The S-corporation is the most widely used pass-through entity for small and mid-size businesses in the US. Its appeal is straightforward: business income flows through to shareholders and is taxed only once at the individual level, while the corporate structure provides limited liability. But the rules governing S-corp taxation - particularly basis, distributions, and the traps that come with converting from a C-corp - are more complex than most owners realize, and errors here have real consequences.
A corporation does not automatically qualify as an S-corp. It must make an election under IRC §1362(a) and meet all eligibility requirements continuously. The election is made by filing Form 2553 (Election by a Small Business Corporation).
To be effective for the current tax year, Form 2553 must be filed on or before the 15th day of the 3rd month of the tax year (March 15 for calendar-year corporations). An election filed after that date is effective for the following year. Late elections can be granted relief under Rev. Proc. 2013-30 if the failure was due to reasonable cause and the corporation has acted as if it were an S-corp.
An S-corp shareholder can only deduct losses to the extent of their basis in the corporation. Unlike C-corp shareholders who simply own shares, S-corp shareholders have two components of basis: stock basis and debt basis. The ordering rules for basis adjustments and the distinction between the two are critical.
When stock basis reaches zero, losses can still be deducted to the extent the shareholder has directly loaned money to the corporation. This is "debt basis." Important: a shareholder guarantee of a corporate loan does not create debt basis - only an actual loan from the shareholder to the corporation creates debt basis. When the S-corp generates income in subsequent years, debt basis is restored before stock basis is increased.
S-corp distributions are tax-free to the extent of the shareholder's stock basis. The accumulated adjustments account (AAA) tracks the cumulative undistributed income that has already been taxed at the shareholder level. For S-corps that were always S-corps (no prior C-corp history), distributions are generally tax-free to the extent of basis.
For S-corps with accumulated earnings and profits (AE&P) from prior C-corp years, the interaction of AAA and AE&P determines the character of distributions. The general ordering: AAA is distributed first (tax-free to extent of basis), then AE&P (taxed as a dividend), then other adjustments account (OAA, for tax-exempt income), then remaining stock basis (return of capital), then any excess (capital gain).
When a C-corporation converts to S-corporation status, the IRS imposes a built-in gains (BIG) tax to prevent taxpayers from using the S-corp election to convert corporate-level C-corp gains into single-taxed pass-through income. The BIG tax applies at the corporate rate (21%) on net recognized built-in gains during the recognition period.
The recognition period is 5 years from the date of the S election. Any asset held by the corporation on the date of the S election that is sold within those 5 years, for a gain that was built-in at the conversion date, is subject to the BIG tax at the S-corporation level - in addition to the shareholder-level pass-through. Effectively, appreciated assets sold within the recognition period face two levels of tax, similar to C-corp treatment.
An S-corporation that has AE&P from prior C-corp years (or from an acquired C-corp) is subject to an entity-level tax on excess passive income if passive investment income exceeds 25% of gross receipts. The tax rate is the highest corporate rate (currently 21%). Passive investment income includes dividends, interest, rents, royalties, and annuities.
If excess passive income persists for three consecutive years, the S election is automatically terminated. This is one of the most overlooked S-corp traps - a profitable S-corp that holds significant investment assets alongside its operating business may unknowingly trigger the §1375 tax and face termination of its election if it has leftover C-corp AE&P.