An S corporation is a domestic corporation that elects to be taxed as a pass‑through entity. Under IRC §1363, the S corporation generally pays no federal income tax. Instead, income, deductions, credits, and other items flow through to shareholders, who report them on their individual returns.
Eligibility and Tax Year
To qualify, the entity must be a small business corporation:
- Domestic entity
- No more than 100 shareholders
- Shareholders must be individuals, estates, certain trusts, or exempt organizations
- No nonresident alien shareholders
- Only one class of stock
S corporations generally use a calendar year, unless a fiscal year is permitted under special rules.
Pass‑Through Reporting
Schedule K and Schedule K‑1
Form 1120‑S includes Schedule K, which summarizes all pass‑through items. Each shareholder receives a Schedule K‑1 showing their pro‑rata share of:
- Ordinary business income (loss)
- Rental income
- Interest, dividends, royalties
- Capital gains and losses
- Section 179 deduction
- Charitable contributions
- Credits
- AMT items
- Basis‑affecting items
- Qualified business income (QBI) data for §199A
Allocations are made per day, based on shares owned each day.
Fringe Benefits for >2% Shareholders
If a shareholder‑employee owns more than 2%, most fringe benefits are taxable compensation and not deductible by the S corporation. Exception: health insurance premiums are deductible by the S corporation but taxable to the shareholder.
International Reporting: Schedules K‑2 and K‑3
S corporations must file Schedules K‑2 and K‑3 when they have internationally relevant items, including:
- Foreign source income
- Foreign taxes paid
- Foreign entities or investments
- Assets generating foreign income
These schedules provide standardized data for shareholders completing Form 1116 and other international forms.
Domestic Filing Exception
An S corporation may skip K‑2/K‑3 if:
- It has no or limited foreign activity
- It notifies shareholders they will not receive K‑3 unless requested
- No shareholder requests K‑3 by the 1‑month date
Small S Corporation Exception
If total receipts and total assets are each under $250,000, the S corporation is exempt from Schedules K‑2 and K‑3.
Filing Requirements
Form 1120‑S is due March 15 for calendar‑year S corporations. Extensions are available via Form 7004.
Electronic filing is required for entities filing 10 or more returns, unless a hardship waiver is granted.
When an S Corporation Owes Tax
Although most items pass through, an S corporation may owe tax if it has:
- Built‑in gains
- Excess net passive income (when AE&P exists)
- LIFO recapture
- Investment credit recapture
Penalties
Penalties apply for:
- Late filing of Form 1120‑S
- Missing or incorrect K‑1, K‑2, or K‑3
- Late payment of tax (if any)
- Intentional disregard of reporting rules
Amounts follow §6699, §6651, and §6722.
Making the S Election
A corporation or eligible entity elects S status using Form 2553. All shareholders must consent. The election must be filed:
- No later than 2 months and 15 days after the start of the tax year, or
- Anytime in the prior year
Late election relief is available under Rev. Proc. 2013‑30.
Termination of S Status
The election ends if:
- The corporation ceases to be a small business corporation
- It has AE&P and passive investment income >25% of gross receipts for three consecutive years
- Shareholders holding >50% consent to revoke
A terminated S corporation generally cannot re‑elect for five years without IRS consent.
Shareholder Loss Limitations
Shareholders may deduct losses only up to:
- Stock basis
- Debt basis (loans from shareholder to S corp)
- At‑risk limits
- Passive activity limits
- Excess business loss limits
Losses exceeding basis are suspended.
S Corporation Distributions
Distributions depend on stock basis and the corporation’s E&P history.
If the S corporation has no accumulated E&P, distributions are:
- Return of capital up to basis
- Capital gain once basis is zero
If the S corporation has AE&P from prior C‑corp years, ordering rules apply:
- AAA — tax‑free, reduces basis
- PTEP — tax‑free, reduces basis
- AE&P — taxable dividend
- OAA — tax‑free, reduces basis
- Return of capital
- Capital gain
Distributions of appreciated property trigger corporate gain recognition, which passes through to shareholders.
Accumulated Adjustments Account (AAA)
AAA tracks post‑1982 S corporation income and losses. It increases for income and decreases for losses and distributions (but not below zero for distributions).
AAA is similar to basis but excludes:
- Capital contributions
- Tax‑exempt income
- Expenses related to tax‑exempt income
Stock Basis
Stock basis adjusts annually in this order:
- Increase for income
- Decrease for distributions
- Decrease for nondeductible expenses
- Decrease for losses and deductions
Basis determines both loss deductibility and distribution taxability.
Summary
S corporations avoid double taxation by passing income and deductions to shareholders. Key principles:
- Eligibility rules must be met at all times
- Income is allocated per‑day based on shares owned
- K‑1, K‑2, and K‑3 reporting is essential
- Distributions follow strict ordering rules
- Basis controls both losses and distributions
- AE&P from C‑corp years creates dividend exposure
- Elections and terminations follow rigid statutory timelines
These rules come directly from IRC §1361–§1379, Form 1120‑S, and IRS pass‑through reporting guidance.