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.

A dividend is a distribution of cash or property by a corporation to a shareholder paid out of the corporation's current or accumulated earnings and profits. Congress has not provided a comprehensive definition of 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 sale or exchange of property.

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. Also, in a small business, especially in sole proprietorship or S corps, what looks like a dividend may be a draw or a salary. Business owners need to do proper bookkeeping to identify these correctly.

Taxation of Shareholder Distributions

Dividends are taxable to a shareholder as ordinary income. Corporations issue shareholders an annual Form 1099 Dividend, 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. This method avoids double taxation. Shareholders must report dividend payments on their tax returns and pay income tax on their personal tax rate.

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

Nondividend Distributions and Their Tax Implications

Suppose an individual receives a distribution from a corporation that does not qualify as a dividend. In that case, the amount received 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. 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.