(Continuation of Taxation Of Corporations, Click Here For Part 1)

WHAT STANDARDS APPLY TO S CORPORATIONS?

An S corporation is a pass-through entity. Even though both partnerships and S corporations are pass-through entities – unlike partnerships – shareholders of S corporations do not have the ability to form advance agreements in order to allocate the entity’s profits and losses. Instead, all of the earnings and expenses pass through to the shareholders based on their percentage of ownership in the corporation.

Requirements For Qualification And Compliance

In order to qualify as an S corporation, the entity must meet the following requirements: (1) it must be a domestic corporation; (2) it generally cannot have more than 100 shareholders; (3) it must have only one class of stock; (4) the business must satisfy the definition of a small business corporation under Section 1361 of the Internal Revenue Code; and (5) shareholders that are individuals must generally be U.S. citizens or residents (shareholders that are corporations or partnerships are generally excluded).

For a calendar year corporation to be eligible to make the ‘S’ election, it must file Form 2553 generally within the first two and a half months of the tax year, if it is seeking for the S corporation treatment to be effective for that tax year. The S corporation must always file a tax return irrespective of its income and losses unless the corporation has been dissolved. The tax returns are filed on Form 1120S.

The shareholders are required to pay estimated taxes if their own tax returns have exceeded or are expected to exceed $500 when the returns are filed. The shareholders are required to report all applicable categories of earnings and losses on Schedule K-1. Shareholders of S corporations must pay taxes on their share of the corporate income regardless of whether distributions are made. The amount of taxes the shareholders may pay is contingent upon their stock basis in the S corporation.

Determining Stock Basis

The basis of the corporate stock is critical since both the taxability of a distribution and the deductibility of a loss are contingent upon the shareholder’s stock basis. The basis may be adjusted annually. It is the individual shareholder’s obligation to track his or her own basis in the corporate stock.

The starting point for determining a shareholder’s basis in an S corporation stock is the initial contribution by the shareholder. Basis is generally determined by how the stock was initially acquired. Generally, the stock of a corporation may be acquired in a number of ways including by purchase, gift, or inheritance.

If the stock was acquired by purchase, the basis of the stock is generally the initial cost of the shares. If it was acquired by gift, the shareholder’s basis is generally the donor’s basis in the stock. If it was acquired by inheritance, the shareholder’s basis is generally the fair market value of the stock on the date of the former shareholder’s death. If it was acquired by the shareholder’s performance of services, the basis of an S corporation stock is measured by the fair market value of the stock at the time the services were rendered (unlike in C corporations where the basis is determined by the fair market value of the services rendered).

If the stock was acquired in accordance with Section 351 of the Internal Revenue Code (where the shareholder acquired control of the corporation immediately after the transfer of property), the basis of the stock is any cash invested, increased by the basis of the property transferred to the corporation, increased by any gain recognized on the transfer, decreased by any boot received from the corporation. If the corporation was operating as a C corporation prior to making the S election, the basis in the S corporation stock is the basis in the C corporation stock at the time of transfer.

Distributions To Shareholders

Distributions by S corporations are generally not treated as dividends. The distributions themselves are not subject to income tax unless they exceed the shareholder’s adjusted basis in the stock. If the corporation makes a distribution of property, the distribution is treated as a sale to the shareholder. If the fair market value of the property exceeds the corporation’s adjusted basis, the corporation would recognize the gain. However, the corporation would not recognize a loss if the fair market value of the property was less than the corporation’s adjusted basis in the property.

Distributions that exceed the shareholder’s basis in the corporate stock are treated as capital gains. When the gain passes through to the shareholder, yet a distribution is not made to the shareholder, the gain increases the basis in his stock. However, if a distribution is made, the shareholder’s basis may be reduced to the extent of the difference between the distribution and the shareholder’s basis in the stock.

To illustrate how basis calculations are relevant to shareholders of S corporations, consider the following example. Shane is the sole shareholder of S Corp whose stock basis is $5,000. S Corp earned $5,000 in 2019. If a distribution is not made to Shane in 2020, his new basis in the stock will be $10,000. If Shane instead receives a distribution in the amount of $10,000, his basis will be reduced to zero since he would have a return of capital on his stock. The remaining $5,000 will be treated as a capital gain because Shane received an extra sum of money after his basis was reduced to zero.

Reasonable Compensation

Instead of making a distribution, an S corporation may provide salaries or wages to its employees. However, salaries and wages are subject to employment taxes whereas distributions are not. If the distributions are received by a shareholder-employee and he or she is not receiving reasonable compensation for the services provided to the corporation, the distributions may be reclassified as wages (in which case they may be subject to employment taxes). The IRS does not have any specific guidelines with regard to reasonable compensation. However, the factors that are considered include training and experience, dividend history, the amount that similar businesses pay for similar services, and compensation agreements.

Qualified Business Income

Since Congress (specifically the GOP) provided significant benefits to C corporations under TCJA by reducing the top rate from 35% to 21% and repealing the Alternate Minimum Tax for corporations, they also assumingly wanted to provide significant benefits to pass-through entities. Under TCJA, there is a new deduction available for pass-through entities under Section 199A of the Internal Revenue Code. For purposes of the new law, pass-through entities include S corporations, sole proprietorships, limited liability companies, partnerships, trusts, and estates. This deduction is known as Qualified Business Income (“QBI”).

Even though QBI is available for pass-through entities more broadly, the following analysis is based on the shareholder-employees of S corporations. Generally, the QBI deduction allows business owners of pass-through entities to potentially receive up to a 20% deduction on their business income. The two primary sources of income available to shareholder-employees generally boil down to two categories: compensation for services and business profits.

The portion of the income represented by the business profits is the amount that is available after the shareholder receives reasonable compensation for his or her services. Compensation for services comes in the form of W-2s and it is classified as wages. The portion of the income that qualifies as business profits (e.g., K-1) is the amount that exceeds the W-2s. It is this (business profits) portion of the shareholder-employee’s income that is potentially entitled to the QBI deduction.

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