S Corporation Taxation

In the United States, corporations can choose to be taxed at the corporate level or at the shareholder level. A corporation that chooses to be taxed as the corporate level files its own corporate tax return, measures its taxable income, and calculates its tax using the corporate tax rates. This treatment is called being a C corporation. When C corporations distribute profits to their shareholders in the form of dividends, those dividends are taxable income to the shareholder.

Alternatively, corporations can choose to be taxed at the shareholder level. The corporation still files its own corporate tax return and measures its taxable income. This taxable income, along with various deductions and tax credits, is divided among the shareholders. Each shareholder includes his or her portion of the corporate income, deductions and credits as part of the shareholder's personal tax return. There is no income tax applied at the corporate level. Instead, all the items of income are taxed using the personal income tax rates. This treatment is called being an S corporation. The letter S refers to the subchapter S of chapter 1 of the Internal Revenue Code.

4 General Features of S Corporations

  • "S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes."
  • "Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates."
  • "This allows S corporations to avoid double taxation on the corporate income."
  • "S corporations are responsible for tax on certain built-in gains and passive income at the entity level."

Source: S Corporations, IRS.gov.

Taxes Applied at the Corporate Level

S corporations are responsible for paying the following taxes at the corporate level.

  • Excess net passive income
  • LIFO recapture tax
  • Built-in-gains tax

The excess net passive income tax and the LIFO recapture tax apply only if an S corporation was previously a taxable C corporation or if the S corporation went through a tax-free reorganization with a C corporation.

Excess net passive income is a corporate-level tax on the passive income earned by an S corporation. Passive income includes income from interest, dividends, annuities, rents and royalties (Internal Revenue Code section 1362 paragraph (d)(3)(C). If passive income is more than 25% of the S corporation's gross receipts, the excess net passive income tax applies. The IRS provides a worksheet for calculating this excess net passive income tax in the Instructions for Form 1120S (pdf).

LIFO recapture tax applies if one of the following two conditions are true of the S corporation:

  • "The corporation used the LIFO inventory pricing method for its last tax year as a C corporation, or

  • "A C corporation transferred LIFO inventory to the corporation in a nonrecognition transaction in which those assets were transferred basis property."

Source: instructions for line 22a in the Instructions for Form 1120S, IRS.gov. For more details on the LIFO recapture tax, see the Income Tax Regulations section 1.1363-2.

LIFO refers to the last-in, first-out method of measuring inventory for tax purposes.

Built-in gains tax applies when an S corporation disposes of an asset within five years of acquiring that asset and the S corporation either

  • acquired the asset when the S corporation was a C corporation, or
  • acquired the asset in a transaction whereby the basis of the asset is determined by reference to its basis in the hands of a C corporation. 

For details, see part III of the Instructions for Schedule D for Form 1120S, IRS.gov; see also Internal Revenue Code section 1374, and the Income Tax Regulations section 1.1374-1 through section 1.1374-10.

Pass-Through Treatment of Tax Items

S corporations pass through items of income, deduction, and tax credits to their shareholders. Pass-through means the income and other tax items flow from the corporate return to the personal tax returns of the shareholders.

Let's take a simple example. Suppose ABC Corporation is an S corporation and has a single shareholder, Mr. D. ABC has net taxable income of $100,000. That one hundred thousand dollars is reported from the corporation to the shareholder via Schedule K-1. The shareholder takes this amount from Schedule K-1 and reports it on his Schedule E page 2, and adds this income to the rest of his income on Form 1040. 

Pass-through treatment means that items of income, deduction or credit retain their character as they flow from the S corporation to the shareholder's personal tax return. If the S corporation sold some assets that qualify for long-term capital gains treatment, that income is reported as long-term gain on the Schedule K-1 from the corporation to the shareholder, and thus the individual would report this income on his or her Schedule D as long-term gains. 

Similarly, suppose an S corporation donates money to charity. That item is reported as a charitable donation on the Schedule K-1. And the shareholder would report his portion of the charitable donation as an itemized deduction for charity.

The pass-through treatment of tax items means that all the items of income, deduction and tax credits are handled in the appropriate way when these items are reported on the shareholder's personal tax return.