1. Other Corporate Models
2. Pass Through
3. Operating an S Corporation
4. Active v Passive Shareholder for an S Corporation
5. S Corp Taxation
6. Passive Income
7. Built-in Gains
8. Pass-through taxation

S corp personal taxes provide flexibility. In the US, a corporation chooses whether to be taxed at the corporate or shareholder level. It can be taxed at the corporate level if it:

  • files a corporate tax return;
  • measures taxable income; and
  • calculates tax liability with a corporate tax rate.

These are characteristics of a C corporation.

Other Corporate Models

Corporations have the flexibility to choose taxation at the shareholder level. In such an instance, a corporation would file a corporate tax return and determine taxable income. The taxable income, which considers deductions and tax credits, would be divided among shareholders. A shareholder would include his part of the income earned by the company, including deductions and credits, on his personal tax return. Under this model, no income tax is applied at the corporate level; rather, income is taxed at the personal tax rate, whatever that rate may be. These are characteristics of an S corporation.

The “S” in the word S corporation relates to the IRC, Chapter 1, subchapter S.

Pass Through

S corporations elect to “pass through” corporate income, losses, deductions, and credits to shareholders for tax purposes. Once received, a shareholder reports the pass-through income, or losses, on his personal return. In turn, taxes are assessed per a shareholder’s personal income tax rate. As a result, an S corporation avoids double taxation.

Operating an S Corporation

To operate as an S corporation, there are a number of IRS requirements:

  • the business is a domestic corporation;
  • maximum of 100 shareholders;
  • shareholders are U.S. citizens; and
  • the shareholders are not other businesses.

Once these requirements have been satisfied, you file IRS Form 2553 that elects S corporation status.

Active v Passive Shareholder for an S Corporation

An active shareholder participates in the management of the day-to-day business activities whereas a passive shareholder has no such responsibilities.

S Corp Taxation

S corporations are taxed, at the corporate level, on the following items:

  • Excess of net passive income;
  • Any LIFO recapture tax; and
  • Any built-in-gains tax.

Note that excess of net passive income and LIFO taxes only apply when the S corporation was a C corp or when an S corporation was a tax-free reorganization operation with a C corporation.

Passive Income

With respect to excess net passive income, this is income from:

  • Interest from loans and the like;
  • Dividends;
  • Annuities or the like;
  • Rent; and
  • royalties

When passive constitutes a number above 25% of an S corporation's (gross) receipts, then that triggers the excess of net passive income tax. The relevant IRS worksheet used to calculate excess net passive income is Form 1120S.

Built-in Gains

The application of built-in gains tax is when an S corporation rids itself of an asset within five years of purchasing such asset, provided that such S corporation either:

  • purchased the asset while the S corporation was formed as a C corporation, or
  • it purchased the asset in a transaction that the asset’s basis was determined by its reference to the asset’s basis that would be purchased by a C corporation.

Pass-through taxation

The tax scheme for an S corporation is a pass-through scheme that affects income, deductions, and tax credits for shareholders. This means that profit earned passes to the shareholder’s personal tax returns.

To illustrate, suppose X corporation is formed as an S corporation with a single shareholder A. X has taxable income of $500,000. The amount, $500,000, is reported from the corporation to the shareholder in Schedule K-1. A takes the amount from the Schedule and reports it on his personal tax report via Schedule E page 2. He then adds this amount to rest of his income via Form 1040.

In other words, pass-through taxation is that income, deductions or credit will retain its character as it passes from the S corporation to the shareholder.

Similarly, when an S corporation sells assets that qualify for long-term capital gains tax, such income is r long-term gain on Schedule K-1, which goes from the corporation to the shareholder. As a result, the shareholder reports such income on his Schedule D as long-term capital gains.

If an S corporation donates to charity then that item would be reported as a charitable donation via Schedule K-1.

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