How Subchapter S Corporations Are Taxed

People often think that S corporations are complicated. That's not really true in most cases, however. S corporations are actually less complicated, in many ways, than partnerships and than limited liability companies treated as partnerships.

The General Rule on S Corporation Taxation

The general rule for S corporation taxation works like this. An S corporation calculates its income just like a regular corporation. However, rather than taxing the corporation on those profits, the corporation's owners get taxed on their shares of the corporation's profit.

Suppose, for example, that an S corporation is equally owned by Tom, Dick and Harry. Each shareholder owns one-third of the corporation's stock. In this case, if the corporation makes $300,000 in profit, the corporation doesn't pay the income tax on this profit. Instead, each shareholder includes his share of the corporation profit--$100,000 per person—in his or her taxable income. The shareholders pay the taxes owed on the $100,000 of corporate profit on their individual income tax returns.

Just to flesh out this example a bit more, suppose that a corporation loses $30,000. In this case, each of the owners includes a $10,000 loss in his or her taxable income.

Three other quick observations: First, note that the income or loss from an S corporation is reported on the front of your 1040 tax return. Second, note that while the income from an S corporation is subject to federal and state income taxes, the income is not subject to self-employment or payroll taxes. Third, note that a shareholder is taxed on his or her income regardless of whether the corporation pays the income out to the shareholder.

So far, so good, right? This S corporation taxation stuff is maybe a little bit weird. But it's not too tough to see how it works. So let's go over a couple of other things you should understand.

Sometimes Distributions Create Tax Liability

As mentioned, an S corporation shareholder gets taxed on his or her share of the corporation's profits. Distributions that an S corporation makes to shareholders are, in most cases, irrelevant.

However, in one special case, a distribution can create tax liability for a shareholder. But first, you need to understand the concept of basis.

"Basis" refers the amount you've invested in your S corporation stock.

If you purchase some shares in an S corporation for $10,000, at the point you make the purchase you have $10,000 of basis in your stock.

If over the course of the first year, your share of the corporation's profits equals $20,000, that $20,000 if reinvested increases your basis from $10,000 to $30,000.

If the corporation doesn't make any money in the second year but distributes $16,000 to you, that distribution decreases your basis to $14,000 because $30,000 minus $16,000 equals $14,000.

So here's why basis is important. If an S corporation makes a distribution to a shareholder that's in excess of his or her basis, the excess amount is treated as a capital gain. For example, if you have $14,000 of basis in your S corporation stock and the corporation makes a $15,000 distribution, the extra $1000 gets treated as capital gain.

Bottom-line: While distributions usually don't have any tax effect on shareholders, a distribution can in special cases create capital gains. (One common situation where this occurs, by the way, is when a small corporation has used Section 179 depreciation to create large depreciation deductions which wipe out lots of basis.)

When a C Corporation Converts to an S Corporation

Often times, a corporation starts out right from the get-go as an S corporation. But several special rules come into force when a corporation has been a C corporation prior to becoming an S corporation.

Most of these special rules don't apply to the typical C-corporation-to-S-corporation conversion, but one called the "built-in gain tax" does. So you may want to know how that works and why it sometimes surprises people.

In a nutshell, if an S corporation sells an appreciated asset and the appreciation comes from the period of time when the corporation was a regular C corporation, that gain, called built-in gain, can be taxed at the highest corporate income tax rates.

In effect, the built-in gain tax prevents C corporations from saving income taxes by converting to S corporation status right before they sell appreciated assets.

If you're a C corporation considering an S corporation election, by the way, you'll want to get a competent tax practitioner involved in your analysis and decision-making. The built-in gain tax rules are a little complicated. For example, you get to net built-in gains and built-in losses. As another example, sometimes what the tax laws consider a built-in gain is a little surprising. For example, a cash-basis taxpayer will have built-in gain in their accounts receivable and built-in loss in their accounts payable.

Note: Your current tax accountant should be able to help you with C corporation to S corporation issues. However, if you don't have a good tax accountant, we might be able to help you. Click the Becoming a Client link for more details.

Related Topics:

 

Additional Tax Information for Small Businesses

In addition to the hundreds of pages of free information I provide on this website, I also sell three e-books filled with more precise information that can help your business or investment save money.

One of the best ways for any business to save money is to maximize tax deductions. Correctly arranging your affairs can save you thousands every year. Read More

If your business is an S corporation, you'll want to set low salaries for shareholders to minimize income and payroll taxes. But this is complicated. Read More

If you invest in real estate, you'll want to take advantage of the giant tax loopholes in real estate laws. I explain how in this book. Read More