S corporation shareholders are taxed on their share of the corporation’s profits, not necessarily their distributions. Distributions that are not dividends are considered a return of capital. Profit or loss from the corporation is included in the shareholder’s basis, and any distributions would decrease the shareholder’s basis. The shareholder would be taxed on distributions that exceed the amount of their basis as a capital gain on Schedule D.
Dividend distributions, however, are paid out of profits and earnings, and therefore would be taxed as ordinary income unless they meet the requirements to be taxed as a capital gain.