1. ELIGIBILITY AND ELECTION

Q1: What is an S corporation?

An S corporation is a special type of corporation that lets profits, losses, and tax items pass directly to its owners (called shareholders) instead of being taxed at the corporate level.

Q2: Why would someone want their business to be an S corporation?

Because it helps avoid double taxation—your business income is only taxed once, on your personal tax return.

Q3: What are the basic rules to Qualify as an S corporation?

The corporation must be a U.S. company with no more than 100 shareholders, only one class of stock, and all shareholders must be U.S. citizens or residents.

Q4: Can a foreign person be a shareholder in an S corporation?

No. Nonresident aliens (foreigners without U.S. tax resident status) cannot be shareholders.

Q5: Can another business or corporation own shares in an S corporation?

Generally no, but certain trusts, estates, and other S corporations can in specific cases.

Q6: What is meant by “one class of stock”?

All shares must provide e Qual rights to profits and assets. However, some shares may have different voting rights.

Q7: Can an S corporation issue debt or take out loans?

Yes, it can have debt—just not debt that acts like a second class of stock.

Q8: How many shareholders can an S corporation have?

Up to 100. But a family (including up to 6 generations) can count as just one shareholder.

Q9: What kinds of trusts can be shareholders?

Special types like grantor trusts, testamentary trusts (for up to 2 years), and electing small business trusts.

Q10: Can a charity or nonprofit be a shareholder?

Yes, some tax-exempt organizations can own shares in an S corporation.

Q11: What kinds of businesses cannot be S corporations?

Certain financial companies like insurance businesses, DISCs, and foreign corporations.

Q12: How does a company become an S corporation?

Q13: When is the deadline to file the S election for it to apply this year?

By March 15 (or within 2.5 months of the start of the tax year).

Q14: What happens if you miss the S election deadline?

The S status may apply to the following year unless you show “reasonable cause” for filing late.

Q15: What is Form 2553?

It’s the IRS form used to elect S corporation status. All shareholders must sign it.

Q16: What if a former shareholder refuses to sign Form 2553?

The S election will be delayed until the next year unless they eventually consent.

Q17: Can an S election be revoked?

Yes, if more than 50% of shareholders agree to cancel it.

Q18: How often can you make or revoke an S election?

Once every 5 years unless you get IRS permission.

Q19: Can the IRS fix an invalid S election?

Yes, if the problem was unintentional and corrected Quickly.

Q20: What can cause the S corporation status to terminate automatically?

If it has an ineligible shareholder, more than one class of stock, too much passive income, or breaks any eligibility rule.

Q21: What is a “passive income termination”?

If an S corporation has old C corporation earnings and earns too much passive income (like rent or interest) for 3 years straight, it loses S status.

Q22: What is the difference between an S corp and a C corp?

A C corporation pays its own taxes. An S corporation passes income through to owners, who pay taxes on their individual returns.

Q23: What happens if a shareholder dies?

The estate can hold the shares temporarily, but transferring them to an ineligible person (like a foreign heir) can terminate S status.

Q24: Can an S corporation own another corporation?

Yes. It can own a C corporation or 100% of a Qualified S subsidiary (called a QSub).

Q25: If an S election is accidentally lost, can it be restored?

Possibly. The IRS may allow it to continue if the mistake is corrected and the shareholders act Quickly.

2. OPERATIONS

Q1: How is an S corporation taxed differently from a regular (C) corporation?

S corporations don’t pay federal income tax. Instead, profits and losses pass through to the owners’ personal tax returns.

Q2: Does an S corporation file a tax return?

Yes, it files Form 1120S, which reports income, expenses, and how much is passed on to each shareholder.

Q3: When is the S corporation tax return due?

By March 15 (or the 15th day of the third month after the year ends). You can re Quest a 6-month extension.

Q4: What is a “Schedule K-1”?

It’s a form that shows each shareholder’s share of income, losses, and deductions from the S corporation.

Q5: Do S corporation owners pay self-employment tax on their share of profits?

No, but they must pay themselves a reasonable salary, which is subject to employment tax.

Q6: What is “reasonable compensation”?

It means paying yourself a fair wage for the work you do before taking any profit distributions.

Q7: What happens if an owner doesn’t take a salary?

The IRS may reclassify all distributions as wages and apply payroll taxes and penalties.

Q8: Can an S corporation pay employee benefits to owners?

Yes, but if you own more than 2% of the stock, most fringe benefits are taxable to you.

Q9: Are health insurance premiums deductible?

Yes, if the S corporation pays them and includes the amount in the owner’s W-2.

Q10: Can an S corporation have a fiscal year (not calendar year)?

Usually, no. It must use the calendar year unless it gets IRS permission or Qualifies under special rules.

