It was a casual meeting with one of my clients who mentioned about his brother in law who has been a member of S Corporation, a tax entity under U S Taxation. He wanted me to write this article, since we do not have similar tax entity in India.
What is a S Corporation?
Quoting directly from irs.gov, our well known American federal government website for income tax purposes, “S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.”
I am delighted to explain various facts about S Corporation for the intellect of our budding and brilliant tax/advocate/management professionals. Let us have a closer look at Internal Revenue Service instructions on S Corporation from its web site:
https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations
Reproducing from above web site to give more information intellectually and legally to proceed further, we read as under:
“Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income at the entity level.
To qualify for S corporation status, the corporation must meet the following requirements:
- Be a domestic corporation
- Have only allowable shareholders
- May be individuals, certain trusts, and estates and
- May not be partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations) “
To become a S Corporation, it must submit Form 2553, Election by a Small Business Corporation which should be signed by all stake holders. Detailed instructions as to how to fill up the form will be covered later in this article.
Failure to adhere to the instructions on S Corporation issued by IRS has landed several S Corporations into deeper troubles and financial issues. This reason alone propels this writer to quote extensively for giving legal information.
Why does the corporation choose S Corporation status and are they some advantages?
- An S corporation can easily be set up under any State law with the same liability protection like a regular C Corporation.
- Pass through taxation – S Corporation does not pay tax at entry level. With the passage of income, loss, and deductions passing on to the shareholder, the corporation avoids paying double taxation like a C Corporation.
- Self-employment tax – To the often-repeated refrain of my clients whether net come passing through to the shareholder is subjected to self-employment tax or payroll tax, the answer is negative in nature.
- But net operating losses would automatically pass on to the shareholder to be claimed in his/her tax return.
If someone can claim these as advantages, the obvious disadvantages can also be summed up as under:
- Only one class of stock: An S corporation can have only one class of stock and all shareholders enjoy equal rights of distributions. But special allocations are not allowed. Some loans can even violate one-class-of-stock rule and eventually would result in loss of S- Election.
- Loan basis – By assuming some liability on a loan does not increase the shareholder’s basis unless it is a direct loan to the corporation.
- Avoidance of distribution of profit – To the specific question, whether profit distribution can be delayed till such time the shareholder would be in a lower tax bracket, the distributions easily pass on the income to the shareholder automatically and there is no question of avoidance of distribution of income which is not unusual in case of a C Corporation which is also called as an advantage by C Corporation.
Filing deadline
We are not aware of the question regarding the tax return to be filed until informed as Form 1120 S which is due 15th day of the third month following the end of the Corporation’s tax year, which is naturally March 15 for a Calendar Year Corporation.
Schedule K and K-1 (Form 1120 S)
S Corporations File Form 1120 S as tax entity for filing their tax returns.
Form 1120 S may be viewed at the web site quoted below:
www.irs.gov/pub/irs-pdf/f1120s.pdf
Details of Form 1120 S are explained page wise:
- Page 1 (Income, deductions, tax and payments)
- Page 2 (Schedule B with details like accounting method, details of ownership, details of receipts whether they are above $250,000 or less to verify whether forms L, M1 or M 2 to be filled up)
- Page 3 (Schedule- K, explained below, with details)
- Page 4 (Schedule-K and Schedule- L)
- Page 5 (Schedule M-1 and Schedule M-2)
While discussing LLC in one of my earlier articles, I did not touch Schedule K and K-1 with the intention to explain in a future article and the opportunity has arisen now.
Shareholders are liable for tax on their share of the corporation’s income and must include their share of the income on their tax return whether or not it is distributed to them.
Let us explain Schedule K.
One can have a look at Schedule K. at:
www.irs.gov/pub/irs-pdf/f1120s.pdf
Schedule K consists of the following heads:
- Income(loss)
- Deductions
- Credits
- Foreign transactions
- Alternative Minimum Tax(AMT) Items
- Items affecting shareholder basis.
- Other information
- Reconciliation
Schedule K consists of 18 items starting with Ordinary Income(loss) and ending with Reconciliation. It is not uncommon that many Corporations fail to give Schedule K 1 as it is called which is ought to be given to each shareholder on time. It is the duty of the shareholder to report the income in his tax return whether it is distributed to him/her on time or not. Recently, I had to point out this fact to one of my clients.
However, for the intellectual curiosity of any Chartered Accountant from India, I have given below the exact details of 10 items of Income(loss) as under:
- Ordinary business income/loss
- Net real estate income/loss
- Other gross rental income/loss, expenses from other rental activities, other rental income/loss
- Interest income
- Dividends, ordinary dividends, qualified dividends
- Royalties
- Net- short term capital gain/ loss
- Net- long term capital gain/ loss, Collectibles, Unrecaptured section 1250 gain
- Net section 1231 gain/loss
- Other gain/loss.
