What Is an S corporation?

The "S" in S corporation refers to Chapter 1, Subchapter S of the Internal Revenue Code, which deals with the tax treatment of S corporations and their shareholders.

Pass-Through Entity

An S corporation is a pass-through entity. This means, it is not a tax-paying entity at the federal level, it is a tax-reporting entity. However, there are a few specific situations (discussed later) where an S corporation that was previously a C corporation before converting to S status, may itself be liable for federal taxes. Also, some states assess a minimum tax on S corproations even if the S corporation has a zero tax liability at the federal level.

Pass-Through Items

All items of income, deductions, credits, gains, and losses pass through the S corporaton to the shareholders according to their proportionate ownership interest. For example, if shareholders A and B each own 50% of the stock in the S corporation, they would each report 50% of the business's income on their individual income tax returns.

Schedule K-1

The purpose of Schedule K-1 (Form 1120S), which is issued annually by the S corporation to each shareholder, is to report the shareholder's share of the corporation's income, deductions, credits, gains and losses. Each shareholder reports the items shown on his Schedule K-1 on his individual income tax return.

When an S corporation May Be Liable for Taxes

The following three situations may result in an S corporation having to pay taxes:

  1. Built-In Gains:
  2. LIFO Recapture
  3. Passive Investment Income

Built-In Gains:

Property held by a C corporation that has appreciated in value upon conversion to S status, will include a built-in-gain to the date of conversion. This gain is reported as a built-in-gain if the property is sold or disposed of within 10 years of the conversion.

LIFO Recapture:

Two common inventory cost flow methods are used for valuing inventory are:

  1. LIFO (last-in-first-out)
  2. FIFO (first-in-first-out).

Comparing LIFO to FIFO during times of inflation, here's what happens:

  • LIFO results in higher cost-of-cost-goods-sold (COGS) amount and a lower ending inventory during times of inflation.
  • FIFO results in a lower COGS amount and a higher ending inventory during times of inflation, the opposite of LIFO.
  • Since LIFO results in a higher COGS amount than would result under FIFO during times of inflation, net profit under LIFO would be lower. And a lower net profit means a lower income tax.

Recognizing the tax impact of using LIFO during inflationary times, the IRS takes back the tax benefit achieved under LIFO via so-called LIFO recapture.

LIFO recapture is the excess of FIFO ending inventory over LIFO ending inventory. This excess amount is the amount by which net income was understated as a result of using LIFO instead of FIFO during inflationary times. The excess amount is recaptured as income and taxed to the S corporation itself on Form 1120S rather than the shareholders.

Passive Investment Income:

An S corporation must pay tax on excessive passive investment income earned during a tax year when it operated as a C corporation. A tax results when passive investment income exceeds 25% of gross receipts.

Passive investment income includes: rents, royalties, dividends, interest, annuities, and proceeds from the sales or exchange of stock or other securities.

If all accumulated earnings and profits are distributed to shareholders before year-end, the corporation can avoid paying the tax. However, the shareholders will have a taxable dividend.

Note If S status is elected and approved immediately after initially incorporation, none of the above three items will apply to your new S corporation. In other words, older C corporations that subsequently converted to S status are affected by the above three situations..

State Taxes and S corporations

Although an S corporation generally doesn't pay federal taxes, some states may assess a minimum tax on an S corporation. For example, Arizona has a $50 minimum tax on S corporations. California assesses a minimum tax of $800 on S corporations. This means, while there may be a zero tax liability for the S corporation at the federal level, some states will nevertheless assess a minimum tax. Check the rules of your state regarding S corporation taxation.

For an unincorporated business, such as an limited liability company (LLC), that converts to an S corporation, the corporation will not be liably for federal income taxes. Some states assess an annual fee

does not pay taxes on its net income. Instead, shareholders are responsible for the tshare of the corporation's income, deductions, credits, gains, and losses pass through the entity to each shareholders via Schedule K-1 (Form 1120S). Shareholders use Schedule K-1 to report their share of items reportedBased on the information reported on Schedule K-1, shareholders report these items on their individual income tax returns. Shareholders receive Schedule K-1 (Form 1120S) annually from the corporation

Schedule K-1 to each shareholder reporting their individual share of these items. from the reports his share of these items on his individual income tax return.

Keep in mind, you do not form an S corporation, you ELECT to be taxed as one under Chapter 1, Subchapter S of the Internal Revenue Code (IRC). You make the election on Form 2553, Election by a Small Business Corporation.

Before you can even elect S corporation tax treatment, you must first form either a corporation or a limited liability company (LLC).

S corporation vs C corporation

When you form a corporation the IRS automatically taxes it under the rules of Chapter 1, Subchapter C of the IRC. This is the default tax treatment for corporations when they are initially formed.

Because the default tax treatment for a corportion falls under the rules of subchapter C of the IRC, the entity is referred to as a C corporation. Moreover, since the default tax treatment falls under subchapter C, a special election must be made to be taxed under the rules of subchapter S by filing Form 2553 with the IRS.

