In recent years, the S corporation has become a popular choice for structuring businesses, for holding investments and for organizing a range of ventures. But the S corporation or the Subchapter S corporation as it used to be known has some drawbacks, also.



What it is



An S corporation is a corporation for every purpose except for one feature-it ordinarily does not pay income tax. Rather, the income, gains, losses and credits pass through to the shareholders to be reported on their own income tax returns. It still has officers, directors and shareholders, just like any other corporation. It pays salaries and declares dividends and affords limited liability to its shareholders.



Requirement of reasonable salaries



A sore point with the Internal Revenue Service is that S corporations are expected to pay reasonable salaries, which are subject to the usual employment taxes. But some S corporations cut back on their salaries (or even eliminate salaries) with the result that employee-shareholders are compensated with distributions from the corporation that are not subject to employment taxes.

This is considered an abuse of S corporation rules by IRS and is one of their audit priorities. It's necessary to pay reasonable compensation to those rendering service to the corporation.



"2%" shareholders



Since 1982, employee benefits for anyone owning more than two percent of the stock of an S corporation are limited with those shareholders treated much the same as partners in a partnership. This rule affects the exclusion of accident and health plan benefits from income, the exclusion of group term life insurance benefits up to $50,000 of coverage on an employee's life and the exclusion from income of meals and lodging furnished for the convenience of the employer.



S corporation residence



Under another provision, for a residence owned by an S corporation and occupied by a shareholder, deductions are allowed on the residence only to the extent the residence is used regularly and on an exclusive basis for business purposes. That greatly limits the deductibility of depreciation and other expenses on S corporation-owned residences.



Dividend treatment for S corporation distributions



The low rate of tax on dividend distributions raises the question of which distributions from an S corporation qualify as "dividends." The rules are actually fairly clear-most S corporations have little, if any, traditional dividends eligible for the lower tax rates.



Distributions are classified based on the "layer" from which the distribution originates.

  • The first layer is the accumulated adjustments account. Ordinarily, distributions from that account are taxed as ordinary income each year.
  • The next layer is accumulated earnings and profits from years the S corporation was a C corporation. If the corporation had never been a C corporation, there are no earnings and profits and so no part of the distribution is a "dividend."
  • Beyond the second layer, distributions represent the return of basis, which is not taxable.
  • Finally, further distributions are taxed as capital gain, long-term if the stock had been held for more than one year.

Built-in gains

To discourage C corporations from electing to be taxed as an S corporation, Congress added a "built-in gains" tax in 1986. A tax at the highest corporate rate is imposed on sales or exchanges of appreciated assets disposed of within 10 years after the corporation became an S corporation. The tax even applies to inventory property such as stored grain.

In the event of a merger or consolidation of a C corporation into an S corporation, the 10-year built-in gains clock is restarted and the assets coming from the C corporation are subject to the built-in gains tax.



Dr. Neil E. Harl is a Charles F. Curtiss Distinguished Professor in Agriculture and Emeritus Professor of Economics, Iowa State University, Ames, Iowa. He is a member of the Iowa Bar. He can be reached at 515-294-6354.

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