Most small businesses these days operate as S corporations. Owners of these small businesses are generally aware of the tax savings from operating as an S corporation, namely, reduced Social Security and Medicare taxes.
However, some small businesses still operate as C corporations. You may be operating a C corporation for a variety of reasons. Maybe you don’t meet the requirements to be taxed as an S corporation. Maybe you have a net operating loss from the C corporation (which wouldn’t carry over to the S corporation).
Whatever the reason, you probably generally understand that when the corporation distributes money to you, it gives you a Form 1099-DIV which reports the distribution as a dividend. You then include the dividend income from the Form 1099-DIV on your personal tax return and bitterly recognize that you’ve been double taxed on your work – first the corporation’s income tax and second your personal income tax from the dividend income.
However, before you go ahead and have the corporation issue a 1099-DIV and include it in your income, you may want to review whether that distribution you received is in fact a dividend.
C corporation dividends – What’s the difference between a distribution and a dividend
It’s simple. A dividend is always a distribution but a distribution is not necessarily a dividend.
A distribution is a transfer of money from a corporation (or an LLC) to its owners. That distribution could generally be one of two things – 1) a distribution of the corporation’s earnings, or 2) a return of your investment.
If you have an investment account, you generally understand you include dividend income reported on Form 1099-DIV that you receive from your Charles Schwab or Morgan Stanley account. Sometimes, that 1099-DIV includes an amount in Box 4 for Nondividend distributions. If you’ve prepared your own taxes, you’ll know that nondividend distributions are not included in your income.
What are nondividend distributions?
It’s pretty simple to understand what nondividend distributions are if you understand a core tax principle, which is so simple that most people don’t think they already knew it until they know it.
You don’t pay taxes on it if you didn’t earn it. When you invest money into property, you sell the property for the same price of your investment, you have no gain. You didn’t earn anything. The selling price could be substantial, but none of it is taxable if you didn’t earn anything.
The same applies to corporations. When you invest money into the corporation and then the corporation pays you back the amount you invested, that amount is not dividends. It’s a return of your investment. It’s a non dividend distribution.
That seems simple
The concept is simple, but the application of the principal that a return of your investment is not taxable can be complicated for a C corporation. You have to calculate the amount of the corporation’s accumulated earnings, which will not equal the retained earnings balance on your balance sheet. Then, there are ordering rules for determining whether a current year distribution is from those accumulated earnings or from your investment in the company. It can be a mess to figure, but it could certainly be worth the time if you’ve invested a substantial amount into your corporation.