805 / What is an S corporation? How is an S corporation taxed?

An S corporation is one that elects to be treated, in general, as a pass-through entity, thus avoiding most tax at the corporate level.¹ To be eligible to make the election, a corporation must meet certain requirements as to the kind and number of shareholders, classes of stock, and sources of income. An S corporation must be a domestic corporation with only a single class of stock and may have up to 100 shareholders (none of whom are nonresident aliens) who are individuals, estates, and certain trusts. An S corporation may not be an ineligible corporation. An ineligible corporation is one of the following: (1) a financial institution that uses the reserve method of accounting for bad debts; (2) an insurance company; (3) a corporation electing (under IRC Section 936) credits for certain tax attributable to income from Puerto Rico and other U.S. possessions; or (4) a current or former domestic international sales corporation (DISC). Qualified plans and certain charitable organizations may be S corporation shareholders.²

Members of a family are treated as one shareholder. “Members of the family” are defined as “the common ancestor, lineal descendants of the common ancestor, and the spouses (or former spouses) of such lineal descendants or common ancestor.” Generally, the common ancestor may not be more than six generations removed from the youngest generation of shareholders who would be considered members of the family.³

Trusts that may be S corporation shareholders include the following: (1) a trust all of which is treated as owned by an individual who is a citizen or resident of the United States under the grantor trust rules (see Q 797); (2) a trust that was described in (1) above immediately prior to the deemed owner’s death and continues in existence after such death may continue to be an
S corporation shareholder for up to two years after the owner’s death; (3) a trust to which stock is transferred pursuant to a will may be an S corporation shareholder for up to two years after the date of the stock transfer; (4) a trust created primarily to exercise the voting power of stock transferred to it; (5) a qualified subchapter S trust (QSST); (6) an electing small business trust (ESBT); and (7) in the case of an S corporation that is a bank, an IRA or Roth IRA.⁴

A QSST is a trust that has only one current income beneficiary (who must be a citizen or resident of the U.S.), all income must be distributed currently, and corpus may not be distributed to anyone else during the life of such beneficiary. The income interest must terminate upon the earlier of the beneficiary’s death or termination of the trust, and if the trust terminates during the lifetime of the income beneficiary, all trust assets must be distributed to that beneficiary. The beneficiary must make an election for the trust to be treated as a QSST.⁵

An ESBT is a trust in which all of the beneficiaries are individuals, estates, or charitable organizations.⁶ Each potential current beneficiary of an ESBT is treated as a shareholder for purposes of the shareholder limitation.⁷ A potential current beneficiary is generally, with respect to any period, someone who is entitled to, or in the discretion of any person may receive, a distribution of principal or interest of the trust. In addition, a person treated as an owner of a trust under the grantor trust rules (see Q 797) is a potential current beneficiary.⁸ If for any period there is no potential current beneficiary of an ESBT, the ESBT itself is treated as an
S corporation shareholder.⁹ Trusts exempt from income tax, QSSTs, charitable remainder annuity trusts, and charitable remainder unitrusts may not be ESBTs. An interest in an ESBT may not be obtained by purchase.¹⁰ If any portion of a beneficiary’s basis in the beneficiary’s interest is determined under the cost basis rules, the interest was acquired by purchase.¹¹ An ESBT is taxed at the highest income tax rate under IRC Section 1(e) (currently, 37 percent).¹² The 2017 Tax Act expands the definition of a qualifying beneficiary under an electing small business trust (ESBT) to include nonresident aliens.¹³ This provision is effective beginning January 1, 2018.

A corporation will be treated as having one class of stock if all of its outstanding shares confer identical rights to distribution and liquidation proceeds.¹⁴ However, “bona fide agreements to redeem or purchase stock at the time of death, disability or termination of employment” will be disregarded for purposes of the one-class rule unless a principal purpose of the arrangement is to circumvent the one-class rule. Similarly, bona fide buy-sell agreements will be disregarded unless a principal purpose of the arrangement is to circumvent the one-class rule and they establish a purchase price that is not substantially above or below the fair market value of the stock. Agreements that provide for a purchase price or redemption of stock at book value or a price between book value and fair market value will not be considered to establish a price that is substantially above or below fair market value.¹⁵ Regulations provide that agreements triggered by divorce and forfeiture provisions that cause a share of stock to be substantially nonvested will be disregarded in determining whether a corporation’s shares confer identical rights to distribution and liquidation proceeds.¹⁶

An S corporation is generally not subject to tax at the corporate level.¹⁷ However, a tax is imposed at the corporate level under certain circumstances described in Q 809. When an S corporation disposes of property within 10 years after an 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 if it were not an S corporation.¹⁸ ARRA 2009 provided that, in the case of a taxable year beginning in 2011, no tax is imposed on the built in gain if the fifth taxable year of the 10-year recognition period precedes such taxable year.

Like a partnership, an S corporation computes its taxable income similarly to an individual, except that certain personal and other deductions (see Q for a discussion of the new QBI deduction) are allowed to a shareholder but not to the S corporation, and the corporation may elect to amortize organizational expenses.¹⁹ Each shareholder then reports on his individual return his proportionate share of the corporation’s items of income, loss, deductions and credits. These items retain their character on pass-through.²⁰ 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.²¹ 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.²² Items that do not need to be passed through separately are aggregated on the corporation’s tax return and each shareholder reports his share of such non-separately computed net income or loss on his individual return.²³ Items of income, deductions, and credits (whether or not separately stated) that flow through to the shareholder are subject to the “passive loss” rule (see Q 8009 through Q 8020) if the activity is passive with respect to the shareholder (see Q 8010). 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 8009). See Q and Q for a discussion of how the deduction for business interest was impacted by the 2017 Tax Act.

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.²⁴ The S corporation income must also be included on a current basis by shareholders for purposes of the estimated tax provisions (see Q 648).²⁵

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.²⁶