Yes, but not in the way you might think. A company can’t send you a bill instead of a check. A “negative” distribution happens when taking money out of your company creates negative results, like a surprise tax bill on your personal return or a negative balance in your company’s equity accounts.
The primary conflict comes from a disconnect between your company’s accounting books and the IRS tax code. Specifically, Internal Revenue Code § 1368 for S-Corporations and § 731 for partnerships create a rule where a distribution you think is tax-free becomes taxable if it exceeds your “basis”—your total after-tax investment. This mistake is incredibly common, with studies showing that a significant percentage of S-Corporation returns have errors, many related to basis and distribution reporting.
This article will give you the knowledge to navigate these complex rules.
- 💰 You will learn the critical difference between your company’s “retained earnings” and your personal “tax basis,” the number that truly governs tax-free distributions.
- ⚖️ You will understand the completely different rules for S-Corps, C-Corps, and Partnerships, and why you can’t apply the logic of one to another.
- 🚨 You will see real-world scenarios of how business owners accidentally trigger huge tax bills and learn the specific steps to avoid those traps.
- 📝 You will get a line-by-line breakdown of the tax forms involved, like the K-1 and 1099-DIV, so you know exactly what the numbers mean.
- 🛡️ You will discover the absolute legal lines you cannot cross and how to protect yourself from personal liability for improper distributions.
The Great Divide: Your Company’s Books vs. The IRS Rulebook
The single biggest mistake business owners make is looking at the company bank account and thinking that cash is available to be taken out tax-free. Your accounting software, like QuickBooks, operates in a world of debits and credits, not tax law. The IRS has its own, completely separate set of rules.
To understand distributions, you must first understand the language of your balance sheet’s equity section. Shareholder Equity is the value of the business that belongs to the owners. It’s calculated as Assets – Liabilities = Equity.1
This equity is made up of a few key parts:
- Paid-In Capital: This is the actual money owners invested to buy stock in the company.1 Think of it as the initial buy-in.
- Retained Earnings: This is the running total of all profits the company has made and kept over the years, after paying taxes and any past dividends.4 When this number is negative from accumulated losses, it’s called an “accumulated deficit”.4
- Treasury Stock: This is stock the company bought back from shareholders. It’s subtracted from total equity.1
When these parts add up to a negative number, it’s called a shareholder deficit, which means liabilities are greater than assets—a serious sign of financial trouble.7
Why Your “Retained Earnings” Can Lie to You
You might see a healthy retained earnings balance and assume any distribution is a payout of profits. Or you might see a negative balance (an accumulated deficit) and assume any distribution must be a tax-free return of your original investment. Both assumptions can be dangerously wrong because of two specific tax concepts.
| Concept Comparison | Accounting View (What you see in QuickBooks) | Tax View (What the IRS sees) |
|—|—|
| C-Corporation Metric | Retained Earnings: The company’s lifetime book profits, calculated using standard accounting rules (GAAP).11 | Earnings & Profits (E&P): A special tax calculation that determines if a distribution is a taxable dividend. It starts with taxable income and makes many adjustments, so it rarely matches retained earnings.13 |
| S-Corp / Partnership Metric | Owner’s Equity / Capital Account: The owner’s stake as shown on the company’s books. A partner’s capital account can go negative.15 | Shareholder/Partner Basis: Your personal, after-tax investment in the business. This is like your “tax checking account” with the company and it can never go below zero.17 |
This difference is the source of almost all distribution-related tax problems. A C-Corp with a huge accumulated deficit can still pay a fully taxable dividend.13 An S-Corp with tons of cash can make a fully taxable distribution to an owner whose basis is zero.19
The Different Flavors of Distributions
The IRS classifies money taken from a company in several ways, and each has a different tax treatment.
