S Corporation vs. C Corporation Taxation
Understanding the differences between S corporations and C corporations is essential for the REG section of the CPA exam. While both are state-law corporations, their federal tax treatment differs fundamentally: C corporations are taxed at the entity level, while S corporations are flow-through entities similar to partnerships.
S Corporation Eligibility (IRC §1361)
To qualify as an S corporation, the entity must meet all of the following requirements:
- Be a domestic corporation
- Have no more than 100 shareholders (members of a family treated as one shareholder)
- Shareholders must be individuals, estates, certain trusts, or tax-exempt organizations - no partnerships, corporations, or nonresident aliens
- Only one class of stock (voting rights may differ, but economic rights must be identical)
- Not be an ineligible corporation (certain financial institutions, insurance companies, DISCs)
- All shareholders must consent to the election (Form 2553)
Tax Treatment Comparison
| Feature | C Corporation | S Corporation |
|---|---|---|
| Entity-level tax | Yes - flat 21% corporate rate (§11) | Generally no - income passes through to shareholders |
| Filing | Form 1120 | Form 1120-S with Schedule K-1 |
| Double taxation | Yes - corporate income taxed, then dividends taxed again to shareholders | No - single level of tax at the shareholder level |
| Loss flow-through | No - losses stay at corporate level (NOL carryforward) | Yes - losses flow to shareholders (limited by basis, at-risk, passive activity rules) |
| Qualified dividends | Dividends qualify for preferential 0/15/20% rates | Not applicable - distributions are generally tax-free return of basis |
| §199A deduction | Not available | Shareholders may be eligible for the 20% QBI deduction |
| Fringe benefits | Deductible for all employees including shareholder-employees | >2% shareholder-employees treated as partners (benefits included in W-2) |
| Self-employment tax | Not applicable to dividends | Not applicable to distributions, but reasonable salary required for shareholder-employees |
| Fiscal year | Any fiscal year allowed | Generally required to use calendar year (§1378) |
S Corporation Shareholder Basis
An S corporation shareholder's stock basis is critical for determining the taxability of distributions and the deductibility of losses. The ordering rules for basis adjustments are:
- Increase for income items (including tax-exempt income)
- Decrease for distributions (nontaxable to the extent of basis)
- Decrease for nondeductible, noncapital expenses
- Decrease for deductible losses and deductions
Unlike partnerships, S corporation shareholders increase their basis for their share of income but NOT for entity-level debt. Shareholders can deduct losses only to the extent of their stock basis plus any direct loans from the shareholder to the corporation (debt basis under §1366(d)).
S Corporation Distributions (§1368)
Distribution treatment depends on whether the S corporation has accumulated earnings and profits (AE&P) from prior C corporation years:
- No AE&P: Distributions are tax-free returns of basis, reducing stock basis. Excess over basis is capital gain.
- Has AE&P: Distributions come first from the Accumulated Adjustments Account (AAA), then from AE&P (taxed as dividends), then from remaining basis, then as capital gain.
Built-In Gains Tax (§1374)
When a C corporation converts to S status, it may be subject to the built-in gains (BIG) tax on the net recognized built-in gain during the recognition period (5 years under current law). The BIG tax is imposed at the highest corporate rate (21%) on the lesser of net recognized built-in gain or taxable income. This prevents corporations from converting to S status simply to avoid entity-level tax on appreciated assets.
Termination of S Election
The S election terminates if the corporation ceases to meet eligibility requirements, or shareholders holding more than 50% of shares consent to revocation. After termination, the corporation generally cannot re-elect S status for 5 years without IRS consent.
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