Q11: What is Section 444?

A rule that allows an S corporation to adopt a different tax year if it deposits estimated taxes with the IRS.

Q12: Can an S corporation deduct charitable contributions?

Yes, but they are passed through to shareholders and deducted on their personal tax returns.

Q13: What is “ordinary business income”?

It’s the profit from regular operations after subtracting regular expenses—not including special items like capital gains.

Q14: What are “separately stated items”?

Special items like capital gains, charitable donations, and interest that must be reported separately on each shareholder’s K-1.

Q15: Do S corporations pay corporate taxes on profits?

No, unless special taxes apply (like on excessive passive income or built-in gains).

Q16: Can an S corporation carry forward net operating losses (NOLs)?

Not at the entity level. Losses are passed to shareholders, who can use them based on their personal tax situation.

Q17: How is profit split among shareholders?

Based on ownership percentage and how many days each shareholder owned the stock during the year.

Q18: What happens when a shareholder buys or sells stock midyear?

Income is divided per-day, per-share. An optional election can treat the year as split into two parts.

Q19: Who decides the accounting method (cash or accrual)?

The S corporation chooses, unless it sells inventory, in which case it may need to use accrual for those items.

Q20: Can an S corporation own rental property?

Yes, but if it’s passive rental income, shareholders may not be able to deduct losses unless they’re active in the business.

Q21: What are passive activity rules?

They limit how much loss you can deduct if you don’t “materially participate” in the business.

Q22: Do shareholders report the same items the S corporation does?

Yes. Shareholders must report everything passed through to them—even if they didn’t get a distribution.

Q23: What if a shareholder disagrees with what the corporation reports?

The shareholder must notify the IRS of the inconsistency or risk penalty.

Q24: Who tracks a shareholder’s basis?

The shareholder—not the S corporation—must keep track of their own basis in the stock and loans.

Q25: What happens if the return is filed late?

There’s a penalty of $235 per shareholder per month (up to 12 months), plus more if tax is due.

3. DISTRIBUTIONS

Q1: What is a distribution from an S corporation?

A distribution is when the S corporation gives cash or property to its shareholders.

Q2: Are distributions the same as salary?

No. Salary is payment for work and is subject to payroll taxes. Distributions are returns on ownership and may not be taxable—depending on your basis.

Q3: Are all S corporation distributions tax-free?

Not always. They are tax-free only up to your stock basis. Any excess may be taxed as a capital gain.

Q4: What is “stock basis”?

It’s the amount you’ve invested in the S corporation, including contributions and income you’ve been taxed on (even if not distributed).

Q5: What if I get more in distributions than my basis?

The excess is taxed like you sold part of your stock—for most people, this means capital gains tax.

Q6: What is AAA (Accumulated Adjustments Account)?

It’s a record the S corporation keeps of profits that have already been taxed to shareholders. It helps determine the order of tax treatment for distributions.

Q7: What is OAA (Other Adjustments Account)?

It tracks tax-exempt income and related expenses. It doesn’t affect AAA but can affect basis.

Q8: What happens if the S corporation used to be a C corporation?

Then it might have old C corporation earnings (called E&P). These could turn part of a distribution into taxable dividends.

Q9: How are distributions taxed if there is no C corporation E&P?

First, they reduce your stock basis (no tax). If distributions exceed your basis, the rest is taxed as a capital gain.

Q10: How are distributions taxed if there is C corporation E&P?

They are taxed in this order:

• 1. Reduce AAA (not taxable)
• 2. Taxed as dividend from E&P
• 3. Reduce stock basis (not taxable)
• 4. Any leftover is capital gain

Q11: Can shareholders elect to have distributions come out of E&P first?

Yes, they can file an election to make distributions come first from C corporation E&P, making them taxable dividends.

Q12: Can distributions ever reduce the AAA below zero?

No. AAA can’t go below zero from distributions, but losses can create a negative AAA.

Q13: Do distributions affect shareholder basis?

Yes, they reduce your stock basis. If the distribution exceeds basis, the extra becomes taxable gain.

Q14: Can a shareholder take a loss if basis is already zero?

No. Losses are suspended until new basis is created by income or contributions.

Q15: What is a “nonli Quidating distribution”?

A regular distribution when the business is still operating (not shutting down).

Q16: What is a “li Quidating distribution”?

It happens when the business is closing and distributing all its assets. These are treated as if you sold your stock.

Q17: What if an S corporation gives me property instead of cash?

The property is treated as if it were sold at fair market value. The S corp may recognize a gain, which is passed to you.

Q18: Can an S corporation recognize a loss when it distributes property?

No. If property is worth less than its basis, the loss is not allowed unless the property is sold instead of distributed.

Q19: What if the S corporation sells property and gives me the cash?

