The S corporation combines the limited liability of corporate shareholders with the pass-through tax treatment of partnerships. Shareholders of S corporations can offset losses against other income. A good alternative to the S corporation is the limited liability company or the limited liability partnership, which offers many of the same benefits as the S corporation but with fewer requirements.
The primary reasons for selecting an S corporation include:
- avoiding double taxation of distributions, as occurs with C corporations
- allowing corporate losses to pass through to shareholders
- and for those shareholders who also work for the corporation, to allow the characterization of some compensation as dividends, which are not subject to employment taxes
S corporations are named after the subchapter of the Internal Revenue Code that governs their taxation, specifically by 26 USC Chapter 1, Subchapter S - Tax Treatment of S Corporations and Their Shareholders. Although most states recognize S corporations, some states may assess special taxes, such as the corporate franchise tax, on S corporations as a separate entity and some states do not even recognize S corporate status, so they treat them as C corporations.
Income and losses pass through to shareholders who pay tax according to their own individual rates, thus eliminating the double taxation of business profits that occurs with C corporations. The S corporation must file annual tax returns with both the IRS and the incorporation state and provide information returns to the shareholders.
Many businesses start as an S corporation (after the necessary brief initial existence as a C corporation) to take advantage of pass-through losses that are common in the startup phase of a business. Later on, the S corporation can be converted into a C corporation which offers many tax-free fringe benefits. Income can be split between the shareholders and the corporation, offering more options to reduce taxes, because, depending on their respective incomes, corporate tax rates may be lower than the marginal tax rates of the shareholders.
Qualification requirements for an S corporation include:
- The corporation must be a United States corporation with no more than 100 shareholders, although up to 6 generations of family members are treated as 1 shareholder.
- Shareholders must be individual United States citizens or resident aliens, other S corporations, or an electing small business trust.
- The corporation can issue only 1 class of stock – there can be no preferred shares or any other type of shares that provide special privileges to some stockholders.
State law may also have additional rules for S corporations operating within their state. Nonresident aliens cannot be shareholders because the taxes paid on income earned by the S corporation are paid by the shareholders and the United States cannot tax nonresident aliens.
The Tax Cuts and Jobs Act has reduced the maximum tax rate for C corporations to 21%, while the tax rate for S corporations continues to be taxed at the shareholder rate. Hence, revoking the S corporation election to become a C corporation will save substantially on taxes. To revoke an S election to be a C corporation, the TCJA requires that:
- The corporation report net adjustments over 6 years attributable to the revocation. Revenue Procedure 2018-44
- Distributions of cash following the post-termination transition may be treated as coming out of the accumulated adjustments account and accumulated earnings and profits proportionally, resulting in part of the distributions being treated as non-dividend distributions. The non-dividend distributions will be tax-free if the shareholder has sufficient basis in the stock.
However, these changes only apply to a C corporation that was an S corporation on December 21, 2017, and revokes its S status after December 21, 2017, but before December 22, 2019, and has the same proportional ownership by the same owners on the date of revocation and on December 22, 2017.
Under the new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, allows pass-through entities, such as partnerships, limited liability companies, and S corporations, and sole proprietorship's and independent contractors to deduct 20% of their qualified business income. However, this deduction starts to phase out for couples earning at least $315,000 or $157,500 for singles.
This new business deduction, referred to as the §199A deduction or the deduction for qualified business income, equals the lesser of:
- 20% of qualified business income + 20% of qualified real estate investment trust dividends and qualified publicly traded partnership income, or
- 20% of taxable income – net capital gains
Unlike the changes for regular taxpayers, most of which expire in 2025, most of the tax changes for businesses have been made permanent.
S Corporation Disadvantages
- Earnings are taxed to the shareholders, even if they are not distributed.
- Employee fringe benefits do not enjoy the tax advantages that such benefits have under a C corporation.
- Converting a C corporation into an S corporation may be a taxable event if the C corporation had passive income from investments, used the last-in, first-out (LIFO) method to report inventory, or had unrealized gains on assets.
- Most S corporations must use the calendar tax year unless there is a strong economic reason to choose a fiscal year and the S corporation must file a tax return every year of its existence, even if it has no income to report. An S corporation must file a return by the 15th day of the 3rd month after the end of its tax year, which, for calendar-year filers, is March 15.
- Most states charge an annual franchise fee and may also impose their own taxes on S corporation income or on its gross receipts.
S Corporation Taxation
An S corporation not only reports profits and losses but also separately stated items, such as capital gains or losses, which are taxed differently from ordinary income. Profits or losses and separately stated items are divided proportionately among the shareholders according to their ownership interest. The corporation must send Form K-1 (Form 1120S), Shareholder's Share of Income, Deductions, Credits, etc. both to the shareholders and to the IRS, which lists the apportionment of profits or losses and separately stated items for each shareholder, including the following:
- ordinary business income or loss
- interest income
- ordinary and qualified dividends
- net rental real estate income or loss
- other net rental income or loss
- net short-term and long-term capital gain or loss
- collectibles gain or loss
- unrecaptured §1250 gain
- net §1231 gain or loss
- other income or loss
- §179 deduction
- other deductions
- foreign transactions
- alternative minimum tax items
- items affecting shareholder basis
However, even if the shareholder's Schedule K-1 shows a loss, the loss that can be claimed are limited by:
- the shareholder's basis in the stock plus debt of the corporation
- the amount of investment that is at risk
- and passive loss limitation rules
At-risk limitations are figured on Form 6198, At-Risk Limitations, then the information on that form is used to figure passive loss limitations on Form 8582, Passive Activity Loss Limitations. A shareholder would then fill out Part II of Schedule E, Supplemental Income and Losses, using the information provided in the K-1 informational report. Shareholders must also pay estimated taxes. S corporations must also file the annual corporate tax return Form 1120S, U.S. Income Tax Return for an S Corporation.
