S Corporation Taxable Income: Everything You Need to Know
S corporation taxable income comes in the form of passing through profits to its shareholders. 3 min read
2. LIFO Recapture Tax
3. Built-In Gains Tax
4. How Tax Items are Treated as Pass-Through
5. No Need to Pay Self-Employment Tax
S corporation taxable income comes in the form of passing through profits to its shareholders. This is known as a pass-through corporate structure and allows shareholder/owners to potentially pay a lower effective tax rate on their income. S corporations don't have to deal with the double taxation issue, whereas a C corporation does. However, an S corporation does have to pay tax on some gains and passive income the corporation earns money on.
Excess Net Passive Income Tax
Passive income is derived from financial instruments that include:
In the event the passive income exceeds 25 percent of the gross receipts of the corporation, the excess net passive income tax comes into play.
LIFO Recapture Tax
LIFO is shorthand for the "last-in-first-out" method of inventory valuation. It's a system that may allow the S corporation to avoid paying the built-in gains tax, but only in the event that inventory amounts remain at a stable level or increase in the years ahead. But there is a provision that can prevent the S corporation from avoiding the built-in gains tax. That is, the amount of the first-in, first-out inventory (FIFO) value has to exceed the inventory value determined under LIFO.
Built-In Gains Tax
This is invoked when a C corporation converts to an S corporation and has taxable income in the five years prior to the conversion. The built-in gains tax is applied to any profits that were showing at the time of conversion. The gain is then due if any equipment bought in those five years is sold after the conversion to an S corporation.
How Tax Items are Treated as Pass-Through
Certain income items are passed through to the shareholders in an S corporation. The term "pass-through" is shorthand for the fact that any financial gains made by the company pass from the corporate level to the shareholder's individual income tax return.
In the event the S corporation sold an asset that qualifies for long-term capital gains treatment, the income is reported as such on the shareholder's Schedule K-1. The individual shareholder reports this income on Schedule D of his personal tax return under the long-term gains entry.
A similar situation is when an S corporation makes charitable donations. The item is then listed as a charitable donation on the appropriate line of entry on the Schedule K-1. The shareholder reports her share of the charitable donation as a deduction under itemized deductions.
The pass-through treatment of taxable items means all items are handled in the correct way on the shareholder's individual tax return. And S corporation shareholders pay the same income tax rates as private individuals. But the amount of taxes paid by shareholders can vary depending on how much effort they put into the business. However, the S corporation has an advantage in that the corporate income is only taxed at the personal level instead of undergoing double taxation at the individual and corporation levels.
No Need to Pay Self-Employment Tax
Because profits from the S-corporation is not treated as employment income, the shareholder is not required to pay self-employment taxes on his portion of the profits. However, before a profit can be realized from the corporation, each owner who works as an employee has to be paid a "reasonable amount" in compensation. The savings from not paying self-employment taxes are only realized when the S corporation is earning enough money to distribute profits after the mandatory "reasonable amount" is paid in compensation.
How each owner is taxed depends on how the payroll taxes and ACA Net Investment Income Tax impacts their personal situation. An active shareholder usually receives two income types from the S-corporation: profit distribution and income. Income has to pay the payroll taxes which is 15.3 percent on the first $117,000, while the profit distribution is exempted from payroll taxes.
Passive shareholders, ones that have no daily role in the operation of the S corporation, don't pay payroll taxes on their profits, as they don't draw income from the business. They are liable for the ACA's Income Tax, and this tax only kicks in when the income is over $200,000. The implication is that a passive shareholder may have to pay higher tax rates than a shareholder who is active.
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