S Corporation Taxation

Why this topic matters

An S corporation is a corporation under state law that elects to be taxed like a pass-through entity: income flows to shareholders and is taxed once. Taxation and Regulation (REG) tests eligibility, the election and its termination, allocation of income, shareholder basis and loss limits, distributions, and the entity-level taxes that can still apply.

Eligibility

• Domestic corporation (not an ineligible corporation such as a bank using the reserve method or an insurance company).
• No more than 100 shareholders — members of a family (up to six generations from a common ancestor) and their spouses count as one shareholder.
• Shareholders must be individuals (US citizens or residents), estates, certain trusts (grantor trusts, qualified subchapter S trusts, electing small business trusts), and certain tax-exempt organizations (charities, qualified retirement plans).
• No nonresident alien, partnership, or C corporation shareholders.
• One class of stock — all shares have identical rights to distributions and liquidation proceeds. Differences in voting rights are allowed.

Making and ending the election

• File Form 2553 with the consent of all shareholders on the date of the election (and all who held shares earlier in the year if it is to be effective that year).
• To be effective for the current year, file by the 15th day of the 3rd month of the tax year (March 15 for calendar-year corporations); later elections take effect the next year (late-election relief is available for reasonable cause).
• Termination:
  • Voluntary revocation by shareholders holding more than 50% of the shares.
  • Ceasing to be eligible (for example, a partnership or nonresident alien acquires shares) — effective on that date.
  • Passive investment income above 25% of gross receipts for 3 consecutive years while the corporation has accumulated earnings and profits from C corporation years — effective the first day of the fourth year.
• After termination, the corporation generally must wait 5 years to re-elect without Internal Revenue Service (IRS) consent.

Pass-through of income

• The S corporation files Form 1120-S (due March 15 for calendar years) and gives each shareholder a Schedule K-1.
• Ordinary business income and separately stated items (capital gains and losses, Section 1231 gains and losses, charitable contributions, tax-exempt income, Section 179 expense, investment interest, dividends) flow to shareholders.
• Allocation is per share, per day — unless all affected shareholders elect to close the books when a shareholder's interest terminates.
• Shareholder-employees must receive reasonable compensation, which is subject to payroll taxes; the remaining pass-through income is not subject to self-employment tax.
• Fringe benefits for shareholders owning more than 2% (such as health insurance) are treated as wages, and the shareholder may deduct self-employed health insurance.

Shareholder basis

Stock basis adjustments (in this order each year)
Beginning stock basis (initial: cash + adjusted basis of property contributed)
+ Income items, including tax-exempt income
− Distributions (non-dividend)
− Nondeductible expenses (fines, 50% of meals)
− Losses and deductions
= Ending stock basis (never below zero)

• Losses first reduce stock basis, then debt basis — loans the shareholder personally made to the corporation. Later income restores debt basis before stock basis.
• Corporate debt owed to third parties does not create basis, even if the shareholder guarantees it — a key difference from partnerships.
• Losses above stock and debt basis are suspended and carried forward indefinitely (lost if the stock is sold).
• Losses must then pass the at-risk, passive activity, and excess business loss limits.

Distributions

S corporation without accumulated earnings and profits	S corporation with accumulated earnings and profits (former C corporation)
1. Tax-free to the extent of stock basis 2. Excess = capital gain	1. Tax-free to the extent of the accumulated adjustments account (AAA) — undistributed S corporation income already taxed 2. Dividend to the extent of accumulated earnings and profits 3. Return of remaining basis 4. Capital gain

Distributing appreciated property triggers gain at the corporate level (as if sold), which passes through to shareholders; losses on distributed property are not recognized.

Entity-level taxes

• Built-in gains tax: a C corporation converting to S status pays tax at 21% on net unrealized built-in gain existing at conversion if recognized within the 5-year recognition period. The gain (net of tax) also passes through.
• Excess passive investment income tax: 21% on excess net passive income when passive investment income exceeds 25% of gross receipts and the corporation has accumulated earnings and profits.
• Inventory recapture on conversion from a C corporation using last-in, first-out (LIFO) inventory — the LIFO reserve is taxed, paid over 4 years.

How it is tested

• Decide whether a corporation qualifies, or whether an event terminates the election.
• Allocate income per share, per day.
• Compute shareholder basis and the deductible loss.
• Taxation of distributions with and without accumulated earnings and profits; built-in gains tax.