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An Overview of the Federal Taxation of S Corporations

An Overview of the Federal Taxation of S Corporations

By Anthony Diosdi

A U.S. corporation can be taxed as either a C or S corporation. C corporations are subject to a double tax regime meaning that there is a tax at the corporate level and a second tax when a dividend is paid to the shareholders. An S corporation is an alternative to the two-tier tax system applicable to C corporations. For federal tax purposes, with an S corporation, there is no corporate taxation. Instead, only the shareholders of an S corporation are subject to tax when there is a distribution from the corporation. Since S corporations are only subject to one layer of tax, S corporate shareholders tend to recognize less tax than C corporate shareholders. This article will discuss the basic rules governing the federal taxation of S corporations.

Election to be a S Corporation

An otherwise eligible corporation may elect S corporate status under Section 1362 of the Internal Revenue Code if all the shareholders consent. Once made, an election remains effective until it is terminated under Section 1362(d) of the Internal Revenue Code. An election is effective as of the beginning of a taxable year if it is made either during the preceding taxable year or on or before the fifteenth day of the third month of the current taxable year. If the election is made during the first 2 1/2 months of the year, the S corporation eligibility requirement must have been met for the portion of the taxable year prior to the election, and all shareholders at any time during the pre-election portion of the year must consent to the election. See IRC Section 1362(b)(2). If the eligibility requirements are not satisfied during the pre-election period or if any shareholder who held stock during that period does not consent, the election does not become effective until the following taxable year. See IRC Section 1362(b)(2)(B). In some cases, where an S-corporation election has not been timely filed, the Internal Revenue Service (“IRS”) may permit a late filed election.

An S election may be revoked with the consent of more than one-half of the shares of the stock of the corporation on the day the revocation is made. See IRC Section 1362(d)(1)(B). The S corporation may specify any effective date on or after the day of the revocation. If an effective date is not selected, a revocation is effective: 1) on the first day of the taxable year if made before the sixteenth day of the third month of such year, or 2) ob the first day of the next taxable year if it is made after the fifteenth day of the third month of the year.

Eligibility for S Corporate Status

Eligibility to make a Subchapter S election is limited to a “small business corporation,” defined in Section 1361(b) of the Internal Revenue Code as a domestic corporation which is not an “ineligible corporation” and which has: 1) no more than 75 shareholders; 2) only shareholders who are individuals, estates, and certain types of trusts and tax-exempt organizations; 3) no nonresident alien shareholders; and 4) not more than one class of stock. A husband and wife (and their estates) are considered as one shareholder for purposes of the 75-shareholder limit. If stock is owned (other than by a husband and wife) by tenants in common or joint tenants, each owner is considered to be a shareholder of the corporation.

An S corporation may not have as a shareholder a person (other than an estate and certain trusts) who is not an individual or a 501(c)(3) tax-exempt charitable organization or qualified pension trust.

The following types of domestic trusts are eligible S corporation shareholders:

1) Grantor trusts-i.e., domestic trusts for income tax purposes as owned by an individual who is a U.S. citizen or resident. The deemed owner of the trust is treated as the shareholder. If the deemed owner of a grantor trust dies and the trust continues in existence as a testamentary trust, it continues to be a permissible shareholder for the 2-year period following the deemed owner’s death.

2) Testamentary Trusts- to which stock has been transferred pursuant to a will, but only for the 2-year period beginning on the day of transfer.

3) Voting Trusts- trusts created to exercise the voting power of stock. Each beneficiary owner is treated as a separate shareholder.