Making the election to be taxed as an S corporation does not change the legal status of the entity. State rules governing corporations and LLCs still apply.

Therefore, upon initial incorporation, the entity is referred to as a C corporaion. The entity will become an S corporation only after IRS approval to be taxed as an S corporation.

Because the default tax treatment for a corportion falls under the rules of subchapter C of the IRC, an election must be made to be taxed under the rules of subchapter S by filing Form 2553 with the IRS.

Making the election to be taxed as an S corporation does not change the legal status of the entity. State rules governing corporations and LLCs still apply.

C corporations file Fome 1120. S corporations file Form 1120S.

Unlike an S corporation, a C corporation is not a pass-through entity. A C corporation is liable for income taxes on the net profit of the corporation. Shareholders of a S corporation are responsible for the taxes on their share of the profits.

Self-Employment Tax

 

S corporation Tax Treatment

For federal income tax purposes, an S corporation is treated as a pass-through entity. This means, items of income, deductions, credtis, gains, and losses pass-through the S corporation to the shareholders who then report these items on their individual income tax returns. This is the same tax treatment that unincorporated businesses receive, such a sole proprietorships and general partnerships.

Schedule K-1 (Form 1120S) is issued annually by the S corporation to each shareholder. Schedule K-1 includes each shareholder's proportionate share of income, deductions, credits, gains, and losses, which are reported by each shareholder on his indiviudal income tax return.

Since S corporation shareholders who work for the business are not considered self-employed (they are employee/sharholders), they do not pay self-employment tax.

which is how a partnerhip is taxes like a partnerhip and receives the limited liability protection of a regular C corporation.

NoteUnder the U.S. Code there are currently 54 Titles. For example, Title 1 deals with General Provisions and Title 54 deals with Naional Park and Related Services. Title 26 contains the internal Revenue Code.

The Internal Revenue Code is divided into:

  1. Subtitles
  2. Chapters
  3. Subchapters
  4. Parts
  5. Subparts

For example, with respect to S corporations, here's the general breakdown:

Subtitle A: Income Taxes

  • Chapter 1: Normal taxes and surtaxes
    • Subchapter S: Tax Treatment of S Corporations and Their Shareholders
      • Part I: In general (no subpart)
      • Part II: Tax Treatment of Shareholders (no subpart)
      • Part III: Special rules (no subpart)
      • Part IV: Definitions; miscellaneous (no subpart)

Limited Liability Protection and Tax Treatment of S corporations

S corporation shareholders enjoy the same limited liability protection as shareholders of a regular C corporation. For tax purposes, all items of income, deductions, credits, gains, and losses pass through the S corporation to individual shareholders via Schedule K-1, who then report these items on their personal income tax returns.

S corporations, with a few exceptions, do not pay income taxes. The exceptions deal with older C corporations that subsequently converted to an S corporation.

What is a Pass-Through Entity?

A pass-through entity is a financial conduit.

This means:

  • Income passes through the entity directly to S corporation shareholders.
  • Even if S corporation income is not actually distributed to shareholders (referred to as undistributed earnings), they still report such income on their personal income tax returns..
    • Although an S corporation itself is not taxed, there are a few exceptions where an S corporation that previously operated as a C corporation for a length of time can be taxed.
  • S corporation shareholders include their proportionate share of income, deductions, credits, gains, and losses passed through to them on their individual income tax returns via Schedule K-1, issued to each shareholder annually by the s corporation.
    • For example, if the s corporation has two shareholders who each own 50% of the stock, then each shareholder reports 50% of each pass-through item on his individual income tax return.
  • S corporation stockholders get to deduct S corporation losses from their other sources of income (e.g., wages from a job, wages of a spouse, interest, dividends) on their individual income tax return.
  • It is this pass-through treatment of income that enables S corporations to avoid double taxation of income. In other words, S corporation income is taxed only once, at the individual tax level.
  • Annually, an S corporation files Form 1120S and sends Schedule K-1 to each shareholder detailing his share of income, deductions, gains, losses, and credits.

Limited Liability

S corporation shareholders are not personally liable for S corporation debts.

However, limited liability protection will not shield a shareholder/employee from liability for delinquent trust fund taxes if the shareholder/employee was responsible for payroll tax withholding.

Trust fund taxes include:

  • Federal income taxes required to be withheld from an employee's wages, plus
  • The employee's share of social security and Medicare taxes.

Legal Status of an S corporation

The "S" in S corporation refers to subchapter S of the Internal Revenue Code that governs its tax treatment for federal income tax purposes.

Making an election to change the tax treatment of a regular C corporation to an S corporation does not change the legal status of the business. Only the way the corporation is taxed is changed. Therefore, the same state incorporation laws apply to an S corporation that applied when it was a C corporation.

Tax Year

An S corporation is generally required to use a calendar year (January 1 through December 31). IRS approval is needed to adopt a different tax year.

File your personal and small business taxes (Schedule C)