SimplyCPA
CPA/REG/S Corporation Taxation

S Corporation Taxation

Eligibility requirements, flow-through taxation, shareholder basis, and the accumulated adjustments account.

Hard 1 hr 5 minArea V: Federal Taxation of Entities

Eligibility — strictly enforced

  • Domestic corporation
  • No more than 100 shareholders (family members can elect to count as one)
  • Shareholders limited to individuals, estates, and certain trusts — no partnerships, no corporations, and no nonresident aliens
  • Only one class of stock (differences in voting rights are permitted)

An election requires unanimous shareholder consent, filed by the 15th day of the third month of the tax year to be effective for that year.

IMPORTANT: Violating any eligibility requirement — for example, transferring one share to a nonresident alien or a corporation — terminates the S election immediately. After termination, the corporation generally cannot re-elect for five years without IRS consent.

Shareholder basis ordering

  1. Increase for income items (separately and non-separately stated) and additional contributions
  2. Decrease for distributions
  3. Decrease for nondeductible expenses
  4. Decrease for losses and deductions (only to the extent of remaining basis)

Losses in excess of basis are suspended and carried forward indefinitely until basis is restored.

IMPORTANT — the key S vs. partnership difference: An S corporation shareholder's basis includes direct loans from the shareholder to the corporation but not a share of general corporate debt. A partner's basis does include a share of partnership liabilities. This distinction is heavily tested.

Distributions and the AAA

For an S corporation with no accumulated E&P, distributions are tax-free to the extent of basis, then capital gain. If the corporation has accumulated E&P from prior C years, the ordering is: AAA (tax-free to the extent of basis) → accumulated E&P (taxable dividend) → remaining basis (tax-free) → capital gain.

EXAM TIP: A >2% shareholder-employee's health insurance premiums are included in W-2 wages, then deducted above the line as self-employed health insurance. S corporation income is not subject to self-employment tax — but reasonable compensation must be paid as wages, and the IRS actively challenges under-compensation.