S Corporation Income and Loss: What Owners Need to Know
An S corporation generally passes its federal income, losses, deductions, and credits through to its shareholders. If you own shares, you report your share of those items on your tax return, even when the business keeps the cash.
A loss works differently. The amount shown on your Schedule K-1 isn't automatically deductible. Your investment in the business and other tax rules determine how much you can use.
What S corporation status means
S corporation status is a federal tax election available to qualifying domestic corporations and other eligible domestic entities, including some LLCs. An eligible LLC can be treated as a corporation through its S election; forming an LLC alone does not make that election.
The business generally needs no more than 100 shareholders, only eligible owners, and one class of stock. Differences in voting rights are allowed, but the shares must generally have identical rights to distributions and liquidation proceeds.
Eligible shareholders include individuals, estates, certain trusts, and certain tax-exempt organizations. Partnerships and corporations generally cannot be shareholders. Individual owners generally must be U.S. citizens or U.S. residents for tax purposes. All shareholders must consent to the election. Form 2553 and its instructions explain the requirements.
How income reaches your return
The company files Form 1120-S and provides each shareholder with Schedule K-1. Ordinary business income appears separately from items such as capital gains, dividends, and charitable contributions because those items can receive different treatment on your return.
Income is generally allocated according to shares owned each day. Special elections can change the calculation when ownership changes during the year.
For example, assume two shareholders own 60% and 40% throughout the year. The company reports these amounts:
| Income item | Company total | 60% shareholder | 40% shareholder |
|---|---|---|---|
| Ordinary business income | $70,000 | $42,000 | $28,000 |
| Long-term capital gain | $20,000 | $12,000 | $8,000 |
| Dividend income | $5,000 | $3,000 | $2,000 |
Those allocations apply whether or not the company distributes the earnings. Owners may need estimated tax payments to cover the resulting personal tax.
Profit, salary, and distributions have different rules
An owner who works for the company must treat reasonable compensation for those services as wages. Payments labeled as distributions can be reclassified as wages if they are really compensation for work. Salary is reported on Form W-2 and is subject to employment taxes. The owner's share of S corporation income generally isn't subject to self-employment tax.
Cash distributions are a separate calculation. A non-dividend distribution is generally tax-free up to your stock basis, with any excess generally treated as capital gain. Debt basis does not make a distribution tax-free. Additional rules apply when the company has earnings and profits from C corporation years.
Why basis matters
Basis is the tax measure of your investment. Stock basis generally increases with capital contributions and allocated income. Distributions, losses, and certain other expenses reduce it, but not below zero.
For example, assume Lisa has $10,000 of stock basis and a $5,000 allocated business loss, with no other basis changes. The loss reduces her stock basis to $5,000. Separate rules still determine whether she can deduct that loss now.
Money you personally lend to the corporation can create debt basis, which must be adjusted for prior losses and other changes. Merely guaranteeing a bank loan does not create debt basis. Form 7203 is used to calculate stock and debt basis limitations.
When a business loss is deductible
Losses must pass four limits, applied in order: stock and debt basis, the amount you have at risk, passive activity rules, and the excess business loss limit. Having enough basis clears only the first step.
Suppose Rob has $5,000 of stock basis, no debt basis or other basis changes, and a $7,000 business loss. The basis rules allow up to $5,000 to move to the remaining tests. The other $2,000 is suspended and may become deductible in a later year if the requirements are met.
Company filing and tax obligations
Form 1120-S is generally due on the 15th day of the third month after the tax year ends. For a calendar-year business, that's normally March 15, adjusted for weekends and legal holidays.
S corporations generally avoid the regular corporate income tax, but special taxes can apply to certain built-in gains and excess passive income. A prior C corporation history or assets acquired from a C corporation using its tax basis can matter. Having S status from the beginning does not rule out every corporate tax.
Before taking a large distribution, claiming a loss, or changing ownership, review the effect on both the company and the shareholders. The same business transaction can produce different tax results for different owners.