by As a pass-through entity, S corporations distribute their earnings through the payment of dividends to shareholders, which are only taxed at the shareholder level. Income is taxed only once, when the income is earned by the S corporation, whether the income is reinvested or distributed. Unlike partnerships, S corporations are not subject to either the accumulated earnings tax or the personal holding company tax. Earnings are accumulated in a retained earnings account, but they are not considered earnings and profits (E&P), since the income is taxed on the individual returns of the shareholders. Every share of stock gives the holder an equal right to the retained earnings as any other share. So, any rights to the distribution of retained earnings are represented by the number of shares held by a stockholder, not on any agreement, as in a partnership.
A shareholder’s basis in the stock of the S corporation initially depends on the amount of capital contributed by the shareholder. However, because the S corporation is a pass-through entity, the shareholder’s basis changes every year, depending on income, losses, and other separately stated items. Initial basis is determined by the amount of cash paid to the S corporation for shares and by the fair market value of any property contributed to the corporation. If the stock was received as a gift, then the basis is the carryover basis of the donor; if the stock was inherited, then it receives a stepped-up basis. If the S corporation previously operated as a C corporation before the conversion, then the stock basis will equal the basis in the C corporation stock at the time of the conversion.
Capital Gain = (Note Balance – Debt Basis) ÷ Note Balance × Repayment Amount
Return of Capital = Repayment Amount – Portion Treated As Capital Gain
A shareholder’s stock basis is increased by:
- Ordinary income
- Separately stated income items
- Tax-exempt income
- Excess depletion.
Stock basis is decreased, but not below by:
- Ordinary loss
- Separately stated loss items
- Nondeductible expenses
- Non-dividend distributions
- If applicable, depletion for oil and gas
Dividend distributions do not reduce basis because it is just the distribution of net income, which is taxed to the shareholder, whether distributed or not. Only non-dividend distributions reduce stock basis, which is reported on Form K-1 (Form 1120S), Shareholder’s Share of Income, Deductions, Credits, etc.; dividend distributions are reported on Form 1099-DIV, Dividends and Distributions. The Schedule K-1 does not show how much of the distribution is taxable, because only the shareholder can determine that based on his basis.
The tax on the distribution and the deductibility of a loss depends on stock basis. However, the stock basis must be adjusted by flow-through items from the S corporation in a particular order:
- Basis is increased for income items and excess depletion
- Then decreased for:
- Distributions
- Nondeductible, non-capital expenses and depletion
- Loss and deduction items
The shareholder’s basis in stock is always reduced by current year losses, even if such losses would be limited by at-risk or passive activity rules. In contrast to losses and deductions, the tax benefits of tax credits are not limited by basis. However, they may change basis, depending on the specific type of credit.
Loss and deduction items reduces stock basis 1st, but cannot reduce the basis below 0. If the shareholder also has a debt basis in the corporation, then that basis is reduced by loss and deduction items that could not be used to reduce the stock basis. However, if the shareholder has no debt basis in the corporation or the debt basis is reduced to 0, then the total of loss and deduction items exceeding the basis is suspended and can be carried forward indefinitely. Moreover, if the S corporation repays the debt when the shareholder has a reduced basis, then the amount of the repayment exceeding the basis to the shareholder is taxable to the shareholder. Any suspended loss and deduction items can be carried forward indefinitely, but they retain their character. When the shareholder finally disposes of the stock, all suspended loss and deduction items are lost; they cannot be used to reduce any gain on the stock. Additionally:
- Non-dividend distributions exceeding the stock basis is taxed as capital gain, which is treated as long-term if held longer than 1 year.
- Non-deductible expenses reduce basis, but cannot be carried forward.
- Because items carried forward retain their character, any loss and deduction items that exceed basis must be allocated pro rata to those particular items.
- Current year loss and deduction items are combined with suspended losses and deductions, but are listed separately on Schedule E, Supplemental Income and Loss.
Problems on Retained Earnings
Some of the problems regarding retained earnings include the following:
- Shareholders are taxed on a percentage of the profits whether or not they end up receiving the money thereafter.
- If the S Corp has a silent partner investor, this individual might not be happy with paying taxes on profits that she may not actually receive, particularly if she doesn’t have authority in how the earnings will be handled after taxes are paid.