- Dividend: This is a term specifically for C-Corporations. It’s a distribution paid from the company’s “Earnings & Profits” (E&P) and is taxable to the shareholder.13
- Return of Capital (ROC): This is a tax-free distribution. It means you are getting a piece of your original investment back. An ROC reduces your investment basis; it’s not taxed until your basis hits zero.22
- Distribution in Excess of Basis: This happens in S-Corps and Partnerships when you take a distribution that is larger than your basis. The amount up to your basis is a tax-free ROC, but the excess amount is taxed as a capital gain.19
- Liquidating Distribution: This is a final payment made when a company is shutting down completely. It’s treated as if you sold your stock, resulting in a capital gain or loss.26
Your “Tax Checking Account”: The Magic Number Called Basis
For owners of S-Corporations and Partnerships (including most LLCs), “basis” is the most important number you’ve probably never looked at. Think of it as your personal tax-related checking account with your business.17
Your share of company profits and any new money you invest are deposits. Distributions you take are withdrawals. As long as you have a positive balance, your withdrawals (distributions) are tax-free. When your balance hits $0, any further withdrawal is taxed as a capital gain, like an overdraft fee.19
How to Calculate Your S-Corporation Stock Basis
Your basis is not tracked on the company’s books; it is your personal responsibility to track it every single year.30 The IRS requires a specific order for the calculation. Getting this order wrong is a very common and expensive mistake.17
| Step | Action | Simple Explanation |
| 1 | Start of Year Basis | Your basis from the end of last year. |
| 2 | Add Income & Contributions | Add your share of all company income (taxable and tax-exempt) and any new cash you invested this year. |
| 3 | Subtract Distributions | Subtract any distributions you took during the year. This is your tax-free limit. Your basis cannot go below zero here.17 |
| 4 | Subtract Losses & Deductions | Finally, subtract your share of any company losses or deductions. |
| 5 | End of Year Basis | This is your new basis. If losses were bigger than your remaining basis, those losses are “suspended” and carry over to next year.17 |
A huge mistake is subtracting losses before distributions.33 This incorrectly lowers the amount you can take out tax-free and could cause you to pay capital gains tax when you didn’t need to.
The Loan Guarantee Trap: A Common S-Corp Mistake
S-Corp owners have a second type of basis called “debt basis.” This is created only when you personally lend money directly to your company.17 This debt basis allows you to deduct more company losses if your stock basis is already zero.
The trap is that personally guaranteeing a bank loan for your S-Corp does not create debt basis.17 The loan must be directly from you to the company. Furthermore, distributions can’t be made tax-free against your debt basis. A distribution taken when your stock basis is zero is taxable, no matter how much debt basis you have.25
The Partnership/LLC Difference: Why Debt is Your Friend
Partnerships and LLCs have a similar basis concept called “outside basis,” but with one massive difference: a partner’s outside basis includes their share of the partnership’s debts.15 This is a game-changer and is why this structure is so popular for debt-heavy industries like real estate.
On the company’s books, you have a “capital account,” which is just your contributions plus profits minus distributions. This capital account can go negative, often when you take distributions funded by debt.15 But your “outside basis,” the number for taxes, stays positive because it gets boosted by your share of the company’s loans. This allows you to receive large, tax-free cash distributions even while your book capital account is deeply negative.
Real-World Scenarios: How Good Intentions Lead to Bad Tax Outcomes
The rules are abstract, but the consequences are very real. Here are three of the most common ways business owners get into trouble with distributions.
Scenario 1: The S-Corp “Cash-Rich, Basis-Poor” Trap
An entrepreneur, Sarah, starts an S-Corp with a $10,000 investment, giving her a $10,000 stock basis. In her first year, she finances a $60,000 truck and, on her accountant’s advice, takes a large bonus depreciation deduction. This creates a big “paper loss” for tax purposes, which reduces her stock basis to $0.20
The next year, her business is doing well and gets a $100,000 line of credit from a bank, which Sarah personally guarantees. Seeing over $100,000 in the business bank account, she takes a $50,000 distribution for a home renovation, assuming it’s tax-free because the business has plenty of cash.
| Sarah’s Action | The Painful Tax Consequence |
| Takes a $50,000 distribution, believing the cash is from the business loan and profits. | The bank loan, even with her guarantee, does not increase her stock basis.17 Since her stock basis was $0, the entire $50,000 distribution is “in excess of basis.” It is taxed as a long-term capital gain, resulting in an unexpected $10,000 tax bill (assuming a 20% rate).19 |
Scenario 2: The C-Corp “Nimble Dividend” Surprise
A C-Corporation has a long history of losses, resulting in a negative retained earnings (accumulated deficit) of ($500,000). This year, the company finally turns a profit and has positive current “Earnings & Profits” (E&P) of $100,000 for tax purposes.13
The board of directors, looking at the half-million-dollar deficit on the books, believes the company is still “in the red.” They decide to reward shareholders with a $75,000 distribution, telling them it’s a tax-free return of capital because there are no cumulative profits.
