An S Corporation or S Corp is an eligible domestic corporation that has elected to be treated as an S Corporation for tax purposes. S Corporations avoid double taxation on corporate income because corporate income, losses, deductions and credits are passed through to the shareholders. Shareholders of the S corporation report the income and losses on their personal tax returns. However, S Corps are responsible for tax on certain built-in gains and passive income at the entity level.
Undistributed taxable income of the S corporation that is passed through to its shareholders is not treated as earnings from self- employment (Rev. Rul. 59-221, 1959-1 C.B. 225) and is therefore not subject to self-employment tax.
It is however required that a shareholder who performs service for an S corp should receive “reasonable compensation”. If a shareholder receives “dividends” or other distribution in lieu of reasonable compensation for services performed for the S corporation, the amounts received may be deemed to be wages requiring the payment of payroll taxes and the filing of payroll returns. (Rev. Rul. 74-44, 1974-1 C.B. 287).
Shareholder loss limitations
As mentioned above, shareholders of an S corp report income and losses from the S corp on their personal returns. There are three limitations to the amount of the flow-through loss that can be claimed by the shareholder:
1. Stock and Debt Basis Limitations
2. At Risk Limitations
3. Passive Activity Loss Limitations
The shareholder has to meet each limitation in the order presented to be able to claim the loss. (I will be addressing the S corp shareholder stock and debt basis in a future post).
Although an S corp is generally exempt from federal income tax, there are circumstances where the S corp may have a tax liability. This is usually the case if it was previously a C corp and has:
• Built-in gains
• Excess net passive income
An S Corp may be subject to penalties for:
• Late filing – a charge for each month or part of a month (up to 12 months) multiplied by the number of shareholders during any part of the year for which the return is due. (26 U.S. Code § 6699).
• Failure to furnish K-1 to shareholders. (26 U.S. Code § 6722 (a))
26 U.S. Code § 6699 – Failure to file S corporation return, http://www.law.cornell.edu/, viewed May15, 2014.
26 U.S. Code § 6722 (a)- Failure to furnish correct payee statements, http://www.law.cornell.edu/ viewed May15, 2014.
Rev. Rul. 59-221, 1959-1 C.B. 225, http://www.irs.gov/pub/irs-wd/03-0026.pdf, viewed May15, 2014.
Rev. Rul. 74-44, 1974-1 C.B. 287, Cash Intensive Businesses Audit Techniques Guide – Chapter 11, http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/ ,viewed May15, 2014.