Federal Income Tax Accounting Unit 16 ReviewTaxation of S Corporations

S Corporation Basics

• S corporations pass through income, losses, deductions, and credits to shareholders for federal tax purposes
• Shareholders report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates
• To qualify for S corporation status, the corporation must meet certain requirements set forth by the Internal Revenue Code
• S corporations avoid the double taxation of regular C corporations where profits are taxed at both the corporate and individual levels
• S corporations must have no more than 100 shareholders and can only have allowable shareholders including individuals, certain trusts, and estates
• S corporations are responsible for tax on certain built-in gains and passive income at the entity level

Eligibility and Formation

• Domestic corporation must submit Form 2553, Election by a Small Business Corporation, signed by all shareholders to elect S corporation status
• Corporation must have no more than 100 shareholders (husband and wife treated as one shareholder)
• Shareholders must be individuals, certain trusts, and estates; partnerships, corporations or non-resident alien shareholders are ineligible
• S corporation can only have one class of stock (disregarding voting rights)
• Profits and losses must be allocated to shareholders proportionately to each one's interest in the business
• To be eligible for S corporation status, the corporation must be a domestic corporation and must not be an ineligible corporation (certain financial institutions, insurance companies, and domestic international sales corporations)

Tax Treatment of S Corporation Income

• S corporation income, losses, deductions, and credits flow through to shareholders in proportion to their stock ownership
• Flow-through items are reported on shareholder's Form 1040, U.S. Individual Income Tax Return, and are subject to individual income tax rates
• S corporation income is not subject to self-employment tax, but shareholders who work for the company must pay themselves "reasonable compensation" which is subject to employment taxes
• Losses are limited to the shareholder's basis in the corporation (amount invested or loaned to the corporation)
  • Excess losses can be carried forward and deducted in future years when the shareholder has sufficient basis
• Charitable contributions and foreign taxes paid by the S corporation also pass through to shareholders
• S corporations must use a calendar year unless there is a valid business purpose for a fiscal year

Shareholder Basis and Distributions

• Shareholder's basis in S corporation stock is increased by income items (ordinary income, separately stated items, tax-exempt income) and decreased by distributions and deductible losses
• Distributions are tax-free to the extent of the shareholder's basis in the corporation; distributions in excess of basis are treated as capital gains
• Shareholders cannot deduct corporate losses that exceed their basis but can carry forward the excess losses to future years
• Basis is adjusted at the end of each corporate year before determining the tax treatment of distributions
• Loan repayments from the corporation increase the shareholder's basis while loan advances to the corporation decrease basis
  • Basis cannot be increased by loan guarantees; only actual economic outlay by the shareholder increases basis

Built-in Gains and Losses

• Built-in gains tax applies to S corporations that were formerly C corporations and converted to S status
• Tax is imposed at the corporate level on the net recognized built-in gain that arose prior to the S corporation conversion and is recognized during the recognition period (generally 5 years)
• Built-in gains tax rate is currently 21% (same as C corporation rate)
• Certain built-in losses can be used to offset recognized built-in gains
• Built-in gains tax applies to net recognized built-in gain attributable to appreciated assets held at the time of the S election
  • Gain must be recognized within 5 years of the S election
  • Gain is taxed at the highest corporate rate for the year the gain is recognized (currently 21%)

Special Tax Elections

• S corporations can elect to treat certain passive investment income (rents, royalties, interest, and dividends) as earned income to avoid tax at the corporate level
• S corporations can elect to distribute earnings from pre-S election years first (accumulated earnings and profits) to avoid tax on excess net passive income
• S corporations can elect to amortize start-up expenditures and organizational expenses over a period of 180 months
• S corporations can elect to be treated as a "qualified subchapter S subsidiary" (QSub) if 100% owned by an S corporation parent
  • QSub is not treated as a separate entity for tax purposes; all assets, liabilities, income, deductions, and credits are treated as those of the parent S corporation

Compliance and Reporting Requirements

• S corporations must file Form 1120S, U.S. Income Tax Return for an S Corporation, annually
• S corporations must provide each shareholder with a Schedule K-1 which reports the shareholder's pro rata share of income, losses, deductions, and credits
• S corporations must maintain accurate books and records including basis records for each shareholder
• S corporations are subject to the same recordkeeping requirements as C corporations
• S corporations must make estimated tax payments if expecting to owe tax of $500 or more on built-in gains or excess net passive income
• S corporations must file and pay employment taxes (Social Security and Medicare) for employees, including shareholder-employees

Common S Corporation Tax Issues

• Failure to pay reasonable compensation to shareholder-employees (compensation should be commensurate with services performed)
• Disproportionate distributions to shareholders (must be pro rata based on stock ownership)
• Debt basis issues (shareholder loans and loan repayments must be properly tracked to avoid basis limitations)
• Ineligible shareholders (partnerships, corporations, and non-resident aliens are not allowed)
• Passive income issues (S corporations with excessive passive income may be subject to tax at the corporate level)
• Built-in gains tax (applicable to certain S corporations that were formerly C corporations)
• Late filing or failure to file Form 1120S and Schedule K-1s can result in penalties