S Corporation Basics: Taxes, Owner Pay, and Property Transfers
An S corporation is a federal tax status available to qualifying corporations and LLCs. It generally passes business income through to the owners, who report it on their own tax returns.
The election also comes with rules about who can own the business, how working owners are paid, and how property moves into the company. Those rules matter as much as the potential tax savings.
How the tax returns work
The business files Form 1120-S and gives each shareholder a Schedule K-1 showing their share of income, losses, deductions, and credits. Shareholders generally report their share of taxable income even when the company keeps the cash in its bank account.
The company usually does not pay federal income tax on that business income itself. Exceptions include certain taxes on built-in gains and passive income. Payroll taxes and any applicable state or local taxes also need separate attention.
Who can qualify?
The main federal requirements include:
- A domestic corporation or an eligible domestic entity, such as an LLC that is classified as a corporation for tax purposes through its election.
- No more than 100 shareholders, with special counting rules for certain family members.
- Eligible owners, including individuals, estates, certain trusts, and certain tax-exempt organizations. Partnerships and corporations generally cannot be shareholders, and nonresident aliens cannot own shares directly.
- One class of stock. Shares generally must have identical rights to distributions and liquidation proceeds, although voting rights may differ.
Certain businesses are ineligible, and the company must use a permitted tax year. Forming an LLC does not, by itself, elect S corporation taxation.
Salary, business income, and distributions are different
| Item | What it means for the owner |
|---|---|
| Salary | Payment for work performed. It is reported on Form W-2 and is generally subject to payroll taxes. |
| Share of business income | Reported through Schedule K-1. It can be taxable even if no cash is paid out. |
| Cash distribution | Money paid to an owner because of their ownership. Its tax treatment depends on stock basis and the company's tax history. |
A shareholder who works in the business must receive reasonable compensation for those services before taking non-wage distributions. Reasonable pay depends on the work, time spent, experience, and comparable compensation. There is no universal salary percentage that works for every business.
Stock basis is the owner's investment measured under tax rules. It changes as the company earns income, incurs losses, and makes distributions. Non-dividend cash distributions generally are tax-free up to stock basis; amounts above it generally create capital gain. Companies with prior C corporation earnings can have additional rules.
A loss on Schedule K-1 is not automatically deductible. Each shareholder's stock and direct-loan debt basis, amount at risk, passive activity rules, and excess business loss limit can restrict the deduction.
Putting property into the company
Contributing equipment, a vehicle, or a building is a separate tax question from making the S election.
Section 351 can defer gain when property is exchanged solely for corporate stock and the people transferring property control the corporation immediately afterward. Control generally means at least 80% of the voting power and at least 80% of each class of nonvoting stock. Services do not count as property for this rule. Receiving stock for both property and services requires a closer look at the control calculation.
For example, assume an owner transfers business equipment worth $50,000, with an adjusted tax basis of $20,000, to a new operating corporation for all of its stock. No debt, cash payment, or other property is involved, and all Section 351 requirements are met.
| Item | Amount |
|---|---|
| Equipment's current value | $50,000 |
| Equipment's adjusted tax basis before transfer | $20,000 |
| Gain recognized on the qualifying transfer | $0 |
| Owner's initial basis in the stock | $20,000 |
| Corporation's initial basis in the equipment | $20,000 |
The $30,000 increase in value has not disappeared. The tax basis carries over, so the transfer does not create a new $50,000 depreciation basis. When multiple assets are transferred, each generally keeps its own adjusted basis, subject to required adjustments.
The result can change if the owner receives cash or other property, the corporation assumes debt, or the transferred assets have declined in value. In an otherwise qualifying exchange, cash or other property received along with stock can trigger gain up to the smaller of the realized gain or the value of that extra consideration.
Debt exceeding the adjusted basis of transferred property can also trigger gain, subject to exceptions. Assumed debt can reduce stock basis, and debt assumptions driven by tax avoidance or lacking a business purpose have separate rules. These details need to be evaluated before the transfer.
Making the election
The business generally files Form 2553 with the required shareholder consents no later than two months and 15 days after the beginning of the tax year the election should take effect. An existing business can also file during the preceding tax year.
For a new business, the first tax year can start when it first has shareholders, acquires assets, or begins business. Late-election relief is available in some situations, but it has conditions.
The effective date, ownership, payroll obligations, and treatment of existing assets should all be settled as part of choosing S corporation taxation.