Editor’s Note: The new tax reform bill has received a lot of attention for changes in how income from pass-through entities (S corporations and LLCs) is taxed. The excerpt below from the 2018 edition of Tax Facts explains how an S corporation, and income distributed to its shareholders, is taxed under the current rules.
How is an S Corporation taxed?
An S corporation is generally not subject to tax at the corporate level. However, a tax is imposed at the corporate level under certain circumstances. When an S corporation disposes of property within five years after the S election was 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.
For S elections made after December 17, 1987, a corporation switching from C corporation status to S corporation status may also be required to recapture certain amounts at the corporate level in connection with goods previously inventoried under a LIFO method.
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 following are true:
- 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).
- Passive investment income exceeds 25 percent of gross receipts.
The highest corporate tax rate (currently 35 percent) applies. “Passive investment income” means rents, royalties, dividends, interest, and annuities. The following items are excluded from the definition of passive investment income for this purpose:
- Rents for the use of corporate property if the corporation also provides substantial services or incurs substantial cost in the rental business;
- 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;
- 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;
- If an S corporation owns 80 percent or more of a C corporation, 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.
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.
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.
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. 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.
How is the shareholder of an S corporation taxed?
Like a partnership, an S corporation computes its taxable income and allocates it to an individual, with the exception that certain personal and other deductions are allowed to the S corporation shareholder, but not to the S corporation itself. Further, the S corporation may elect to amortize organizational expenses.
Each shareholder then reports on his individual return the shareholder’s proportionate share of the corporation’s items of income, loss, deductions and credits. These items retain their character when they are passed through from the S corporation to the shareholder.
Planning Point: The shareholder receives a Form K-1 from the S corporation every year which states the shareholder’s proportionate share of such items. The individual shareholder cannot complete their personal income tax return until they receive the Form K-1 from the corporation.
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. 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. 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.
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 nonseparately computed net income or loss on the shareholder’s individual return. Items of income, deductions, and credits (whether or not separately stated) that flow through to the shareholder are subject to the “passive loss” rule if the activity is passive with respect to the shareholder. 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.
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. The S corporation income must also be included on a current basis by shareholders for purposes of the estimated tax provisions.
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.
— Related on ThinkAdvisor: The New 20% Pass-Through Tax Deduction: An Advisor’s Guide