regarding this issue, and the IRS deemed that your salary is not reasonable, they could reclassify distributions to salary. As a result of the reclassification, you could then be faced with late payment penalties and interest due to late deposit of payroll taxes. You also would have to amend payroll reports. They key take-away here is to first and foremost make sure you are and will be able to pay yourself a reasonable salary before taking any distributions, if you are an S Corporation shareholder.
Now that we have covered that, you are ready to take some distributions. Distributions cannot exceed your basis in the company. In a nutshell, your basis is income, gain and losses allocated to you based on ownership percentages since the business has been in operations, plus any contributions you have ever made, less any distributions you have ever taken. If you do take distributions in excess of basis, then you have 2 options on how to handle it.
Your first choice would be to recognize the excess distribution as a long-term capital gain on your personal tax return. If you are in a low tax bracket (10% or 15%), then it may be advantageous to go ahead and pick the distribution up as a long-term capital gain because the gain would have preferential tax treatment of 0% tax. Even if you are in a higher tax bracket, it may still be to your advantage to pick up the capital gain. If you have a significant amount of capital losses, then you could offset the 2 together.
Your second option would be to reclassify the excess distribution as a shareholder loan. If the loan exceeds $10,000, then the IRS requires that you impute interest on the loan. You can use the applicable federal rate, which is currently very low. This may be a more favorable option for you.
In summary, make sure you are monitoring how much money you are taking out of your company to avoid tax implications. Also, make sure to review all of your options when handling excess distributions.