Schedule K 1 shows each shareholder’s separate share of items form Schedule K.
Certain items are subject to limits or other special treatment on the shareholder’s return. These items are separately stated on Schedule K-1(Form 1120S) as per details given below:
- Income or loss from rental real estate
- Income or loss from other rental activity
- Interest
- Dividends
- Royalties
- Capital gains and losses
- IRC Section 1231 gains and losses
- Investment expenses
- Charitable contributions
- Section 179 Expenses
- Tax preferences and adjustments for AMT computations
- Non- business bad debts.
Special rules apply in case S Corporation disposes property under Section 179 provisions.
For returns on which there is no tax due but there are late filing issues, the penalty for S Corporation non-filing of tax return attracts $195 per month times the number of share- holders, up to 12 months. If any S Corporation taxes are due, the penalty is the amount stated above, plus 5% of the unpaid tax for each month or part of a month up to a maximum of 25% of unpaid tax.
Schedule K- 1. A $250 penalty applies for each failure to timely issue of Schedule K1 to a shareholder or failure to provide required information. The penalty gets enhanced if the failure to provide the schedule Is intentional.
Who are the eligible shareholders of a S Corporation?
The list is:
- Individuals – U.S. citizens or residents
- Decedent’s estates
- Bankruptcy estates
- IRC 501 (C) (3) Charitable organizations
- Qualified Sub Chapter S Trusts
- Electing Small Business Trusts
- Employees stock option plans
- Qualified pension plans
- Qualified profit sharing plans
The ineligible shareholders do raise their heads and clamor for mention as under:
- Corporations
- Partnerships
- Charitable remainder trusts
- IRAs
- Simplified employee pensions
- SIMPLE plans
- State and local governments
- Simple – member LLCs (If the LLC has elected to tax itself as a corporation)
What about ineligible Corporations?
- A financial institution using reserve method of accounting for bad debts
- Insurance companies
- A Corporation that elects itself to be treated as a possessions corporation under IRC section 936
- A domestic international sales corporation.
One-Class-of-Stock Rule
A corporation that does have more than one class of stock gets itself disqualified as a S Corporation. Offering identical rights to distribution rights and liquidation proceeds is a sign of existence of one type of stock. Yes, one does make the inference that the stock confers identical rights from the corporation’s governing provisions, which are well defined in the regulations as the corporate charter, articles of incorporation, bylaws, applicable state law, or binding agreements. It is strange that one should make a S Corporation to make it ineligible by simply having more than one class of stock.
Some specialist CPAs have opined that any time distributions are made to shareholders, each one of them must receive a distribution in proportion to the percentage of stock owned. Distributions that may differ either in timing or amount invariably lead one to conclude that second class of stock have been created resulting in termination as S Corporation.
It is important to note that IRS does not take kindly to violations as explained above.
Let us hear how a corporation elects itself as a S Corporation and the procedural aspects thereof.
Form 2553, Election by a Small Business Corporation is filed by any Corporation to elect to be taxed as an S Corporation. The due date for this election obviously falls on 15th of the third month of the tax year when the election has to take place. Our simple knowledge indicates March 15 for a calendar year corporation. Yes, the corporation make the election in one year for application in the next tax year.
Now the additional procedural aspects.
Naturally, all the shareholders have to give consent to an S Corporation election by signing form 2553. One can refer to above form in the following web site.
www.irs.gov/pub/irs-pdf/f2553.pdf
Form 2553 enthralls one with 4 pages and involving also 4 parts. An eligible non-corporate entity that files Form 2553 is said to have made the selection as an S Corporation and will be taxed as such. This obviates the need to file Form 8832, Entity Classification Election in order to choose S Corporation election.
Form 2553 requires share holder information like the name, address, taxpayer ID, information about stock ownership, and taxable year of the share- holder. This also facilitates non-requirement of future shareholders to make the same selection.
Since this write up is a bit of technical in nature, I intend explaining S Corporation Shareholder’s basis both on stock basis as well as loan basis.
Important points to understand:
- All distributions of cash or property and flow through deductions are applied first against stock basis. If there would be sufficient stock basis to absorb the amounts, there is no taxable income to the shareholder, and the losses and deductions are fully allowed on the shareholder’s tax return.
Let us analyze a little better. If a distribution of cash or property exceeds stock basis, the excess is treated as a taxable capital gain. These deductions are taken into consideration before flow-through losses and deductions.
