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S Corp Taxation

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Subchapter S • Form 2553 • K-1 flow-through • Form 7203 basis • Reasonable comp • 2% HI • 199A sunset • BIG tax • WA B&O

S Corporation Taxation Explained (2025): pass-through benefits with corporate-style rules (and audit tripwires)

An S corporation is not a separate “kind” of business entity—it’s a tax status elected by an eligible domestic corporation (or an LLC that elects corporate classification) under Subchapter S. The appeal is straightforward: avoid C corp double taxation while preserving limited liability. The cost is rigidity: shareholder restrictions, one-class-of-stock rules, strict basis tracking, and the notorious “reasonable compensation” battleground. :contentReference[oaicite:0]{index=0}

Jump to contents The reasonable comp rules

Educational overview only — not legal/tax advice.

Contents

  1. What an S corp is (and isn’t)
  2. Eligibility rules: shareholders + one class of stock
  3. Form 2553 election + late election relief (Rev. Proc. 2013-30)
  4. 1120-S + K-1 mechanics (phantom income)
  5. Basis: stock vs debt, ordering rules, and Form 7203
  6. Reasonable compensation: case law and audit posture
  7. 2% shareholder health insurance (W-2 trap)
  8. Section 199A QBI deduction + 2025 sunset
  9. Built-in gains (BIG) tax after C-to-S conversions
  10. State overlay spotlight: Washington B&O + capital gains
  11. Deadlines and late-filing penalties

1) What an S corp is (and isn’t)

S status is a federal tax election available to eligible domestic corporations and LLCs that first elect corporate classification. The S corp generally pays no federal income tax; it is a reporting conduit that passes items through to shareholders. :contentReference[oaicite:2]{index=2}

2) Eligibility rules: shareholders + one class of stock

The “small business corporation” definition is structural, not revenue-based: generally 100 shareholders max (with family aggregation rules), only eligible owners (U.S. individuals and certain estates/trusts), and only one class of stock (economic rights must be identical, even if voting rights differ). Disproportionate distributions can create a “constructive” second class of stock and terminate S status—often retroactively. :contentReference[oaicite:3]{index=3}

3) Form 2553 election + late election relief

S status is obtained by filing Form 2553 by the 15th day of the third month of the tax year (March 15 for calendar-year entities). The report details late-election relief under Revenue Procedure 2013-30 (including the “consistent reporting” requirement and specific filing statements), which can cure missed deadlines without a private letter ruling when conditions are met. :contentReference[oaicite:4]{index=4}

4) 1120-S + K-1 mechanics: ordinary income vs separately stated items

The S corp files Form 1120-S and issues each shareholder a Schedule K-1 showing their pro rata share of ordinary business income and separately stated items (capital gains, charitable contributions, Section 179, foreign taxes, etc.). The critical concept is “phantom income”: shareholders pay tax on K-1 income even if the corporation distributes no cash. :contentReference[oaicite:5]{index=5}

5) Basis: the gatekeeper for loss deductions (Form 7203)

Shareholder loss deductions are limited to stock basis plus debt basis. Debt basis generally requires a direct shareholder loan (the “economic outlay” doctrine); guaranteeing a bank loan typically does not create basis. Since 2021, many shareholders must file Form 7203 to track basis changes and the ordering rules: income increases basis, then distributions reduce it, then nondeductible items, then deductible losses. :contentReference[oaicite:6]{index=6}

Strategy note

Because distributions reduce basis before losses, it’s possible to take tax-free distributions and still end up with suspended losses—surprising owners who “feel like” they had enough income. :contentReference[oaicite:7]{index=7}

6) Reasonable compensation: the S corp audit magnet

The headline S corp planning lever is that distributions are generally not subject to self-employment tax—only W-2 wages are subject to FICA. The IRS counters with “reasonable compensation” enforcement for shareholder-employees. The report highlights key cases (including Watson and Veterinary Surgical Consultants) and common factors used to test reasonableness: duties, experience, time devoted, comparable wages, and dividend history. :contentReference[oaicite:8]{index=8}

7) 2% shareholder health insurance: the W-2 reporting trap

For shareholders owning more than 2%, health insurance premiums paid by the S corp generally must be included in Box 1 wages on the W-2 (but not Boxes 3/5), allowing the shareholder to claim the self-employed health insurance deduction on Form 1040 when properly reported. Misreporting can cause deductions to be disallowed. :contentReference[oaicite:9]{index=9}

8) Section 199A QBI deduction: powerful—then potentially gone after 2025

The report walks through the 20% Qualified Business Income (QBI) deduction mechanics and the high-income limitation framework (W-2 wages/UBIA caps and the SSTB phaseout). It also flags the strategic cliff: 199A is scheduled to sunset after December 31, 2025, which could materially change the relative appeal of S corp vs C corp depending on what Congress does next. :contentReference[oaicite:10]{index=10}

9) Built-in gains (BIG) tax: the conversion penalty after C-to-S

Converting from C to S can trigger entity-level built-in gains tax if appreciated assets are sold within the recognition window (often five years federally). The report also notes state nonconformity risk, where some states may impose different recognition periods or rules. :contentReference[oaicite:11]{index=11}

10) State overlay spotlight: Washington is “no income tax,” not “no business tax”

Washington illustrates why S corps still face meaningful state burdens: the B&O tax is a gross receipts tax (owed even in loss years) and Washington’s capital gains tax can apply to certain long-term gains, including those associated with S corp stock or pass-through gains (with important exemptions such as the QFOSB deduction). :contentReference[oaicite:12]{index=12}

11) Deadlines and penalties: why March 15 matters

S corps generally file by March 15 (Form 1120-S + K-1s). Late filing penalties can be assessed per shareholder per month, creating large liabilities even when the entity owes no income tax. Extensions move the filing deadline (often to September 15) but not payment for any entity-level taxes (e.g., BIG tax). :contentReference[oaicite:13]{index=13}

Bottom line

S corp taxation is a durable model for closely held operating businesses—especially when the owner materially participates and profits are high enough for the wage/distribution split to matter. But it’s not “set and forget”: preserve eligibility, distribute proportionally, track basis with Form 7203 discipline, and defend wages like an auditor is reading your payroll register. And for 2026 planning, scenario-test life after the 199A sunset. :contentReference[oaicite:14]{index=14}

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