S Corporation Operation

S corporations are a prevalent and tax advantaged way to organize a company for many businesses. They are not simple. S corporations do not pay taxes on regular income, but the income tax affects are passed through to the shareholders on a pro rata ownership basis and the shareholders’ personal taxes are effected by those results on their personal tax returns. That means that if you own 50% of the shares in an S corporation, you pay taxes on 50% of the profits and you may be able to take a deduction for 50% of the losses as well.  All of this information is conveyed to the owner on Schedule K-1, part of the S corporation federal tax return Form 1120S. This is sort of a W-2 form for S corporation (and partnership) income or loss.

S Corporation Basis

The biggest complexity in S corporations is the calculation and carryforward of basis in the shares. Basis is a calculation of how much after tax income the shareholder has invested in the business, that is, income that hasn’t been distributed to shareholders, and it can be a loan made directly to the S corporation. This calculation must be made from the inception of share ownership and adjusted each year for the results reported on the K-1. Basis determines whether losses are deductible by the shareholder on the personal tax return.  Basis cannot be negative. If a calculation forces basis negative, the taxpayer either has taxable income or a non-deductible loss. Losses that aren’t deductible because of a lack of basis are carried forward indefinitely. Here’s more information on basis and the calculation on about.com.

Basis also determines whether shareholder distributions are tax-free as well whether or not losses can be fully deducted in any given year. Failure to carry this calculation forward from year to year may eventually mean having to catch up the calculation to get the correct results on a personal tax return. This has been identified as an IRS hotspot on current audits of personal tax returns.

Basis calculations are a complex area of tax law and the IRS can calculate someone’s basis from other information that’s been reported on corporate income tax returns. Give us a call if you don’t have a basis calculation for your S corporation shares or if you need help in this area. This is a very simplistic explanation. Be sure to read the disclaimer here.

S Corporation Salary & Distibutions

Shareholders receive funds from S corporations in two ways.  The first is by distribution.  This is similar to a dividend from a public corporation.  The second is by payroll.  The Internal Revenue Code specifies that before an S corporation can distribute earnings to a shareholder that works in the corporation, the shareholder must be paid a reasonable wage for the work performed. There is some latitude concerning how much a reasonable salary is, but paying no salary  to a shareholder employed by the corporation is an IRS audit focus. The old adage “pigs get fed, hogs get slaughtered” comes to mind. We can help you determine what a reasonable salary might be for the work you’re doing and keep you out of the IRS sights as well.