Generally, the S corporation must pay income taxes and employment taxes on wage income paid to the shareholders. However, some of the profits can be treated as dividends which are not subject to employment tax, which is one of the major advantages of using an S corporation. However, the amount of income that can be declared as a dividend is limited by IRS rules: the shareholders who work in the business must pay themselves market wages for the position that they hold in the corporation. Whether compensation is reasonable is determined by the following factors:
- by the taxpayer:
- provided services
- number of hours worked
- general business and economic factors:
- size and complexity of the business
- compensation paid by similar firms for similar services
- company officer compensation in prior years
- prevailing economic conditions
If the IRS deems the apportionment of dividends over compensation to be unreasonable, then all the dividend income may be re-classified as wages, which will be subject to employment taxes and tax penalties.
For shareholders to be able to deduct losses against other active income, such as from another business or employment, they must satisfy the material participation rules, which means they must be active employees in the corporation — passive investors can only deduct losses against other passive income. Furthermore, the losses that can be claimed by a shareholder are limited to the shareholder's tax basis in the corporation.
Tax Basis = Shareholder's Investment + Shareholder's Loans to the S Corporation
One problem with S corporations is that the shareholders cannot claim a home office deduction. Instead, the expenses must be claimed as unreimbursed employee expenses on Schedule A, Itemized Deductions, which are subject to the 2% AGI floor of miscellaneous itemized deductions. However, the S corporation can adopt an accountable plan that reimburses a shareholder for the business use of his home, in which case, the income is not taxable to the shareholder and the cost is deductible by the S corporation. However, the establishment of an accountable plan must be done pursuit to a written corporate resolution, following specific rules.
Forming an S Corporation
S corporations begin as C corporations that elect the S corporation status. After receiving a corporation charter from the state of incorporation, the shareholders must file Form 2553, Election by a Small Business Corporation no later than the 15th day of the 3rd month after the corporation's taxable year begins. Since most S corporations must use a calendar tax year, the form must be filed by March 15. However, if the deadline is missed, the taxpayer can request an extension under Revenue Procedure 2004-48 and Rev. Proc. 2007-62.
Form 2553, Election by a Small Business Corporation must be signed by all shareholders or future shareholders in writing and filed with the IRS within 2 months and 15 days of the corporation's formation. Everyone who could potentially be a shareholder should sign the form, since there is no penalty if one or more the signatories do not become a shareholder of the corporation. The taxpayer should send Form 2553 to the IRS address of the corporation president's individual tax return. The IRS should respond within 30 days, acknowledging the S corporation status.
Tax Consequences of Converting Between a C and an S Corporation
All S corporations must begin as C corporations, at least briefly, but if the corporation operated as a C corporation, there may be tax consequences on converting to an S corporation. Because a C corporation is a separate taxable entity, and the S corporation is a pass-through entity, the C corporation may have certain gains or income for which taxes must be paid after changing to a pass-through entity. The 3 types of income that may have to be recognized upon conversion are built-in gains, corporate income, and LIFO recapture.
- A built-in gains tax of 35% must be paid on the appreciation of property that was held by the C corporation, but only if the property was disposed of within 10 years after electing the S corporation status, or for 2013 only, 5 years after the election.
- If the C corporation had accumulated earnings and profits, and passive income, such as dividends and interest, that exceeded 25% of its gross receipts, then the newly formed S corporation must pay a 35% tax on that income, but only if the S corporation had income for that year. Note that net operating losses by the C corporation cannot be carried forward to the S corporation.
- If the C corporation used the LIFO inventory method, then taxes must be paid on the income adjustment in equal installments over a 4-year period, with 1/4 of the payment due on the final return of the C corporation and the remaining 3 quarter payments due on the 1st 3 years of the S corporation's tax returns.
Generally, converting from an S corporation to a C corporation can easily be done, but the C corporation cannot convert back into an S corporation for at least 5 years, unless it receives IRS permission.
Ending the S Corporation
If the shareholders wish to revoke the S corporation status, then shareholders with at least 50% of the ownership interest in the corporation must agree to it, and a letter must be sent to the IRS with the name of the corporation, tax identification number, and number of shares outstanding, and it must be signed by all shareholders. When the status of the S corporation is revoked, then the corporation is taxed as a C corporation.
To dissolve an S corporation, all corporation debts must be paid, then any remaining assets are distributed to the shareholders in proportion to their ownership interest. Each shareholder is taxed on the difference between the value of the property received minus the shareholder's tax basis in the stock. The last Form 1120S should be marked "Final Return" at the top of the tax return.