Then you may be able to claim a share of the gain or loss, depending on how the sale went.

Q20: Does the timing of a distribution matter for taxes?

Yes. Distributions are treated based on what happens during the corporation’s full tax year, including total income and losses.

Q21: Do I pay tax when I receive a distribution?

Only if the distribution exceeds your basis or comes from old C corporation earnings (E&P). Otherwise, it’s usually tax-free.

Q22: What form reports dividends from S corporations with E&P?

Form 1099-DIV. It’s used if part of your distribution is considered a taxable dividend.

Q23: If the S corporation made a profit but didn’t distribute it, do I still pay tax?

Yes. Shareholders are taxed on their share of the profit whether or not they received a distribution.

Q24: What happens if an S corporation terminates?

Distributions shortly after a termination may still be treated as coming from AAA and reduce basis (not taxable).

Q25: What’s the best way to avoid surprises from distributions?

Keep track of your stock basis every year and communicate with your tax professional before taking large distributions.

✅ 4. SPECIAL TAXES

Q1: Do S corporations usually pay federal income tax?

No. S corporations generally don’t pay federal income tax—the profits “pass through” to the shareholders, who pay tax on their own returns.

Q2: Are there situations where an S corporation pays tax?

Yes. In certain cases, an S corporation might pay tax—such as the Passive Investment Income (PII) Tax, the Built-In Gains (BIG) Tax, or LIFO Recapture Tax.

Q3: What is Passive Investment Income (PII)?

It’s income from things like dividends, interest, rent, royalties, or annuities—not from your main business.

Q4: When does the PII tax apply?

If the S corporation has C corporation earnings and profits (E&P) and PII is more than 25% of total gross receipts for the year.

Q5: How much is the PII tax?

The tax is 21% of the excess net passive income (not the whole PII, just the portion above the 25% threshold).

Q6: What happens if a corporation has too much passive income for 3 years?

If it also has C corporation E&P, its S status can be terminated and it becomes a C corporation again.

Q7: What counts as passive income?

Interest, dividends, royalties, and most rent—unless the rent involves significant services, like cleaning or a receptionist.

Q8: How can a company avoid the PII tax?

Reduce or eliminate C corporation E&P, or lower passive income to under 25% of gross receipts.

Q9: What is the Built-In Gains (BIG) Tax?

It’s a 21% tax on gains from assets that appreciated in value while the company was still a C corporation.

Q10: When does the BIG tax apply?

When an S corporation sells an asset that had built-in gains during the 5-year recognition period after switching from C to S status.

Q11: What is a built-in gain?

It’s the profit that existed at the time the business changed from a C corp to an S corp—for example, if an asset was worth $100K but had a $70K tax basis, there’s a $30K built-in gain.

Q12: What’s the purpose of the BIG tax?

To prevent companies from switching to S status just to avoid paying tax on gains built up during C corporation years.

Q13: Can the BIG tax be avoided?

Yes—wait more than 5 years before selling appreciated assets or use C corporation loss carryovers to offset gains.

Q14: Does the BIG tax reduce what’s passed through to shareholders?

Yes. The tax reduces the income passed through and also reduces stock basis and AAA.

Q15: What is LIFO recapture?

If the business used the LIFO inventory method as a C corporation, it must “recapture” the difference between LIFO and FIFO values when switching to S status—and pay tax on that difference.

Q16: How is the LIFO recapture tax paid?

It’s spread out over 4 years starting with the last C corporation year.

Q17: What is the General Business Credit recapture?

If a business took tax credits as a C corporation, it may owe back part of the credit (recapture) after becoming an S corporation.

Q18: What is the Qualified Business Income Deduction (QBID)?

It’s a 20% deduction for owners of pass-through businesses, including S corporations, on their share of Qualified income.

Q19: Who claims the QBID—the S corporation or the shareholder?

The shareholder claims the deduction on their individual tax return.

Q20: Is the QBID automatic?

Not always. It depends on the type of business, income level, and whether the business pays wages or owns Qualifying property.

Q21: What types of income don’t Qualify for QBID?

Wage income, investment income, guaranteed payments to partners, and some service business income (at higher income levels).

Q22: Does the S corporation need to do anything special for QBID?

It must report W-2 wages and property information correctly on Schedule K-1 for shareholders to calculate the deduction.

Q23: What happens if the S corporation owes a special tax but doesn’t pay?

It may owe penalties and interest and lose its S status if the issue isn’t resolved.

Q24: Do shareholders have to make estimated payments for special taxes?

No, but the S corporation itself must make estimated payments for BIG or PII taxes it owes.

Q25: Where are these special taxes reported?

On Form 1120S, using separate statements or schedules as re

Quired (e.g., Schedule D for gains).