S Corporations—an Overview

• Pages: 417-435
• Author: Howard E. Abrams,Don A. Leatherman,Thomas J. Brennan

417

Chapter 13

S CORPORATIONS—AN OVERVIEW

13.01 Introduction

We have already looked at C corporations, corporations that are

treated as taxpayers independent of their shareholders. Some

corporations, though, called S corporations, file an informational

return but do not (with some exceptions) pay income taxes.

1

Instead,

an S corporation’s items of income and deduction are passed thru to

its shareholders who report these items directly on their individual

income tax returns.

2

Subchapter C of the Internal Revenue Code,

3

§§ 301–385,

provides most of the provisions governing the taxation of all

corporations, C corporations and S corporations alike. Subchapter S,

§§ 1361–1379, adds those provisions specially applicable to S

corporations. One important aspect of the taxation of S corporations

is the coordination of the rules in these two subchapters. Indeed,

§ 1371(a)(1) provides: “Except as otherwise provided in this title, and

except to the extent inconsistent with this subchapter, subchapter C

shall apply to an S corporation and its shareholders.” Accordingly, in

this Chapter we will examine sections in both subchapters C and S,

but when examining a provision in subchapter C, our emphasis will

be on its application to S corporations.

There are two basic models upon which pass-thru taxation can

be designed: the entity model and the aggregate model. Under a pure

entity model, the entity computes its taxable income without

reference to any tax attributes of its beneficial owners. That is, the

entity’s basis in its assets is independent of any asset basis of its

shareholders or partners, the entity has a taxable year and method

of accounting independent of the taxable years and accounting

methods of its owners, and so on. Once the entity’s taxable income or

loss is computed, it is passed thru to its owners.

Under a pure aggregate model, the entity has no tax attributes

of its own and does not compute a taxable income. Instead, the entity

is treated as no more than an aggregate of its owners, so that, for

example, it has no independent basis in its assets but instead uses

1

The terms “C corporation” and “S corporation” are defined in § 1361(a).

2

The Code uses the phrase “pass thru” to refer to the allocation of tax items

from an S corporation to its shareholders.

3

More accurately, that reference is to subchapter C (corporate distributions

and adjustments) of Chapter 1 (normal taxes and surtaxes) of Subtitle A (income

taxes) of the Internal Revenue Code of 1986, as amended.

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S CORPORATIONS—AN OVERVIEW

Ch. 13

the aggregate of its owners’ bases. Thus, a separate depreciation

schedule must be maintained for each owner’s interest in each entity

asset, each owner may have a distinct holding period for each asset,

etc. While a pure aggregate approach to pass-thru taxation is

possible, in practice it would be quite cumbersome to implement.

4

The remainder of this chapter presents an overview of the

taxation of S corporations, but before that overview begins, one more

detail should be mentioned. A corporation can be a C corporation at

some times and an S corporation at other times. To be sure, most

corporations begin and end as one type or the other without any mid-

life changes. But a C corporation may be permitted to file an S

corporation election and an S corporation’s election may terminate,

and in either event transition issues arise. This chapter as well as

the next consider only S corporations wholly lacking all C corporation

history. Chapter 15 looks at transition issues faced by the corporation

and its shareholders after a C corporation files an S election and after

an S election terminates.

13.02 Qualification and Election

An entity can be an S corporation only if it is treated as a

corporation for federal income tax purposes and qualifies for and

elects S corporation status. For federal income tax purposes,

corporations include all entities organized under federal or state law

as corporations. Regs. § 301.7702–2(b)(1). Thus, federal- or state-law

corporations must be treated as corporations for federal income tax

purposes. Certain other organizations, such as insurance companies,

also must be treated as corporations. Other entities include general

partnerships, limited partnerships, business trusts, limited liability

companies, and limited liability partnerships. Such an entity is

treated as a corporation if it so elects. See Regs. § 301.7701–3(b)(1).

If an entity is treated as a corporation for federal income tax purposes

and qualifies as a “small business corporation,” it may elect to be

treated as an S corporation.

(a) Small Business Corporation

Despite the name, the definition of a small business corporation

is not based in any way on the size of the corporation’s business.

4

The taxation of S corporations is close to a pure entity model. For those

familiar with the taxation of partnerships, this means: (1) there is no corporate analog

to § 752; (2) distributions of appreciated property from a corporation to a shareholder

result in recognized gain to the entity (and through it, to its shareholders), and

contributions to a corporation can be taxable depending on the ownership interests of

the contributing shareholders; (3) there are no optional basis adjustments akin to

§§ 734(b) and 743(b); (4) there is no provision equivalent to § 704(c); and (5) the

flexibility for which partnership taxation is most noted is absent from subchapter S

because there are no special allocations of corporate-level income and deductions.

Thus, subchapter S is quite different from subchapter K.