Obviously, anyone can deduct that loan basis is a second tier of basis that can be applied to deduct flow-through losses and deductions only if the stock basis has been reduced to zero. It is clearly understood that stock basis gets priority over loan basis.
One significant difference between stock basis and loan basis is that tax-free distributions are to be taken against stock basis only and not loan basis. Yes, continuing our argument, the existence of zero stock basis, enables a distribution to be called as a nontaxable repayment of a shareholder loan instead of a distribution.
S Corporation Shareholder’s basis can be increased or decreased. Is it so?
This is answered under the following plus and minus of shareholder’s basis.
Basis gets increased by:
- Ordinary income
- Separately stated income items
- Stock purchases and additional capital contributions
- Tax-exempt income
- Express depletion
Basis also gets decreases and if so, by:
- Distributions
- Nondeductible expenses
- Ordinary loss
- Separately stated loss items.
Stock basis in any case can’t go below zero.
Loans
Yes, direct loans.
By giving direct loan to the S Corporation, a shareholder can increase his loan basis
By Internal Revenue Code 1366(d) (1) (B), a loan increases basis by “the shareholder’s adjusted basis of any indebtedness of the S Corporation to the shareholder” It is very clear that the shareholder has directly lent loan to the S Corporation rather than being a guarantor. The basis is not even increases as per a tax court ruling in case the transaction lacks economic substance.
Interestingly, any increase from income items must be applied towards increasing the basis in loan which were in place at the beginning of the year. The loan basis is restored up to the loan
balance (Original loans less repayments).
Termination of a S Corporation
This article very clearly gave various examples when an S Corporation terminates and becomes a C Corporation. Occurrence of any one of the following situations do result in such a situation:
- Shareholder revokes the election
- The corporation fails to qualify as an S Corporation
- The Corporation violates the passive income restrictions (For corporations with earnings and profits)
Passive investment violation
An S Corporation election shall terminate if passive investment income exceeds 25% of gross receipts for three consecutive taxable years, and the corporation has accumulated earnings and profits from periods when the corporation was existing as a C Corporation. The termination will happen on the first day of the taxable year after three-year period.
However, an inadvertent termination can be rectified by the corporation by taking adequate steps within a reasonable time. Definite permission from IRS is needed to reverse the process.
However, there is a 5-year waiting period for reinstatement of S Corporation election when termination really took place in normal circumstances.
Let us conclude our discussions with a real-life instance from an old court cases.
Real happening
The tax payer in one of the states in U.S.A. took out annual loans from his wholly-owned partnership, which in turn was lent to his S Corporation. The situation continued with the S Corporation paying equivalent amounts of rent back to the partnership. The tax court observed that the tax payer did not acquire a basis in the indebtedness of the S Corporation since the transaction involved a circular flow of funds and the tax payer indeed, did not have an economic out lay. (Kerzner, T.C. Memo 2009-76)
Conclusion
We do not have a tax entity as S Corporation. But is there any guarantee that we would never have it in near future? When we failed to attempt in the past in 1950-1960, we had some of the lowest economic GDP, popularly known as” Hindu Growth”. But, today, India ranks among the fastest growing economies in the world.
Keeping this fact in mind, the writer undertook the writing of this article which explains the concept of S Corporation, the strengths and weaknesses of the Corporation, who can be an eligible/ineligible shareholder, the loan basis and stock basis of the stockholder in the S Corporation, one stock one class rule, and the ways to increase the basis of a stock holder in the corporation and similarly what decreases his/her basis. This article needs to be read in consonance with my article “U S Taxation – Partnership Firms -LLC & Others – Series 1”. There are many similarities among these articles since both are flow through entities. Both rank among the most popular form of tax entities for doing business.
In any case, enrichment of one’s knowledge of American taxation is a birth-right of any growing professional since who knows the next client may emerge from American Taxation.
Reference
- Deluxe edition of Federal 1040-Small Business-Estates &Trusts Tax Year book 2016 published by Tax Materials Inc, Minnetonka, MN 55345, U.S.A. This is considered as the most referred tax book for CPAs in U.S.A., updated every year with maximum passion.
- https://taxguru.in/income-tax/taxation-partnership-firms-llc-series-1.html
- 1120 S – U S Income Tax Return for an S Corporation from irs.gov web site
- 1120 S – Instructions from irs.gov web site
- Schedule K 1 from web site irs.gov or refer it at web site
- https://www.irs.gov/pub/irs-pdf/f1120ssk.pdf
- Form 2553 from web site irs.gov
Author Bio
