7781 / How is an S corporation taxed?

Editor’s Note: See Q to Q for a discussion of the substantial changes to S corporation taxation made by the 2017 tax reform legislation.

An S corporation is generally not subject to tax at the corporate level.¹ However, a tax is imposed at the corporate level under certain circumstances described below. When an S corporation disposes of property within 10 years after the S election has been made, gain attributable to pre-election appreciation of the property (built in gain) is taxed at the corporate level to the extent such gain does not exceed the amount of taxable income imposed on the corporation as if it were not an S corporation.² (ARRA 2009 provided that, in the case of a taxable year beginning in 2009 or 2010, no tax was to be imposed on built in gain if the seventh taxable year of the ten-year recognition period preceded such taxable year. The Creating Small Business Jobs Act of 2010 provided that, for a taxable year beginning in 2011, no built in gain tax was to be imposed if the fifth year of the recognition period preceded that year. The American Taxpayer Relief Act of 2012 extended that rule for taxable years beginning in 2012 and 2013 and the Protecting Americans Against Tax Hikes Act of 2015 (PATH) made the rule permanent.)

For S elections made after December 17, 1987, a corporation switching from a C corporation to an S corporation may also be required to recapture certain amounts at the corporate level in connection with goods previously inventoried under a LIFO method.³

In addition, a tax is imposed at the corporate level on excess “net passive income” of an S corporation (passive investment income reduced by certain expenses connected with the production of such income) but only if the corporation, at the end of the tax year, has accumulated earnings and profits (either carried over from a year in which it was a nonelecting corporation or due to an acquisition of a C corporation), and if passive investment income exceeds 25 percent of gross receipts. The rate is the highest corporate rate (currently 21 percent).⁴ “Passive investment income” for this purpose is rents, royalties, dividends, interest, and annuities.⁵

However, passive investment income does not include rents for the use of corporate property if the corporation also provides substantial services or incurs substantial cost in the rental business,⁶ or interest on obligations acquired from the sale of a capital asset or the performance of services in the ordinary course of a trade or business of selling the property or performing the services. Also, passive investment income does not include gross receipts derived in the ordinary course of a trade or business of lending or financing; dealing in property; purchasing or discounting accounts receivable, notes, or installment obligations; or servicing mortgages.⁷ Regulations provide that if an S corporation owns 80 percent or more of a C corporation, passive investment income does not include dividends from the C corporation to the extent the dividends are attributable to the earnings and profits of the C corporation derived from the active conduct of a trade or business.⁸ If amounts are subject to tax both as built-in gain and as excess net passive income, an adjustment will be made in the amount taxed as passive income.⁹

Also, tax is imposed at the corporate level if investment credit attributable to years for which the corporation was not an S corporation is required to be recaptured.¹⁰

Furthermore, an S corporation may be required to make an accelerated tax payment on behalf of its shareholders if the S corporation elects not to use a required taxable year.¹¹ The corporation is also subject to estimated tax requirements with respect to the tax on built in gain, the tax on excess net passive income, and any tax attributable to recapture of investment credit.¹²

Like a partnership, an S corporation computes its taxable income similarly to an individual, except that certain personal and other deductions are allowed to a shareholder but not to the S corporation, and the corporation may elect to amortize organizational expenses.¹³ Each shareholder then reports on the shareholder’s individual return the proportionate share of the corporation’s items of income, loss, deductions, and credits; these items retain their character on pass-through.¹⁴ Certain items of income, loss, deduction, or credit must be passed through as separate items because they may have an effect on each individual shareholder’s tax liability. For example, net capital gains and losses pass through as such to be included with the shareholder’s own net capital gain or loss. Any gains and losses on certain property used in a trade or business are passed through separately to be aggregated with the shareholder’s other IRC Section 1231 gains and losses. (Gains passed through are reduced by any tax at the corporate level on gains.) Miscellaneous itemized deductions pass through to be combined with the individual’s miscellaneous deductions for purposes of the 2 percent floor on such deductions (these deductions were suspended from 2018-2025). Charitable contributions pass through to shareholders separately subject to the individual shareholder’s percentage limitations on deductibility. Tax exempt income passes through as such. Items involving determination of credits pass through separately.¹⁵

Before pass-through, each item of passive investment income is reduced by its proportionate share of the tax at the corporate level on excess net passive investment income.¹⁶ Items that do not need to be passed through separately are aggregated on the corporation’s tax return and each shareholder reports his or her share of such nonseparately computed net income or loss on his or her individual return.¹⁷ Items of income, deductions, and credits (whether or not separately stated) that flow through to the shareholder are subject to the “passive loss” rules (see Q 8010 through Q 8021) if the activity is passive with respect to the shareholder. See Q 8011. Apparently, items taxed at the corporate level are not subject to the passive loss rule unless the corporation is either closely held or a personal service corporation. See Q 8010.

Thus, whether amounts are distributed to them or not, shareholders are taxed on the corporation’s taxable income. Shareholders take into account their shares of income, loss, deduction, and credit on a per-share, per-day basis.¹⁸ The S corporation income must also be included on a current basis by shareholders for purposes of the estimated tax provisions. See Q 648.¹⁹

The Tax Court determined that when an S corporation shareholder files for bankruptcy, all the gains and losses for that year flowed through to the bankruptcy estate. The gains and losses should not be divided based on the time before the bankruptcy was filed.²⁰