S Corporations
Introduction
An S corporation is a corporation that has elected pass-through tax treatment under Subchapter S of the Internal Revenue Code. Income, losses, deductions, and credits flow through to shareholders on Schedule K-1 and are reported on their individual returns. While REG covers the fundamentals of S corporation taxation, the TCP exam goes deeper — testing your ability to calculate shareholder stock and debt basis, trace the impact of contributions, distributions, and loans on basis, and determine the tax consequences of transactions between an S corporation and its shareholders.
Eligibility Requirements
Before diving into basis and transactions, recall the requirements that a corporation must meet to elect and maintain S status:
| Requirement | Detail |
|---|---|
| Domestic corporation | Must be organized in the U.S. |
| Eligible shareholders | Individuals, estates, certain trusts, and tax-exempt organizations — no partnerships, corporations, or nonresident aliens |
| Maximum shareholders | 100 shareholders (members of a family treated as one shareholder) |
| One class of stock | Only one class of stock allowed (differences in voting rights are permitted) |
| Tax year | Must use a calendar year (or a fiscal year with a valid business purpose, or §444 election) |
An S corporation files Form 1120-S as an information return. The entity generally does not pay federal income tax — income flows through to shareholders.
Basis of Shareholder's Interest
Stock Basis
A shareholder's stock basis is the foundation for determining the deductibility of losses, the tax treatment of distributions, and the gain or loss on disposition of the stock.
Stock Basis Adjustments
Stock basis is adjusted annually in a specific order:
| Step | Adjustment | Direction |
|---|---|---|
| 1 | Contributions of cash or property | Increase |
| 2 | All income items (ordinary + separately stated, including tax-exempt income) | Increase |
| 3 | Nondeductible expenses that are not chargeable to capital (e.g., 50% meals disallowance, penalties, expenses related to tax-exempt income) | Decrease |
| 4 | Distributions (nondividend) | Decrease |
| 5 | Losses and deductions (ordinary + separately stated) | Decrease |
The ordering of adjustments matters. Income items increase basis before distributions reduce it, ensuring that current-year income can be distributed tax-free. Losses are applied last — stock basis cannot go below zero.
Contributions of Noncash Property
When a shareholder contributes noncash property to an S corporation:
| Scenario | Shareholder's Impact | Corporation's Basis |
|---|---|---|
| §351 applies (≥ 80% control) | Substituted basis in stock (adjusted basis of property − liabilities assumed + gain recognized) | Carryover basis from shareholder + gain recognized |
| §351 does not apply | Recognize gain or loss; basis in stock = FMV of property transferred | FMV basis |
If the corporation assumes liabilities in a §351 exchange, the assumption is treated as a distribution of money to the shareholder for basis purposes — it reduces the shareholder's stock basis.
Example: Jordan contributes equipment (FMV $80,000, adjusted basis $50,000, subject to a $20,000 liability) to Bear Co. (an S corporation) in a §351 exchange. Jordan's stock basis = $50,000 (property basis) − $20,000 (liability assumed) = $30,000. Bear Co.'s basis in the equipment is $50,000 (carryover).
Impact of Operations on Stock Basis
Each year, the shareholder adjusts stock basis for their pro rata share of the S corporation's items:
| Item | Effect on Stock Basis |
|---|---|
| Ordinary business income | Increase |
| Separately stated income items (capital gains, interest, etc.) | Increase |
| Tax-exempt income | Increase |
| Ordinary business loss | Decrease |
| Separately stated loss/deduction items | Decrease |
| Nondeductible, noncapital expenses | Decrease |
| Distributions | Decrease |
Example: Alex owns 100% of MAS Inc. (S corporation). At the start of Year 1, Alex's stock basis is $75,000. During Year 1, MAS Inc. has ordinary income of $40,000, tax-exempt interest of $2,000, a charitable contribution of $5,000, and distributes $30,000 to Alex.
| Adjustment | Amount |
|---|---|
| Beginning stock basis | $75,000 |
| + Ordinary income | +$40,000 |
| + Tax-exempt income | +$2,000 |
| − Nondeductible expenses (none in this example) | $0 |
| − Distribution | −$30,000 |
| − Charitable contribution (separately stated deduction) | −$5,000 |
| Ending stock basis | $82,000 |
Debt Basis
Unlike partnerships, an S corporation shareholder does not receive basis from the entity's third-party debt. A shareholder only gets debt basis from direct loans made by the shareholder to the corporation.
| Source of Debt | Effect on Shareholder Basis |
|---|---|
| Corporation borrows from a bank | No effect on shareholder's basis (even if shareholder guarantees the loan) |
| Shareholder loans funds directly to the corporation | Creates debt basis equal to the face amount of the loan |
| Shareholder guarantees corporate debt and makes payment | Increases debt basis only when the shareholder actually makes payment under the guarantee |
This is a critical distinction from partnerships. A partner's basis includes their share of entity-level liabilities (recourse and nonrecourse). An S corporation shareholder's basis includes only direct shareholder-to-corporation loans. A loan guarantee alone does not create debt basis until the shareholder makes an economic outlay.
Using Debt Basis to Deduct Losses
When a shareholder's stock basis is reduced to zero, losses can be deducted against debt basis — but only to the extent of that debt basis.
| Step | Rule |
|---|---|
| 1 | Deduct losses against stock basis first (reduce to zero) |
| 2 | Deduct remaining losses against debt basis (reduce to zero) |
| 3 | Any remaining losses are suspended and carried forward indefinitely |
Restoring Debt Basis
Once debt basis has been reduced by losses, it must be restored before the shareholder recognizes income from loan repayments.
| Event | Treatment |
|---|---|
| Net income in a subsequent year | Restores debt basis first, then increases stock basis |
| Corporation repays loan while debt basis is below face amount | Shareholder recognizes gain to the extent the repayment exceeds the reduced debt basis |
Example: Dana holds stock in Gies Co. (S corporation) with a stock basis of $10,000 and a debt basis of $25,000 (from a direct loan). Gies Co. allocates a $30,000 loss to Dana. The first $10,000 reduces stock basis to zero. The next $20,000 reduces debt basis to $5,000. If Gies Co. repays the full $25,000 loan next year (before any net income), Dana recognizes a $20,000 gain ($25,000 repayment − $5,000 debt basis).
