Basis is the constraint on everything
Shareholder basis ordering: increase for income items → decrease for distributions → decrease for nondeductible expenses → decrease for losses. Losses exceeding basis are suspended indefinitely until basis is restored.
IMPORTANT — the planning lever: An S corporation shareholder gets basis for direct loans to the corporation, but not for corporate third-party debt (unlike a partner). A shareholder anticipating losses can therefore create deductibility by lending personally to the corporation — but merely guaranteeing a bank loan creates no basis.
Reasonable compensation
S corporation flow-through income is not subject to self-employment tax, which creates an incentive to minimize wages. The IRS actively challenges under-compensation and can recharacterize distributions as wages, with payroll taxes, interest, and penalties. Planning must balance the payroll tax savings against defensibility — and note that wages also affect the QBI deduction's W-2 wage limitation at higher income levels.
Distribution ordering with accumulated E&P
For a corporation that was previously a C corporation:
- AAA (accumulated adjustments account) — tax-free to the extent of stock basis
- Accumulated E&P — taxable dividend
- Remaining stock basis — tax-free return of capital
- Excess — capital gain
Built-in gains (BIG) tax
A C corporation that converts to S status faces a corporate-level tax on net recognized built-in gains — appreciation that existed at conversion — if the asset is disposed of within the recognition period. Planning response: delay disposition of appreciated assets until the recognition period expires, where commercially sensible.
EXAM TIP: Two other C-corporation-legacy traps for S corporations: the BIG tax above, and the excess net passive income tax — which can even terminate the S election if passive investment income exceeds 25% of gross receipts for three consecutive years while accumulated E&P exists.