| The Board’s Decision | The Shareholder’s Tax Reality |
| Authorize a $75,000 distribution, assuming it’s a tax-free return of capital due to the large accumulated deficit. | The IRS’s “nimble dividend rule” ignores the accumulated deficit. It states that if there is positive current E&P, any distribution is a taxable dividend up to the amount of that current E&P.13 The entire $75,000 is a taxable dividend, creating a surprise tax liability for every shareholder. |
Scenario 3: The Real Estate LLC and the “Good” Negative Balance
An investor, Tom, puts $100,000 into a real estate LLC to buy an apartment building. The LLC gets a $4 million mortgage to complete the purchase. Tom’s initial “capital account” on the LLC’s books is $100,000. His “outside basis” for tax purposes, however, is his $100,000 cash plus his share of the mortgage (let’s say $1 million), for a total of $1.1 million.15
Over a few years, the LLC generates large depreciation losses, and Tom’s share is $300,000. These losses reduce his capital account to a negative ($200,000). However, they only reduce his outside basis to a still-positive $800,000. The LLC then refinances the mortgage and gives Tom a $500,000 cash distribution.
| Tom’s Move | The Deferred Tax Consequence |
| Receives a $500,000 cash distribution from the refinancing. | The distribution is completely tax-free because his outside basis ($800,000) is greater than the cash received. However, the distribution drives his capital account on the books much deeper into negative territory, to ($700,000). This negative capital account isn’t a debt he owes, but it represents a future tax bill. It’s a measure of the tax-deferred cash he has received, which will be “recaptured” as a taxable gain when he eventually sells his interest in the LLC.16 |
The Absolute Legal Limit: You Can’t Distribute from an Insolvent Company
Beyond the tax rules, there are hard legal limits on distributions designed to protect the people your company owes money to (creditors). State corporate laws, such as the influential Delaware General Corporation Law § 170, establish a “solvency test” .
This test generally forbids a company from making any distribution if:
- The company can’t pay its bills as they come due (the “equity insolvency” test).36
- The company’s total liabilities are greater than its total assets (the “balance sheet insolvency” test).37
Making a distribution that renders the company insolvent is illegal. The consequences are severe and fall directly on the company’s directors.
The Ultimate Risk: Directors Can Be Held Personally Liable
If a board of directors approves a distribution that violates the solvency test, they can be held personally, jointly, and severally liable for the entire amount of the unlawful distribution.39 This means creditors can sue the directors personally to get that money back.
This liability comes from a breach of the directors’ fiduciary duty of care.37 Approving a distribution without carefully checking the company’s financial health is a negligent act. Under laws like Delaware Code § 174, directors who were absent from the vote or who formally recorded their dissent in the meeting minutes can be protected from this liability .
What Happens in a Liquidation? Shareholders Are Last in Line
If a company becomes insolvent and must be liquidated (e.g., in a Chapter 7 bankruptcy), the concept of shareholder distributions is irrelevant. All company assets are sold, and the cash is paid out to claimants in a strict order of priority, often called the “priority waterfall”.27 Shareholders are at the very bottom.
The typical payment order is:
- Secured Creditors: Lenders with collateral, like a bank with a mortgage on the company’s building.43
- Priority Unsecured Creditors: Includes employees owed wages and the government for unpaid taxes.44
- General Unsecured Creditors: Suppliers, vendors, and other lenders without collateral.44
- Shareholders: They get whatever is left. In most liquidations, this amount is zero.43
Decoding Your Tax Forms: Where Distributions Show Up
Understanding your annual tax forms is key to spotting potential issues. The numbers on these forms are the starting point for figuring out the tax consequences of your distributions.
For S-Corp and Partnership Owners: The Schedule K-1
If you own an S-Corp or a partnership/LLC, you will receive a Schedule K-1 each year. This form reports your share of the company’s income, deductions, and credits.
- S-Corporation K-1 (Form 1120-S): Look at Box 16, Code D. This box reports the total “Property distributions” you received during the year.
- Partnership K-1 (Form 1065): Look at Box 19, Code A. This box reports the total “Distributions” you received.
Crucially, the number in this box is NOT your taxable income. It is simply the total cash or property you took out. It is your job to compare this number to your personally-tracked basis to determine if any part of it is a taxable capital gain.19 The IRS now requires many S-Corp shareholders to file Form 7203 with their personal tax return to formally calculate and report their stock and debt basis, increasing scrutiny on this issue .
For C-Corp Owners: The Form 1099-DIV
If you own stock in a C-Corporation, you will receive a Form 1099-DIV if you received a distribution. This form is much more direct about the tax consequences.
- Box 1a, “Total ordinary dividends”: This amount is a taxable dividend. It means the company paid it from its Earnings & Profits (E&P). This amount is taxable income to you.46
- Box 3, “Nondividend distributions”: This amount is a tax-free Return of Capital (ROC). It means the company did not have E&P to cover this portion of the payment. This amount is not taxed immediately; instead, it reduces your stock basis.48
If you receive an amount in Box 3, you must reduce your cost basis in the stock. If Box 3 distributions eventually reduce your basis to zero, any further “nondividend distributions” will be taxed as a capital gain.48
Mistakes to Avoid: Common Distribution Blunders
Mismanaging distributions can create conflict, cash flow problems, and attract IRS scrutiny. Here are some of the most common and damaging mistakes.
