Taxes S Corp: Everything You Need to Know
Doing taxes S Corp style is when a corporation has elected to pass the income, credits, deductions, and losses of the corporation to the shareholders for federal tax filing purposes. 3 min read
2. C Corporations
3. S Corporations
4. Excess Net Passive Income
5. LIFO Recapture Tax
6. Built-In Gains
Doing taxes S Corp style is when a corporation has elected to pass the income, credits, deductions, and losses of the corporation to the shareholders for federal tax filing purposes.
General Information About S Corporation Taxes
- S corporations are considered "pass-through" entities. With this type of structure, federal income tax is not filed by the corporation.
- An S corporation operates like a corporation but it is not taxed in the same way. With an S corporation, each individual shareholder is responsible for filing the taxes. Shareholders will be taxed based on their share of the corporations' income.
- S corporation shareholders do not pay self-employment tax on their share of the corporation's profits.
- Shareholders who work as an employee must be paid a reasonable salary. The salary is subject to Medicare and Social Security taxes.
- The tax code does not specify what constitutes a reasonable salary. Some factors considered in court rulings include the training and experience of the employee-shareholder duties and responsibilities, such as time devoted to the corporation, the amount paid in dividends, comparable salaries for similar services, and the wages paid to non-shareholder employees.
- Since there is the potential risk of tax abuse by an S corporation, the Internal Revenue Service tends to keep a closer eye on this type of entity.
- In some states, an S corporation is required to pay additional fees and taxes. In California, for example, there is a 1.5 percent tax on income with an $800 minimum annual income.
- S corporations use Form 1120S to file its annual federal taxes.
- Forms K-1 and K are also filed by an S corporation to outline the allocated deductions and income among owners.
When a corporation chooses to remain with the standard income tax process, the corporation will file a corporate tax return; no income tax is filed. The taxable income is determined, and the tax is then calculated using the corporate level tax rate. In this structure, the business is considered a C corporation.
A C corporation distributes profits to shareholders via dividends. The dividends become taxable income for shareholders. C corporations have the option to elect to file at the shareholder level. In this situation, the corporation will still file a corporate tax return and determines the taxable income. Once the taxable income and other tax credits and deductions are figured, shareholders will each receive a portion.
Shareholders in an S corporation must report the pass-through income along with any losses that affect their personal federal tax return that is assessed based on individual rates.
An advantage of reporting pass-through income avoids double taxation on the corporate income.
An S corporation is responsible for taxes on:
- Excess net passive income
- Built-in Gains
- LIFO recapture tax
Excess Net Passive Income
This is a corporate-level tax on an S corporation earned passive income. Passive income includes royalties and rents, dividends, interest, and annuities. For more information, see section 1362 paragraph (d)(3)(c) of the Internal Revenue Code. For passive income that exceeds 25 percent of the S corporation's receipts, the excess net passive income tax will be applied.
LIFO Recapture Tax
For the LIFO recapture tax to be applied, one of two conditions exist. In the first instance, the LIFO inventory pricing method was used in its last tax year as a C corporation. The second situation is when a C corporation transferred its LIFO inventory to the corporation by using a nonrecognition transaction, which means those assets were transferred basis property. LIFO — Last In First Out — is the method used to measure a corporation's inventory for tax purposes.
This tax applies when an asset is disposed of within five years after being acquired by an S corporation and either acquired the asset while it was a C corporation, or the asset was acquired in a transaction where the basis of the asset is referenced by the C corporation.
The only time the LIFO recapture tax and the excess net passive income apply is if the S corporation was subject to a tax-free reorganization with a C corporation or the S corporation had previously been a taxable C corporation.
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