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.

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