S Corporation Compliance & Planning

Why this topic matters

S corporations are popular with owner-operated businesses because income is taxed once and payroll taxes can be reduced. Tax Compliance and Planning (TCP) tests Form 1120-S compliance, reasonable compensation, shareholder basis tracking, converting from a C corporation, protecting the election, and exit planning.

Compliance basics

• Form 1120-S is due the 15th day of the 3rd month (March 15 for calendar years), with a 6-month extension. Shareholders receive Schedule K-1 (and Schedule K-3 for international items).
• S corporations generally must use a calendar year unless they have a business purpose or make a Section 444 election (with required payments).
• Shareholders must attach Form 7203 to report stock and debt basis when they claim losses, receive distributions, dispose of stock, or receive loan repayments.
• Late filing penalties are assessed per shareholder, per month.

Reasonable compensation

• Shareholder-employees must receive reasonable compensation as W-2 wages (subject to Social Security, Medicare, and withholding) before taking distributions.
• Remaining profits pass through without self-employment tax — the main payroll tax advantage over a sole proprietorship or partnership.
• Setting salary too low invites the Internal Revenue Service (IRS) to reclassify distributions as wages, with back payroll taxes and penalties. Factors: training, duties, time devoted, comparable pay, and the company's profitability.
• Wages also affect the qualified business income (QBI) deduction: higher wages reduce QBI (and so the 20% deduction) but can increase the W-2 wage limitation for higher-income owners — model both effects.

Fringe benefits for owners

• For more-than-2% shareholders, health insurance premiums paid by the corporation are included in W-2 wages (not subject to Social Security and Medicare if under a plan) — the shareholder then takes the self-employed health insurance deduction.
• Other fringe benefits (such as group-term life, dependent care assistance) are taxable to more-than-2% shareholders.

Basis, distributions, and loans

• Track stock basis yearly: increase for income (including tax-exempt), then decrease for distributions, then nondeductible expenses, then losses.
• Losses are deductible up to stock basis plus debt basis — only for loans the shareholder personally made to the corporation. Guaranteeing a bank loan does not create basis; borrowing personally and lending to the corporation does.
• Repaying a shareholder loan when debt basis has been reduced by losses triggers gain (ordinary if the loan was an open account, capital if evidenced by a note).
• Distributions must be proportionate to share ownership — disproportionate distributions risk creating a second class of stock.
• For former C corporations with earnings and profits: distributions come first from the accumulated adjustments account, then are dividends, then return of basis. An election can distribute earnings and profits first (for example, to avoid the passive income termination rule).

Converting from a C corporation

• Built-in gains tax: net unrealized built-in gain at conversion is taxed at 21% if recognized within the 5-year recognition period. Plan by obtaining an appraisal at conversion, deferring sales of appreciated assets until after 5 years, and using built-in losses to offset gains.
• Inventory recapture: a corporation using last-in, first-out (LIFO) inventory includes its LIFO reserve in the final C corporation year, paying the tax over 4 years.
• Accumulated earnings and profits carry over, triggering the passive investment income rules (tax on excess passive income, and termination after 3 years above 25% of gross receipts).
• C corporation net operating losses can't pass through; they can offset built-in gains only.

Protecting the election

• Watch shareholder eligibility on every transfer — sales to a nonresident alien, partnership, or corporation terminate the election. Shareholder agreements should restrict transfers.
• Trusts can hold stock only as grantor trusts, qualified subchapter S trusts, or electing small business trusts — each needs the right elections on time.
• Relief is available for late elections and inadvertent terminations if corrective action is taken promptly (often through simplified revenue procedures, otherwise a private letter ruling).
• A qualified subchapter S subsidiary (a 100%-owned corporation for which an election is made) is disregarded — its items are treated as the parent's.

State and exit planning

• Many states allow an elective pass-through entity tax: the S corporation pays state tax (deductible federally) and shareholders get a credit — a workaround to the individual state and local tax deduction cap.
• Selling the business: buyers prefer asset purchases (stepped-up basis); sellers usually prefer stock sales (capital gain). A Section 338(h)(10) or Section 336(e) election treats a stock sale as an asset sale for tax purposes — the buyer gets a step-up, and the shareholders are taxed as if the corporation sold its assets (with possible ordinary income from recapture).
• Qualified small business stock treatment is not available for S corporation stock.

How it is tested

• Evaluate reasonable compensation and its payroll and QBI effects.
• Compute basis, deductible losses, and the tax on distributions.
• Plan a C-to-S conversion around the built-in gains tax.
• Identify events that terminate the election and available relief.