- S-Corps: Paying No Salary or an Unreasonably Low One. The IRS requires S-Corp owners who work in the business to receive a “reasonable salary” before taking distributions. Paying yourself a tiny salary and taking all the profits as distributions to avoid payroll taxes is a major red flag that can cause the IRS to reclassify your distributions as wages, hitting you with back taxes and penalties.49
- S-Corps: Making Disproportionate Distributions. S-Corps must have only one class of stock, which means all distributions must be paid pro-rata based on ownership percentage. If you own 60% of the stock, you must get 60% of the total distribution. Giving one owner a special payment can be seen by the IRS as creating a second class of stock, which can terminate your S-Corp status and convert the company to a C-Corp, creating a tax disaster.49
- Partnerships: Not Having a Clear Agreement. Operating without a formal partnership or operating agreement is a recipe for disaster. A clear agreement should define how and when distributions are made, preventing disputes over unequal payouts or a lack of transparency .
- All Entities: Confusing Cash in the Bank with Tax-Free Distribution Capacity. This is the core mistake. Cash from a loan or from customer prepayments does not create basis or E&P. Taking that cash out can easily trigger a taxable event.20
- All Entities: Failing to Track Basis from Day One. Basis is a cumulative number. If you don’t track it from the very beginning, trying to reconstruct it years later is a nightmare. This failure often leads to overpaying taxes on a sale or incorrectly reporting distributions as taxable.18
Do’s and Don’ts for Managing Shareholder Distributions
| Do’s | Don’ts |
| ✅ Maintain a detailed basis schedule for each owner, updated annually. This is your single most important tool for tax planning and compliance.18 | ❌ Don’t assume the “Retained Earnings” on your balance sheet dictates taxability. This is an accounting number; the IRS uses E&P (for C-Corps) or basis (for S-Corps/Partnerships).13 |
| ✅ Pay a reasonable salary to S-Corp shareholder-employees before taking distributions. Document how you determined the salary was reasonable based on industry data.50 | ❌ Don’t make disproportionate distributions in an S-Corp. All distributions must be proportional to stock ownership to avoid risking your S-Corp status.54 |
| ✅ Consult a tax professional before making a large or unusual distribution. A pro-forma calculation can tell you the tax impact in advance, preventing surprises.19 | ❌ Don’t personally guarantee a company loan and assume it gives you basis in an S-Corp. It doesn’t. The loan must be directly from you to the company to create debt basis.17 |
| ✅ Formally document all shareholder loans to your S-Corp with a promissory note. This is essential to prove the existence of debt basis.30 | ❌ Don’t make distributions if the company is insolvent or might become insolvent. This exposes directors to personal liability to the company’s creditors.39 |
| ✅ Have a clear, written partnership or operating agreement. This document should explicitly state the rules for profit allocation and distributions to prevent internal disputes.25 | ❌ Don’t treat the business bank account like your personal piggy bank. Commingling funds can lead to unintended distributions and other legal problems.34 |
FAQs: Quick Answers to Common Questions
Yes or No, then a maximum of 35 words.
My S-Corp K-1 shows a distribution. Is this automatically taxable income?
No. The distribution is tax-free as long as it does not exceed your stock basis. You are responsible for tracking your basis to determine if any portion is taxable as a capital gain.
Can my business partner and I take different distribution amounts from our S-Corp?
No. S-Corporation distributions must be proportional to ownership. Unequal distributions can risk terminating your S-Corp status. A bonus or salary adjustment is the proper way to pay one owner more for their work.
My partnership’s books show I have a negative capital account. Do I owe the company money?
No, not usually. A negative capital account is an accounting entry, often from debt-financed distributions or large paper losses like depreciation. It represents a potential future tax liability, not a current debt to the partnership.
Can a C-Corp pay a taxable dividend even if it has a history of losses?
Yes. Under the “nimble dividend rule,” if the company is profitable in the current year (has positive current E&P), it can pay a taxable dividend, even if it has a large accumulated deficit from prior years.
If I guarantee a bank loan for my S-Corp, can I take a tax-free distribution against it?
No. Guaranteeing a loan does not increase your stock basis, which is the limit for tax-free distributions. The distribution would likely be a taxable capital gain if you have no other basis.
What happens if I take a distribution that’s more than my S-Corp basis?
The portion of the distribution that exceeds your basis is treated as a capital gain on your personal tax return. It is generally a long-term capital gain if you have held the stock for over a year.