S-Corps and Taxation Considerations

An S corporation (sometimes referred to as an S Corp) is a special type of corporation created through an IRS tax election (you must first incorporate the business and then make the IRS election via Form 2553).  Many new business owners often contact us asking if this is a good form to conduct business under.  While there are advantages to operating as an S Corp, there are some things that one should consider prior to making the election.  Depending on your goals, one may find that it’s better to operate under another organizational structure.

Ownership Restrictions

Per IRS guidelines, S Corp owners (shareholders) must first meet the following criteria:

  • Limited to 100 or fewer persons/entities
  • Must be US citizens/residents (cannot be non-resident aliens)
  • Cannot be C Corporations (C Corp), other S Corps, limited liability companies (LLCs), partnerships or certain trusts
  • Any shareholder who works for the company must pay him or herself “reasonable compensation.” Basically, the shareholder must be paid fair market value, or the IRS might reclassify any additional corporate earnings as “wages”

Benefits

Many small business owners elect S Corp status for two main reasons:

  • Avoid double taxation on distributions
  • Allow corporate losses to flow through to its owners (however there are 3 loss limitations discussed later)

Other typical advantages include:

  • Limited liability protection. Owners are not typically responsible for business debts and liabilities.
  • Easy transfer of ownership. Ownership is easily transferable through the sale of stock.
  • Unlimited life. When a corporation’s owner incurs a disabling illness or dies, the corporation does not cease to exist.
  • Potential use of personal assets for business use.  Check out this post about S-Corp vehicle usage and this one for S-Corp home office usage.

Pass Through Taxation

What makes the S Corp different from C Corp is that profits and losses pass through to your personal tax return. Consequently, the business is not taxed itself, only the shareholders are taxed.  The amount which is taxed is determined by the shareholders basis (i.e. their interest in the business).  What is unique about S Corp basis is that it fluctuates depending on several things including the company’s operational performance.

Additionally, since the tax liability lies with the shareholder and not the corporation, individuals have to make sure that they receive enough money from the corporation in the form of distributions in order to satisfy their tax obligation.  Non dividend distributions aren’t taxable to the extent the shareholder has adequate basis.

Importance of Basis

It is important that a shareholder know their stock AND debt basis at all times. As such, it is imperative that it be calculated every year.  If the corporation allocates a loss or deduction to the shareholder, in order to claim it the shareholder needs to demonstrate that they have enough stock or debt basis.  For example, if a person invests $10,000 in a company (i.e. stock basis) and the company then passes through a $18,000 loss to them in a single year, only $10,000 will be deductible in that year.  The remaining $8,000 becomes “suspended” until the shareholder has adequate basis in the future.

Loss Limitations

As mentioned above, losses are limited to the extent that an owner has basis.  However, there are in fact three limitations which could cause a loss to be nondeductible at any given time.  Each limitation must be met in the following order before a shareholder is allowed to claim a flow through loss:

  • Stock and Debt Basis Limitations
  • At Risk Limitations
  • Passive Activity Limitations

Calculating Stock Basis

A good way to think of stock basis is in terms of a checking account.  Basis essentially equals deposits and earnings less any withdrawals made.  Furthermore, similar to a bank account (with no overdraft protection) basis cannot go negative – that is more cannot come out than goes in.

  • Initial basis typically starts with the money a shareholder paid for the S Corp shares, property contributed to the corporation, carryover basis if gifted stock, stepped-up basis if inherited stock or basis of C Corp stock at the time the C Corp converts to an S Corp.
  • Subsequent basis is made via adjustments which are typically recorded at the end of the corporations tax year.  First they are increased by income items, then decreased by distributions and lastly decreased by deduction and loss items.  The order is important because if basis is positive before distributions but would be negative if all deduction items were subtracted (however, again, basis cannot be negative) then the excess loss would be suspended rather than the excess distribution being taxable.

Other Important Considerations

  • S Corps must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made to the shareholder-employee.
  • The instructions to the Form 1120S, U.S. Income Tax Return for an S Corporation, state “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.”
  • Under section 7436 of the Internal Revenue Code, the IRS has the authority to reclassify payments made to shareholders from non-wage distributions to wages (which are subject to employment taxes).
  • Suspended losses and deductions due to basis limitations retain their character in subsequent years. Any suspended loss or deduction items in excess of stock and/or debt basis are carried forward indefinitely until basis is increased in subsequent years or the shareholder disposes of their stock.
  • In determining current year allowable losses, current year loss and deduction items are combined with the suspended loss and deduction items carried over from the prior year, though the current year and suspended items should be separately stated on the Form 1040 Schedule E or other appropriate schedule on the return.
  • If the current year has different types of loss and deduction items, which exceed stock and/or debt basis, the allowable loss and deduction items must be allocated pro rata based on the size of the particular loss and deduction items.
  • If a shareholder sells their stock, suspended losses due to basis limitations are lost. Any gain on the sale of the stock does not increase the shareholder’s stock basis. A stock basis computation should be reviewed in the year stock is sold or disposed of.
  • A non-dividend distribution in excess of stock basis is taxed as a capital gain on the shareholder’s personal return. Stock held for longer than one year is a long-term capital gain (LTCG).