Shareholders, Dividends, and Taxes

When we talk about businesses, whether a small business run by sole proprietors or a big corporation, understanding how money moves is crucial. Shareholders, dividends, and taxes are key parts of the financial journey. Knowing how these elements work, especially taxes, is important for small-business owners. This guide explores how dividends are paid and taxed and how business structures like C corporations (C corps) and S corporations (S corps) affect these processes.

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Dividends at a Glance

Dividends are payments made to shareholders out of a company’s profits. When a business, like a C corp, makes money (net income), it can distribute part of these earnings to its stockholders. The board of directors usually makes this decision.

The amount of dividends depends on the company’s dividend policy and cash flow. However, not all businesses can pay dividends. For example, nonprofits and sole proprietorships typically do not. Also, the type of business, like an S corp or a limited liability company (LLC), can influence how to handle dividends.

What Is a Shareholder Dividend?

According to the Internal Revenue Service (IRS), a dividend is a distribution of cash or property by a corporation to a shareholder paid out of the corporation’s current and accumulated earnings and profits. It is an economic measure of a corporation’s ability to pay dividends without distributing any capital its shareholders or creditors contributed.

Earnings and profits include all items of income, gains, losses, and deductions resulting from the corporation’s economic activities since the date of the corporation’s inception or Feb. 28, 1913 (the date of enactment for federal income tax).

Is It a Dividend?

Sometimes, it’s unclear if a payment is a dividend. Distributions to shareholders are deducted from current earnings and profits and then from accumulated earnings and profits. Suppose the distribution amount exceeds current and accumulated earnings and profits. In that case, the distribution is not taxed as a dividend but as a return of capital. Any distribution which reduces a shareholder’s cost basis of the capital to zero is taxed at a capital gain.

Regular dividends are common, but there are other types of dividends, too. For example, a business might reinvest profits into business expenses or real estate, affecting its dividend payout.

Taxation of Shareholder Distributions

Dividend payments are taxable to a shareholder either as qualified dividends which are taxed at lower long-term capital gains rates or non-qualified dividends (or ordinary dividends) which are taxed at ordinary taxable income rates. Corporations issue shareholders an annual Form 1099-DIV, Dividends and Distributions, which reports dividends paid during the year. The shareholder reports the amount as income on Schedule B of the shareholder’s return. The shareholder must report the dividend amount as income even if they reinvest it in corporate stock. If so, the amount reported as income is added to the shareholder’s cost or basis in the stock.

Here’s where it gets complex. Dividends can be taxed twice. First, the corporation pays corporate tax on its profits. Then, when these profits are given as dividends, the shareholders pay income tax on them. This is “double taxation.” As an S corp, this is different. The profits and losses pass through to the owners’ personal tax returns. These pass-through profits are treated as distributions, not dividends. This method avoids double taxation. Shareholders pay income tax on their pro-rata share of the corporation’s profits, reported on a Schedule K-1.

Understanding the dividend tax and the corporate tax rate is crucial for business owners, and consulting with a CPA or tax lawyer can help.

Non-Dividend Distributions and Their Tax Implications

A non-dividend distribution is a payment made by a corporation to its shareholders that is not from the corporation’s current or accumulated profits. This is a return of capital, essentially giving back part of the shareholder’s original investment. A non-dividend distribution reduces the cost basis (the amount originally paid for the shares). The amount of non-dividend distributions received that exceeds the original cost basis is reported as a sale or exchange of an asset on Schedule D of the shareholder’s return. The gain reported will equal the distribution received minus the shareholders’ cost or basis in the stock. The gain will be long-term or short-term, depending on whether the shareholder held the stock for a year or more.

Taxpayers often receive dividends from mutual funds. These dividends are categorized as ordinary dividends or capital gain dividends. The characterization of the dividends reflects the investment activity of the mutual fund. Ordinary dividends are reported on Schedule B as ordinary income.

Capital gain dividends are reported on Schedule D as long-term capital gain income. Certain credit unions report interest income as dividend income. However, dividend income from credit unions should be reported as interest income on Schedule B.

Contact an Attorney to Learn More About Shareholders, Dividends, and Taxes

Even an honest mistake about dividends or cash distributions to shareholders can have serious consequences. Luckily, you can contact an experienced tax law attorney who can help sort out your taxes and ensure you comply with the law.