Foreign Investment Utilizing a Small Business Trust

As discussed above, a corporation may only be classified as an S corporation if its shareholders are U.S. citizens or residents. Because of its single layer of tax, S corporations would typically be the vehicle of choice for foreign investors. The residency restriction ordinarily prevents foreign investors from utilizing an S corporation as an investment vehicle. The Tax Cuts and Jobs Act of 2017 removed the prohibition against non-resident alien shareholders of an S corporation by amending Internal Revenue Code Section 1361(c)(2)(B)(v) to allow for non-resident alien indirect shareholders of an S corporation. Non-resident aliens under the Tax Cuts and Jobs Act 2017 revision may become indirect shareholders of an S corporation by becoming beneficiaries of an Electing Small Business Trust or (“ESBT”).  
The U.S. federal taxation of an ESBT as compared to the direct U.S. person shareholders principally remains the same. In other words, the same capital gains rates generally apply if the “S” corporation shares were sold or the “S” corporation produced capital gains income from the sale of the “S” corporation assets. Additionally, there is only one level of U.S. income tax (i.e., the “S” corporation pays no U.S. income tax- the shareholders of the “S” corporation report and pay their respective share of net income from the company on their individual income tax returns). The main advantage of an ESBT (besides avoiding double taxation) is that its alien beneficiaries could be insulated from curtain U.S. transfer taxes (i.e., estate and gift) altogether while aliens investing directly in the U.S. or investing through a U.S. corporation would likely be subject to U.S. transfer taxes. The other potential advantage of an ESBT is that it could avoid the U.S. federal branch profits tax. (The branch profits is a tax equal to 40% of a foreign corporation’s dividend equivalent amount for the taxable year, subject to treaty reductions. The dividend equivalent amount estimates the amount of U.S. earnings and profits that a U.S. branch remits to its foreign shareholders during the year).

Tax Treatment of S Corporation Shareholders

Although an S corporation is generally exempt from tax for federal tax purposes, an S corporation must determine its gross income, deductions and other tax items in order to establish the amounts which pass through to its shareholders. An S corporation also must file its own tax return (Form 1120S) and is subject to audit and examination by the IRS and state tax authorities.

An S corporation is required to compute its taxable income in the same manner as an individual except that it is not permitted certain deductions allowed only to individuals, such as personal exemptions, medical expenses, alimony and expenses for the production or collection of income under Section 212. Because an S corporation’s losses pass through to its shareholders, the corporation is not permitted a net operating loss deduction. In order to preserve their unique character as they pass through to the shareholders, the corporation must separately report any item of income, loss, deduction or credit the separate treatment of which could affect the tax liability of any shareholder. These are known as “separately stated” items. Certain separately stated items, such as charitable contributions, foreign taxes, and depletion, are not deductible by the corporation in computing its taxable income, but they are still passed through to the shareholders. An S corporation generally is free to select its own accounting method. The shareholders of an S corporation are required to include in income their pro rata share of S corporation income in the taxable year in which the S corporation’s taxable year ends.

Section 1366(d) limits the amount of losses or deductions that may pass through to a shareholder to the sum of the shareholder’s adjusted basis in the stock plus his or her adjusted basis in any indebtedness of the corporation to the shareholder. In certain limited cases, a guarantee of an S corporation’s loan by its shareholders may be treated as an additional investment in the corporation that will increase a shareholder’s basis. See Selfe v. United States, 778 F.2d 769 (11th Cir.1985). In Selfe, the Eleventh Court Circuit of Appeals reasoned that debt-equity principles of Subchapter C are applicable in determining whether a shareholder-guaranteed debt should be characterized as a capital contribution.

Losses disallowed because of an inadequate basis may be carried forward indefinitely and treated as a loss in any subsequent year in which the shareholder has a basis in either stock or debt. Losses that pass through to a shareholder of an S corporation also may be restricted by the at-risk limitations in Section 465 and the passive activity loss limitations in Section 469. Both these limitations apply on a shareholder-by-shareholder basis rather than at the corporate level. In the case of an S corporation, the at-risk rules are applied on an activity-by-activity basis, except that activities which constitute a trade or business generally are aggregated if the shareholder actively participates in the management of the trade or business and at least 65 percent of the losses are allocable to persons actively engaged in the management of the trade or business. See IRC Section 465(c)(3)(B).

Types of Distributions to Shareholders from S Corporations

The shareholders of an S corporation are required to include in income their pro rata share of S corporation income in the taxable year in which the S corporation’s taxable year ends. See IRC Section 1366(a). Each shareholder’s pro rata share of S corporation tax items is determined on a per share, per day basis. Because the shareholders of an S corporation are taxed directly on their share of the corporation’s income, whether actually received or not, distributions of that income should not be taxed again. There are two types of distributions from S corporations to its shareholders. The first type of distributions by S corporations are distributions no E&P. These are tax free to the extent of the shareholder’s adjusted basis in stock of the corporation. If the distribution exceeds the shareholder’s stock basis, the excess is treated as gain from the sale or exchange of stock, normally capital gain if the stock is a capital asset. The shareholder’s stock basis is reduced by the amount of any distribution which is not includible in income by reason of the distribution rules.

