CPA REG: S Corporation Taxation Guide

S Corporation Taxation for the CPA REG Exam

An S corporation is a corporation that has elected pass-through taxation under Subchapter S of the IRC. Like partnerships, S corporations generally do not pay entity-level tax. Instead, income and losses pass through to shareholders. However, S corporations have strict eligibility requirements and operate under different rules than partnerships, making them a distinct and heavily tested topic on the REG exam.

Eligibility Requirements

To elect S corporation status under IRC Section 1361, a corporation must be a domestic corporation, have no more than 100 shareholders (family members within six generations count as one shareholder), have only eligible shareholders (individuals, estates, certain trusts, and certain tax-exempt organizations; nonresident aliens, partnerships, and most corporations are not eligible), and have only one class of stock (though differences in voting rights are permitted).

The election is made on Form 2553 and must be filed by the 15th day of the third month of the tax year for which the election is effective (March 15 for calendar-year corporations). All shareholders must consent to the election. Once made, the election remains in effect until revoked or terminated.

Revocation and Termination

An S election may be revoked with the consent of shareholders holding more than 50% of the stock. If the revocation specifies a future date, the S status terminates on that date. Otherwise, a revocation made by the 15th day of the third month is effective for the current year; a later revocation is effective the following year.

The election terminates automatically if the corporation ceases to meet any eligibility requirement. After termination or revocation, the corporation generally cannot re-elect S status for five years without IRS consent.

Shareholder Basis Calculation

The S corporation shareholder's stock basis is adjusted annually in a specific order. Basis is increased by the shareholder's pro rata share of all income items (including tax-exempt income) and by additional capital contributions. Basis is then decreased (but not below zero) by distributions, then by nondeductible, noncapitalizable expenses, and finally by the shareholder's pro rata share of losses and deductions.

Unlike partnerships, S corporation shareholders cannot include entity-level liabilities in their stock basis. However, shareholders who make direct loans to the corporation have a separate debt basis equal to the loan amount. Losses exceeding stock basis may be deducted to the extent of debt basis, reducing it accordingly. When the corporation later has income, debt basis is restored before stock basis is increased.

Distributions

Distributions from S corporations with no accumulated earnings and profits (E&P) are tax-free to the extent of the shareholder's stock basis. Distributions exceeding basis are treated as capital gain. The analysis is more complex when the S corporation has accumulated E&P from prior C corporation years. In that case, distributions are applied in the following order: first from the Accumulated Adjustments Account (AAA), which is tax-free to the extent of stock basis; then from accumulated E&P, which is taxable as a dividend; then from any remaining AAA; and finally from Other Adjustments Account (OAA) and additional paid-in capital.

Built-In Gains Tax

If a C corporation converts to an S corporation, the built-in gains (BIG) tax under IRC Section 1374 applies to gains on assets that had built-in gain at the time of the S election, if those assets are sold within the recognition period (currently five years). The BIG tax is imposed at the highest corporate rate (21%) on the net recognized built-in gain, limited to the corporation's taxable income and the net unrealized built-in gain at the time of conversion. This tax is an entity-level tax that reduces the amount passing through to shareholders.

Passive Investment Income Tax

An S corporation with accumulated E&P from C corporation years that receives passive investment income exceeding 25% of gross receipts is subject to a tax under IRC Section 1375 on the excess net passive investment income. Passive investment income for this purpose includes royalties, rents, dividends, interest, and annuities. If this threshold is exceeded for three consecutive years, the S election is automatically terminated.

Comparison with Partnerships

Key differences between S corporations and partnerships for exam purposes include: S corporation shareholders cannot include entity debt in basis (only direct loans); S corporations cannot make special allocations (all items are allocated pro rata per share per day); S corporations can have only one class of stock; contributions of appreciated property to an S corporation may trigger gain if the Section 351 requirements are not met; and the distribution rules differ significantly, particularly when accumulated E&P exists.

Exam Strategy

• Know the eligibility requirements cold, especially the shareholder limitations
• Master the basis adjustment order: income first, then distributions, then losses
• Debt basis only comes from direct shareholder loans, not entity liabilities
• Understand the AAA and accumulated E&P ordering rules for distributions
• The built-in gains tax applies only during the five-year recognition period
• Remember that excess passive investment income can terminate the S election