S Corp Distributions: How to Record Them and Tie Schedule L

How do I record an S corp distribution in the books?

The journal entry for a cash distribution from an S corporation is a debit to a shareholder distributions account in equity and a credit to cash, dated the day the corporation pays it. The profit and loss statement does not change. Owners often call this a draw or a dividend; the books call it a distribution, and a tax "dividend" is narrower (explained below). Account names are bookkeeping practice, not IRS rules. Property is covered further down.

A distribution is money or property paid to an owner because the owner holds stock. It is not a cost of earning income, so it stays out of expenses; the return reports it on Schedule K, line 16d, not as a deduction (Form 1120-S instructions). Date it on the payment date; for the distribution rules in section 1368, the regulations take a distribution into account on the date the corporation makes it.

Keep one account, or one sub-account, per shareholder. Each Schedule K-1 shows that shareholder's own distributions.

A case is not simple when:

• The owner took distributions but no salary.
• Amounts differ between shareholders.
• Distributions were more than profit.
• The balance sheet does not tie to last year's Schedule L.
• Personal bills were paid from the company account.
• The corporation was once a C corporation.

Each of these can mean the entries need restating, or the tax answer changes, before a preparer can finish the return.

Gather:

• Bank statements for the whole year
• The ledger detail for distributions and retained earnings
• Last year's Schedules L and M-2
• Each shareholder's Schedule K-1
• Payroll reports
• Who owns how many shares, and from what date

Is it a distribution, wages, a reimbursement or a loan?

Money is a distribution when it is paid to a shareholder because of the stock the shareholder owns. Pay for work is wages, repayment of a business cost is a reimbursement, and money the owner must pay back is a loan. Each is booked and reported differently.

Reasonable wages come before distributions. The IRS says an S corporation must pay reasonable compensation to a shareholder-employee before non-wage distributions, and it can reclassify distributions as wages. A reimbursement is not wages when it follows accountable plan rules; see reimbursing owner expenses.

Health insurance premiums the corporation pays for a shareholder who owns more than 2% of the stock or voting power are not distributions either. The corporation deducts them and reports them as that owner's wages on Form W-2; see health insurance for owners.

If losses earlier reduced the shareholder's basis in a loan, part of a repayment can be taxable (Schedule K-1 instructions, code E). See shareholder loans to an S corporation.

Whether a personal bill the company paid is a distribution, wages or a loan depends on the facts. See S corporation paying personal expenses.

How do I close the distributions account into retained earnings?

At year-end, debit retained earnings and credit the distributions account for its full balance. Ending retained earnings then equals beginning retained earnings plus net income minus distributions. Accounting software often runs this close itself; check the result instead of assuming it.

• The distributions account starts the new year at zero.
• Schedule L shows retained earnings on line 24, not a distributions account (Form 1120-S).
• Net income per books is the same whether distributions were small or large.

Why are S corp distributions throwing off my balance sheet and Schedule L?

A distribution recorded correctly lowers cash and equity by the same amount, so the balance sheet still balances. Retained earnings falls with it and goes negative when distributions and losses exceed income; that is arithmetic, not an error. A Schedule L that no longer ties usually comes from how an entry was recorded, because the Schedule L balance sheet should agree with the corporation's books and records.

If the balance sheet still does not tie, or you are tempted to force it with the equity adjustments line, see Schedule L will not balance.

Are distributions in excess of retained earnings a problem, and how is that different from basis?

Negative retained earnings is a books result: over the period the books cover, distributions and losses together have exceeded income. It is not a tax event by itself. Tax on a distribution turns on the shareholder's stock basis, which starts with what the shareholder paid or contributed for the stock (shares received by gift or inheritance start from other rules) and then moves with the company's income, losses and distributions. For an S corporation with no accumulated earnings and profits (the tax measure of profit left from years as a C corporation), a distribution is not taxed up to stock basis, and the excess is treated as gain from selling property.

Three numbers get mixed up:

Distributions reduce stock basis only to zero (Schedule K-1 instructions) and the accumulated adjustments account only to zero too, though losses can make it negative (Schedule M-2 instructions). The three differ because they measure different things. The IRS says the shareholder, not the corporation, is responsible for tracking stock basis, but the books supply the distributions and income it is built from. A shareholder who receives a non-dividend distribution files Form 7203 with their own return. See S corporation shareholder basis.

Two more rules can affect a payout, outside the books. A corporation that was once a C corporation may have accumulated earnings and profits. Distributions then come from the accumulated adjustments account first, unless the corporation elects, with all affected shareholders' consent, to distribute earnings and profits first (a statement attached to a timely filed original or amended Form 1120-S for that year; it applies to that year only and cannot be revoked). The part that is a dividend up to those earnings is taxed even when stock basis is high. State law also limits distributions, and it differs by state; for example, Delaware allows dividends out of surplus as its statute defines it or, if there is none, out of net profits of the current or preceding fiscal year. A Delaware director who willfully or negligently approves an unlawful dividend is personally liable to the corporation, and to its creditors if it is dissolved or insolvent, for 6 years after payment. For negative equity in any entity type, see negative owner's equity.

Where do distributions show on Form 1120-S and the K-1?

Distributions flow to Schedule K, each Schedule K-1, Schedule L through retained earnings, and Schedule M-2. Every one of them should come from the same ledger.

Sources: Form 1120-S instructions, Form 1120-S and Schedule K-1 instructions.

Does a small S corporation still have to complete Schedule L?

A small S corporation does not have to complete Schedules L and M-1 if it answers Yes to Schedule B, question 11. That requires total receipts for the year and total assets at year-end to both be under $250,000 (Form 1120-S). Total receipts for this question count more than sales; the question 11 instructions list the lines.

