Taxation of S Corporations
Taxation of S Corporations
An S corporation pays no tax
However, because of the shareholders of an S corporation, rather than the S corporation, is taxed on its income and some expenses items are subject to special rules, it is necessary to divide the items of income, loss, expense, and credit of the S corporation into two categories. One category consists of items that are separately stated items, subject to special rules. The other category consists of combined items, resulting in a net amount. Each shareholder reports a pro rata share of each item of profit, loss, deduction, or credit that is separately stated and a pro rata share of combined items on his or her income tax return. When it is reported on the shareholder’s income tax return, the character of any item included in a shareholder’s pro rata share is determined as if the item were realized directly from the source from which the S corporation realized it, or incurred in the same manner in which the corporation bore it. Quote origin
S Corporation Income & Expense
To figure S corporation income, divide the S corporation’s items of income, loss, expense, and credit into two categories:
(1) Separately stated items, and
(2) Items used to figure non-separately stated income or loss. The separately stated items and the non-separately stated profit or loss are collectively known as passthrough items because they are passed through to the shareholders on pro-rata basis. However, before they are passed through, some items may be reduced. The character of each “pass-through” item is preserved. Thus, an item of tax-exempt income received by the corporation is tax-exempt to the shareholders; long-term capital gain earned by the corporation is a long-term capital gain for the shareholders (§1366(b)). If a shareholder owns the stock for less than the entire year, the items are prorated on a daily basis (§1377(a)). Origin of the quotes
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Separately Stated Items
The items of income, loss, expense, and credit that must be separately stated are those items that, when separately treated on the shareholder’s income tax return (not as part of a lump-sum amount) could affect the shareholder’s tax liability.
The list of items that must be separately stated includes, but is not limited to:
1. Net profit or loss from rental real estate activity
2. Net income or loss from other rental activity
3. Portfolio income or loss
(a) Interest income
(b) Dividend income
(c) Royalty income
(d) Short-term capital gain or loss
(e) Long-term capital gain or loss
4. Section 1231 net gain or loss
5. Charitable contributions
6. Health insurance premiums
7. Section 179 expense deduction
8. Expenses related to portfolio income or loss
(a) Low-income housing credit
(b) Qualified rehabilitation expenses
(c) Other credits
(d) Investment interest expense
(e) Tax preference and adjustment items needed to figure shareholders’ alternative minimum tax.
Note: The indirect deduction through an S corporation of amounts that are not allowable as a deduction if paid or incurred directly by an individual is not allowed. For example, an individual cannot avoid the 2% floor on miscellaneous itemized deductions or the limits on personal interest by allowing an S corporation in which he or she is a shareholder to pay and deduct these amounts.
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The S corporation makes all the elections that affect the computation of items it has to report on its return, except as noted below. Each shareholder, rather than the S corporation, makes the following elections:
1) The elections on deduction and recapture of certain mining exploration costs.
2) The election on whether to deduct or claim a foreign tax credit on taxes the S corporation pays or accrues to foreign countries or U.S. possessions.
Nonseparately Stated Items
Nonseparately stated income or loss is the net income or loss (gross income minus allowable deductions) of the corporation stated after excluding all the items that must be separately stated.
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Interest Expense on Debt-Financed Distributions
If an S corporation distributed borrowed funds to a shareholder, the corporation should separately state the interest expense on these funds and list as “Interest expense allocated to debt-financed distributions” under other deductions on the shareholder’s Schedule K-1. The shareholder deducts this interest on his or her tax return depending on how the shareholder uses the funds. If the S corporation borrows money to buy or carry investment property, interest expense from these debts must be identified and separately stated on Schedule K-1 (Form.1120S) for each shareholder. The stockholders are subject to a limit on the deduction of this interest expense. This interest expense does not include any amounts used in determining income or loss from a passive activity, nor does it include any interest expense allocable to a rental real estate activity.
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Tax Exempt Income
Tax-exempt income of an S corporation is also passed through directly to the shareholders without losing its character as tax exempt. If tax-exempt income is not distributed, the basis of the shareholders stock will be proportionately increased. Any subsequent distribution of the tax-exempt income will pass through to the shareholders tax-free and will result in a corresponding reduction in basis.
Net Operation Losses
Any net operating loss (NOL) of the S corporation is passed through to the shareholders and is currently deductible by them (§1374(c)(1)). NOLs also pass through on a daily basis, to those who were shareholders at any time during the corporation’s taxable year. This is one of the important advantages of subchapter S corporation status for new businesses that often incur losses early on. There are some limits, however, on the deductibility of the losses to the shareholders (§1374(c)(2)).
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Carryover of C Corporation NOLs
A corporation that becomes an S corporation generally cannot have carryovers or carrybacks from tax years when it was not an S corporation for years when it is an S corporation. See the tax on built-in gains, discussed later, for an exception to this general rule. However, each year the corporation is an S corporation counts as a year for the purpose of determining the number of years to which an item may be carried back or carried forward.
In its first tax year, a corporation had a net operating loss. In its second year, it elected to become an S corporation. It generally cannot use the net operating loss carryover in this second tax year or in any tax year during which the corporation remains an S corporation. Each year that the corporation is an S corporation counts as a year for purposes of figuring the 20 year carryover period for net operating losses. Therefore, if the corporation does not terminate its S corporation election before the end of the 20-year net operating loss carryover period, the net operating loss incurred in its first tax year, when no S corporation election was in effect, may not be used. 9-30
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