S Corporation Compliance & Planning

Compliance

Form 1120-S due March 15; Schedule K-1; calendar year usually required; Form 7203 for shareholder basis.

Reasonable compensation

• Pay salary first (payroll taxes); rest passes through without self-employment tax.
• Too low → Internal Revenue Service (IRS) reclassifies distributions as wages.
• Wages reduce qualified business income (QBI) but may raise the wage limit.
• More-than-2% shareholders: health insurance in wages, then deduct.

Basis

• Order: + income → − distributions → − nondeductible → − losses.
• Debt basis only for direct shareholder loans (not guarantees).
• Distributions must be proportionate (one class of stock).

C-to-S conversion

Built-in gains tax 21% for 5 years · last-in, first-out (LIFO) inventory reserve recapture over 4 years · passive income limits with earnings and profits.

Protect and exit

• Restrict transfers to ineligible shareholders; trust elections; relief for late or inadvertent errors.
• Pass-through entity tax avoids the state and local tax cap.
• Section 338(h)(10) / 336(e): stock sale taxed as asset sale → buyer basis step-up.

Exam traps

• The built-in gains tax applies only to gain built in at conversion — later appreciation isn't subject to it.
• Shareholders are taxed on their share of income even if the company keeps the cash — there's no deferral as with a C corporation.
• A limited liability company (LLC) taxed as an S corporation must keep distributions proportionate; operating-agreement allocations can create a second class of stock.