Reviewing Stock and Debt Basis Schedules
The TCP Blueprint includes a representative task requiring candidates to review shareholder basis schedules for accuracy. Common errors to identify:
| Common Error | What to Check |
|---|---|
| Including entity-level debt in shareholder basis | S corp shareholders get basis only from direct loans |
| Including a loan guarantee as debt basis | Guarantee creates basis only when payment is made |
| Applying losses before income adjustments | Income must be applied before distributions and losses |
| Failing to restore debt basis before stock basis | Net income restores debt basis first |
| Distributing in excess of stock basis without recognizing gain | Excess distributions are capital gain |
Simulation questions may present a completed basis schedule with embedded errors. Work through the adjustments in the correct order: (1) income, (2) nondeductible expenses, (3) distributions, (4) losses. Verify that debt basis is from direct loans only and that loan repayments are tested against reduced debt basis.
Transactions Between Shareholder and S Corporation
Contributions of Noncash Property
Contributions to an S corporation follow the same IRC §351 rules as C corporations — if the transferor(s) control ≥ 80% of the corporation immediately after the exchange, the transaction is generally nonrecognition.
| Element | Rule |
|---|---|
| Shareholder gain/loss | No gain or loss recognized (unless boot received or liabilities exceed basis) |
| Shareholder's stock basis | Adjusted basis of property − boot received − liabilities assumed + gain recognized |
| Corporation's basis in property | Carryover basis + gain recognized by shareholder |
Example: Sam contributes land (FMV $120,000, adjusted basis $70,000) to Kingfisher Industries (S corporation) for 100% of the stock. No boot is received. Sam's stock basis = $70,000. Kingfisher's basis in the land = $70,000.
Nonliquidating Distributions
S corporation distributions follow a different framework than C corporation distributions because S corporations may have an Accumulated Adjustments Account (AAA).
| Source of Distribution | Tax Treatment |
|---|---|
| AAA (from S corporation operations) | Tax-free to extent of stock basis; excess is capital gain |
| Accumulated E&P (from prior C corporation years) | Taxable dividend |
| Remaining stock basis | Tax-free return of capital |
| Excess over basis | Capital gain |
Most S corporations that have always been S corporations have no accumulated E&P — distributions simply reduce stock basis, and any excess is capital gain. The AAA/E&P ordering becomes relevant only for corporations that converted from C to S status with accumulated E&P.
Distribution of Noncash Property
When an S corporation distributes appreciated property:
| Party | Tax Consequence |
|---|---|
| S corporation | Recognizes gain as if the property were sold at FMV (gain flows through to shareholders) |
| Shareholder | Receives a distribution equal to FMV of property; taxed under the ordering rules above |
| Shareholder's basis in property | FMV on the date of distribution |
Example: Bear Co. (S corporation, 100% owned by Jordan) distributes equipment with FMV of $45,000 and adjusted basis of $20,000. Bear Co. recognizes a $25,000 gain, which flows through to Jordan (increasing stock basis by $25,000). The $45,000 distribution then reduces Jordan's stock basis.
Liquidating Distributions
In a complete liquidation of an S corporation:
| Party | Tax Consequence |
|---|---|
| S corporation | Recognizes gain or loss on all assets as if sold at FMV |
| Shareholder | Treats the distribution as payment in exchange for stock — capital gain or loss (FMV of assets received − stock basis) |
| Shareholder's basis in property received | FMV on the date of distribution |
Allocation of Income/Loss After Sale of Ownership Interest
When an S corporation shareholder sells their stock during the year, the corporation's income and loss must be allocated between the selling and purchasing shareholders.
| Method | Description |
|---|---|
| Per-day allocation (default) | Income and loss allocated based on the number of days each shareholder owned the stock during the year |
| Interim closing of the books (elective) | Requires consent of all affected shareholders; income and loss allocated based on actual results in each period |
Example: Illini Entertainment (S corporation with $365,000 of ordinary income for the year) has one shareholder, Marcus, who sells 100% of his stock to Pat on July 1 (day 182). Under the per-day method: Marcus is allocated 181/365 × $365,000 = $181,000; Pat is allocated 184/365 × $365,000 = $184,000.
Summary
| Topic | Key Concept |
|---|---|
| Stock basis adjustments | Income → nondeductible expenses → distributions → losses (in that order); cannot go below zero |
| Noncash contributions | §351 applies if ≥ 80% control; substituted basis for shareholder; carryover basis for corporation |
| Debt basis | Only from direct shareholder loans — not entity debt, not guarantees (until payment) |
| Loss deduction ordering | Stock basis first → debt basis second → excess suspended indefinitely |
| Debt basis restoration | Net income restores debt basis first, then stock basis |
| Distributions (no E&P) | Reduce stock basis; excess is capital gain |
| Distributions (with C corp E&P) | AAA first (tax-free) → accumulated E&P (dividend) → stock basis → capital gain |
| Property distributions | S corp recognizes gain (flows through); shareholder takes FMV basis |
| Liquidating distributions | S corp recognizes gain/loss; shareholder has capital gain/loss |
| Income allocation on sale | Default is per-day; elective interim closing of books requires consent |