Schedule M-2 is not in that exemption. The M-2 instructions say a corporation with accumulated earnings and profits must maintain the accumulated adjustments account and recommend that every S corporation maintain it. The books should still produce a year-end balance sheet, because that is where retained earnings and shareholder loans are tracked.

How do I record a distribution of property instead of cash?

A property distribution is any payment to a shareholder that is not cash, such as equipment, a vehicle or securities. The return values appreciated property at fair market value, and the corporation recognizes gain if the property is worth more than its tax basis.

• On the return: line 16d asks for a statement with the date acquired, the date distributed, the fair market value on that date and the corporation's basis.
• Amount: the distribution is counted at the property's fair market value, before the liability rules below. That value is also the shareholder's basis in the property (section 301).
• Gain: the corporation recognizes gain as if it sold the property at fair market value; subchapter C rules apply to an S corporation except where the S rules differ. That gain passes through to the shareholders with the character it would have had on a sale, so gain on depreciated equipment can be ordinary income. Stock basis is figured with the year's income increase before the distribution is tested.
• Loss: when the property is worth less than its tax basis, no loss is recognized.

One common way to book it, when the books follow fair value:

Books kept on another basis may record the property at its carrying value with no gain. The return uses fair market value and the corporation's tax basis either way, so the entry and the return can differ. Property with a loan on it follows special rules for liabilities, and a corporation within 5 years of its S election (or of acquiring assets at a C corporation's carryover basis) may owe built-in gains tax on property that gained value while it was a C corporation. These need a preparer before the entry is final.

What if distributions were unequal, or I took distributions but no salary?

Distributions should follow share ownership. An S corporation can have only one class of stock, which means all shares must carry identical rights to distribution and liquidation proceeds under the corporation's governing documents. Book each shareholder's distribution separately and compare it with ownership. State income tax the corporation pays or withholds for particular shareholders, such as nonresident owners, counts as a constructive distribution to them; if every share still has identical rights once those payments are counted, a difference in timing does not create a second class of stock (26 CFR 1.1361-1(l)(2)(ii)). Unequal amounts need a preparer's review before the return; see unequal S corporation distributions, which covers the effect on the S election.

Distributions with no salary are a separate trap. The Form 1120-S instructions say distributions and other payments to an officer must be treated as wages to the extent they are reasonable compensation. Calling the money a distribution in the books does not settle it. See how much salary to pay yourself and S corporation payroll never run.

What records should I keep for each distribution?

Keep enough to show who was paid, how much, when and what it was.

• The date paid, the shareholder, the amount and the bank record
• Whether it was cash or property; for property, the dates, the fair market value support and the corporation's basis
• Any written approval the corporation's governing documents require
• The running ledger by shareholder, each K-1, and the prior-year Schedules L and M-2

Keep records that support a return item, usually for 3 years from the later of the due date or filing of each shareholder's return. Keep records that verify the corporation's basis in property as long as needed to figure the basis of the original or replacement property (Form 1120-S instructions). The distribution ledger, each K-1 and prior Schedules L and M-2 feed balances that carry forward, so they may be needed longer: the instructions say to keep the corporation's records for as long as they may be needed for any provision of the Internal Revenue Code. Each shareholder is responsible for keeping the information needed to figure stock basis.

Example

These examples are illustrative, in US dollars.

Monthly distributions

An owner who is already paid a salary through payroll also takes $5,000 a month in distributions from an S corporation. Each month the books show debit Shareholder Distributions $5,000, credit Cash $5,000, twelve entries in all. At year-end $60,000 is closed to retained earnings. The profit and loss statement is the same as it would be with no distributions.

Distributions larger than profit

A one-owner S corporation earns $50,000 and distributes $80,000. Retained earnings falls by $30,000. If it started the year at $20,000, it ends at negative $10,000 ($20,000 plus $50,000 of income, minus $80,000 of distributions). The tax answer comes from stock basis, assuming no accumulated earnings and profits from C corporation years. The year's $50,000 of income raises basis before the distribution is tested. If the owner started the year with $50,000 of basis, basis after that income is $100,000 and the $80,000 is tax-free. If the owner started with no basis (book and tax numbers can differ), basis after that income is $50,000: $50,000 is tax-free and the other $30,000 is capital gain. Retained earnings is negative in both cases.

Two shareholders, 60/40

Two shareholders own 60 percent and 40 percent. A $10,000 distribution is booked as $6,000 and $4,000. If each is paid $5,000, the amounts no longer follow ownership, and a preparer needs to review them before the return.

Different for you?

• Your distributions were more than profit, unequal or paid without payroll, or the balance sheet will not tie to last year's Schedule L: how to restate the entries, what each owner's basis and the accumulated adjustments account really are, and whether a filed return needs amending are professional questions. See S corporation bookkeeping help and corporate tax help.
• Distributions did not follow ownership, or you took them without running payroll: see unequal S corporation distributions and S corporation payroll never run.
• You took more than your basis, or need your basis worked out: see distributions in excess of basis and S corporation shareholder basis.
• The company paid your personal bills or taxes: see S corporation paying personal expenses.
• The books are months behind, or you want the whole set kept: see S corporation catch-up books and S corporation bookkeeping.
• The corporation was a C corporation before, or an LLC just elected S status: see switching a C corporation to an S corporation and books after an S corporation election.
• You are an LLC or sole proprietor, not an S corporation: see recording an owner's draw.
• An owner lives in Canada: see US S corporation owner in Canada.