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Although S corporations are rarely subject to a “corporate level” income tax, they must compute their taxable income like individual taxpayers. The S corporation tax return facilities the process of passing through items of income, loss, deduction and credit to shareholders. Most decisions used to determine the amount and timing of income recognition are made at the corporate level rather than by shareholders.

This includes the corporation's overall accounting, inventory, and depreciation methods. In determining a shareholder's taxable income, the shareholder's pro rata share of the corporation's items of income; loss, deduction, non-taxable income and credits are taken into account. Its important to note that the tax treatment of certain items are determined at the shareholder level even though these items are included in the gross income of the S corporation. Once an S corporation identifies and measures the relevant items of income, deduction and credit, these items are passed through to shareholders to be reported on their own return. The more common separately stated items include rental income or loss, portfolio income or loss, portfolio expenses, IRC section 1231 gain or loss, charitable contributions, IRC section 179 expensing election, investment interest expense, tax preference items, foreign taxes paid, tax exempt income and passive activities.

Making the S Corporation Election

Any corporation that elects to be an S Corporation must qualify as a "small business corporation," which is defined as a domestic corporation that: Has 100 or fewer eligible share holders; Is an eligible corporation; Has only one class of stock; and All shareholders must consent to the election. A timely filed election is effective for the corporation's current taxable year and all successive taxable years until revoked.

Corporation Requirements To Qualify as an S corporation

The corporation must meet certain requirements. In addition to having only one class of stock and no more than 75 shareholders, shareholders must meet certain qualifications. To prevent intentional or inadvertent violations of these requirements, S corporations can restrict share transfers through buy-sell agreements and right of first refusal rights. Corporate charters often prohibit the issuance of more than one class of stock, and shareholders may agree to avoid certain disqualifying transactions, such as becoming a non-resident of the United States.

Shareholder Requirements

An S corporation may have no more than 75 shareholders at any one time .Stock owned by a husband and wife is treated as if owned only by one share holder as long as both spouses are citizens or residents of the United States. If divorced, former spouses are treated as separate share holders. There are significant limitations on what individuals or entities may be S corporation shareholders.

Eligible shareholders include:

1. Individuals who are citizens or resident aliens of the United States;
2. Estates:
3. certain trusts; and
4. Charitable organizations, certain pension trusts and employee stockownership plans.

C corporations, S corporations, non-resident aliens, partnerships and foreign trusts may not be S corporation shareholders. One important exception to the S corporation prohibition of an S corporation owning another S corporation is the 100 percent owned electing S subsidiaries. Another relatively new change to S corporation shareholder rules is the creation of Electing Small Business Trusts, which allow income to be distributed to, or accumulated for, a class of individuals. Electing Small Business Trusts are often used to facilitate estate and family financial planning.

S Corporations Losses

Each shareholder's share of net losses may not exceed his or her basis in the corporation. The shareholder's basis is generally his or her investment in the corporation plus any undistributed accumulated income. Losses exceeding the shareholder's basis may be carried forward indefinitely to be used when the shareholder's basis is increased. When basis is insufficient and there is more than one item that reduces basis, the flow through of each item is determined in a pro rata manner. Any items increasing basis flow through to the owner before items reducing basis. This includes distributions. S corporation shareholders may be entitled to Section 1244 ordinary loss treatment if they sell their stock at a loss.

Entity Level Taxes - Built-in Gains Tax and LIFO Recapture

To prevent C corporations from using S corporations to evade the double tax imposed on corporate liquidations, Congress enacted the built-in gains tax, or BIG tax. This tax imposes a corporate-level tax on gain from certain property sales made in the 10-year period following an S election by C corporation. The BIG tax does not apply to S corporations that have never been C corporations nor to gain on assets acquired during S status, unless it has a carryover basis from C corporation or from a tax-free acquisition. The tax itself is only imposed if the property is sold or distributed. If the corporation retains the property for the required 10 years, the double tax threat disappears. If a C corporation elects to become an S corporation and used the LIFO method of accounting for inventories in its last taxable year as a C corporation, it must include and additional sum, called the LIFO recapture amount, in taxable income. This amount is the difference between inventory carried at FIFO and inventory carried at LIFO. Any increase in taxes that results can be paid in four equal installments over four years.

Tax Treatment of Fringe Benefits to Shareholder Employees

Fringe benefits provided to a shareholder employee who owns 2 percent or less of the corporations stock are deductible by the corporation. These benefits are not taxable to the share holders. Those shareholders who own more than 2 percent are treated like partners. Fringe benefits requiring employee status are considered compensation. These benefits are deductible by the corporation and are subject only to income taxes. They are not subject to FICA or FUTA, unlike a partnership. While the more than 2 percent shareholder is required to include the benefit in income, he or she is also entitled to treat such benefit as if he or she paid for it.