S Corporations Explained

By azling-marketing | Uncategorized

Jul 26

An S-Corporation is a regular corporation that has made an election (via Form 2553) to be taxed as a flow through entity – the corporation itself does not pay federal taxes.  In California, S-Corporations pay 1.5% of taxable income with an $800 minimum annual tax.

The corporation tax return is reported on Form 1120S for federal and 100S for California which reports the business activity for the year.  Income earned, expenses incurred, nondeductible items, items affecting shareholder basis (below) and a Balance Sheet are included.

S-Corporations can be owned by one individual and that individual can hold all three required corporate officer positions in California (President, Treasurer and Secretary).  An annual report of officers is due on the anniversary of the incorporation date.  A requirement worthy of highlighting is a corporation must pay wages to those operating the business.  In some cases, the only employee is the shareholder.  When this is the case the compensation must be “reasonable” as defined by the Internal Revenue Code.  Payroll is reported to employees annually on Form W-2.

Shareholders of S-Corporations receive a K-1 for their respective share of the taxable income or loss.  Additional information reported on the K-1 will include, as appropriate, accelerated depreciation under Internal Revenue Code Section 179, non-deductable amounts (such as non-business related expenditures and the non-deductible portion of meals and entertainment), distributions of cash and property to the shareholder, etc.

The K-1 income for the shareholders is reported on Schedule E page 2 of their 1040 return.  The taxpayer pays income tax on their respective share of taxable earnings as reported on the K-1.  The payment of tax on S-Corporation profits generates “Basis” in the S-Corporation stock.  Distributions from an S-Corporation are not taxable as dividends if the shareholder has stock Basis greater than zero.

S- Corporation Stock Basis:

A shareholder’s net investment is called Basis.  Basis begins with the shareholder’s initial investment in the corporation.  There is activity that increases and decreases Basis each year.  Activity increasing basis include, but not limited to, additional investment from the shareholder and paying income tax on S-Corporation earnings.  Activity decreasing basis include, but not limited to, distributions of assets to the shareholder, Section 179 depreciation, net losses of the S-Corporation and nondeductible expenses (e.g. 50% meals and entertainment).

When Stock Basis is positive, there are no significant tax issues.  When a shareholder’s Stock Basis becomes negative S-Corporation losses are “suspended” (i.e. not deductible by the shareholder) until the basis is restored.  Additionally, distributions are taxed as dividends to the shareholder and reported on Form 1099-DIV.

There are other topics within the scope of Basis, such as Debt Basis, which is beyond the scope of this overview.

Fees Related to S-Corporation Ownership:

There is no question the Internal Revenue Code benefits business owners in exchange for the risk taken to create taxable income and jobs.  However, there are costs incurred to own and operate a business.  Here’s a list of some of the fees that are pertinent to owning a corporation:

Cost to create entity

Cost to set up accounting system, Bookkeeping fees, and Payroll processing fees

Annual minimum franchise tax (CA is $800)

Tax preparation cost

Our goal is to protect the investment an owner makes in their business while maintaining compliance with federal and state laws.

This document is for tax purposes only and is not intended to be legal advice.  Please consult an attorney regarding legal matters.

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