Next, there are distributions of S corporations with earnings and profits or (“E&P”). In order to determine the tax consequences of a distribution by an S corporation with E&P, a concept is needed to separate the results of the corporation’s operations as an S corporation from any prior C corporation existence. The concept adopted for taking into account any prior C corporation existence is the accumulated adjustment account or (“AAA”). To the extent of AAA, distributions from an S corporation to shareholders are treated in the same fashion as distributions by S corporations without E&P. Under this method, the distribution is treated first as a tax-free recovery of stock basis. Next, the distribution is treated as gain from the sale of exchange of stock. If distributions during the year exceed the AAA, the AAA is proportionately allocated based on the amount of each distribution. Amounts distributed in excess of the AAA are first treated as a dividend to the extent of the corporation’s E&P and then as a recovery of any remaining stock basis and gain from the sale or exchange of stock. In the alternative, shareholders of an S corporation receiving distributions during the year may jointly elect to have all distributions first treated as dividends to the extent of available E&P.

The Internal Revenue Code does not disguise between cash and property distributions to shareholders. According to Section 301(b), the amount of a property distribution will be the fair market value of the property and a shareholder will take a fair market value basis in the distributed property. The shareholder’s stock basis will be reduced by the fair market value of the distributed property.

Sections 1374 and 1375 of the Internal Revenue Code and Built in Gains

In general, Section 1374 is designed to tax an S corporation on the net gain accrued while it was subject to Subchapter C if that gain is subsequently recognized on sales, distributions and other dispositions of property within a tax-year “recognition period” beginning with the first taxable year in which the corporation was an S corporation. If an S corporation has E&P from a C corporation operation and more than 25 percent of its gross receipts consist of “passive investment income,” it will be subject to tax on its “excessive net passive income.” Passive investment income typically consists of dividends, interest, and rents.

Tax-Free Reorganizations and Mergers and Acquisitions Investing an S Corporation

Even though an S corporation is not subject to corporate income tax for federal tax purposes, an S corporation may participate in potentially tax-free or taxable corporate acquisitions as the purchasing corporation or the target. An acquisition of an S corporation may be structured as either a purchase of stock from the shareholders or a purchase of assets from the corporation. An asset acquisition usually is preferable because the purchaser will obtain a cost basis in the S corporation’s assets at the cost of a shareholder-level tax. In contrast, for federal tax purposes, an acquisition of assets from a C corporation generates tax at both the corporate and shareholder levels if the target liquidates.

The acquisition of an S corporation is more complicated. If the purchaser of an S corporation is a C corporation, the S corporation’s shareholders will recognize gain or loss on the sale of the entity. The acquisition will also cause the S corporation to lose its S tax status. This is because a C corporation cannot be shareholders of an S corporation. If the acquiring corporation is another S corporation, the S corporation being acquired will retain its S status. However, care must be exercised in these types of acquisition not to run afoul of the 75-shareholder limit or the prohibition against having more than one class of stock.

An S corporation may be either the target or the acquiring corporation in a tax-free acquisitive reorganization. Where an S corporation is the target, it will lose its S status if it remains in existence as an 80 percent or more subsidiary following a tax-free acquisition of its stock by a C corporation in a Type B reorganization or reverse triangular merger. If an S corporation-target’s assets are acquired in a merger or Type C reorganization, the transaction may proceed on a tax-free basis, and the target will terminate its existence as a result of the merger or liquidation that follows in a Type C reorganization.

If an S corporation is the acquiring corporation in a tax-free reorganization, it necessarily must issue new stock to the target shareholders. Whatever form of acquisition is used, care must be exercised to avoid termination of the election by exceeding the 75 shareholder limit. An S corporation may divide itself into separate corporations in a transaction that is tax-free at both the corporate and shareholder levels if all the requirements of Section 355 are satisfied.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.