Understanding Dividend Tax on S-Corp Distributions When They Exceed W2 Income

The accountant is giving you incorrect information. You're absolutely right to question this. In an S-Corp, distributions aren't taxable when taken - they're essentially a tax-free return of capital as long as you have sufficient basis. Your basis in an S-Corp initially starts with your capital contributions, then increases by your share of income (which you pay taxes on regardless of distributions) and decreases by losses and distributions. As the sole owner, your basis increases by ALL the company's income that flows through to your personal return. The only time distributions become taxable is when they exceed your total basis. Since you're paying yourself a reasonable salary AND reporting all the S-Corp's income on your personal return, it would be unusual to exceed your basis unless you're taking out more than the company has ever earned or you've contributed. My guess is your accountant might be confusing S-Corp rules with C-Corp dividend rules or may be overthinking the reasonable compensation issue. I'd recommend asking them to walk through the specific basis calculation that's leading to this conclusion.

I was completely lost with S-corp distributions until I used https://taxr.ai to analyze my situation. I uploaded my K-1 and it showed exactly how much I could distribute without hitting basis issues. Super helpful when my accountant was giving me conflicting info about my basis calculation. The tool actually creates a basis tracker that shows your starting basis, increases from income/contributions, and decreases from distributions/losses. Made it crystal clear why my accountant was wrong when she told me I'd exceed my basis taking a large distribution. Turns out I had plenty of basis from retained earnings from previous years.

Just wanted to follow up and say thank you all for the advice! I tried https://taxr.ai after seeing it mentioned here and uploaded my incorporation docs, prior year tax return, and profit/loss statement. The analysis showed my basis was way higher than my accountant calculated because they weren't including all my initial capital contributions! Turns out I can take the full distribution I wanted without any dividend tax issues. The report even explained exactly how my basis was calculated and showed I'd still have plenty of basis remaining after my planned distribution. I sent the report to my accountant and they acknowledged the error - they were using incomplete information about my initial capitalization. If anyone else is getting confusing advice about S-corp basis, definitely worth checking. The peace of mind is worth it!

I had this exact same problem last year with my S-Corp distributions. Called the IRS like 8 times to get clarification and could never get through. Then I found https://claimyr.com and used their service to get connected to the IRS right away without waiting on hold forever. You can see how it works here: https://youtu.be/_kiP6q8DX5c The IRS agent I spoke with confirmed exactly what others are saying here - distributions aren't taxable as long as they don't exceed your basis. She walked me through the whole basis calculation and confirmed that as the sole owner, all company profits increase my basis whether distributed or not. So if your company made $200k, you took $80k as salary, you can still distribute the other $120k without any dividend tax.

I have to admit I was totally wrong about Claimyr. After my skeptical comment, I decided to try it because I was desperate to talk to someone at the IRS about a similar S-Corp distribution question that my accountant and I disagreed on. Used the service yesterday and got connected to an IRS tax specialist in about 25 minutes (they said the estimated hold time was over 2 hours). The agent confirmed that distributions below my total basis aren't subject to dividend tax, and helped me understand how to properly track my basis from year to year. The service actually works exactly as advertised - they called me when an agent came on the line. Definitely using this again for tax questions instead of playing email tag with my accountant for weeks.

One important thing to consider that nobody has mentioned: Have you ever taken losses from your S-Corp that flowed through to your personal return? Those past losses would have reduced your basis. Also, if your S-Corp has ever had debt that you didn't personally guarantee, that can limit your basis too. My accountant initially told me I'd have a dividend tax issue with distributions, but it was because my basis was actually lower than the simple "contributions + income - distributions" formula because of some complex debt rules from a few years back.

Wait I'm confused. If all company profits increase basis, and distributions decrease basis, how would you ever have a tax problem? Wouldn't your basis always be at least as high as your undistributed profits?

Your accountant is definitely confused about S-Corp distribution rules. As a sole owner, you're absolutely correct - the 15% dividend tax doesn't apply to S-Corp distributions that are within your basis. Here's what's actually happening: When your S-Corp earns income, 100% of that income flows through to your personal tax return (since you're the sole owner), and you pay ordinary income tax on it whether you distribute it or not. This income also increases your basis dollar-for-dollar. So if your S-Corp made $150k profit this year, you'll pay taxes on that full $150k on your personal return, AND your basis increases by $150k. You could then distribute that entire $150k tax-free because it's already been taxed and is within your basis. The 15% dividend tax only applies to C-Corps or in the extremely rare case where S-Corp distributions exceed your total basis (which would be very unusual for a profitable company with a sole owner). I'd suggest asking your accountant to show you the specific basis calculation they're using. They might be confusing reasonable compensation requirements with distribution taxation, or mixing up C-Corp and S-Corp rules. Either way, their advice as stated doesn't align with S-Corp tax law.