EA Part 2 S-Corporation Taxation: Elections, Shareholder Basis, and Distributions

S-corporations occupy a middle ground between partnerships and C-corporations: they avoid the double taxation of C-corps while offering the liability protection and formal structure of corporate law. That hybrid nature is precisely what makes S-corp questions tricky on Part 2 — you must know both the corporate rules that apply and the pass-through rules that replace standard corporate taxation.

S-Corporation Eligibility Requirements

To make and maintain a valid S election, a corporation must meet all of the following requirements continuously:

• Eligible corporation: Must be a domestic corporation. Certain financial institutions, insurance companies, and DISCs are ineligible.
• Maximum 100 shareholders: All members of a family — defined broadly as a common ancestor up to six generations removed and their spouses and former spouses — count as one shareholder for this purpose.
• One class of stock: All shares must have identical rights to distributions and liquidation proceeds. Differences in voting rights alone do not create a second class of stock.
• Eligible shareholders only: Allowed shareholders are U.S. citizens and resident aliens, certain trusts (grantor trusts, QSSTs, ESBTs), and 501(c)(3) organizations. Partnerships, corporations, and nonresident aliens cannot hold S-corp stock.

The S election is made on Form 2553 and must be filed by March 15 of the year it is to take effect (for calendar-year corporations) or within two months and fifteen days of the beginning of the tax year.

Shareholder Stock Basis

Shareholders must track stock basis to determine whether distributions are taxable and whether losses can be deducted. Stock basis starts with the amount paid for shares and adjusts annually in the following order:

1. Increase for the shareholder's pro-rata share of income items (including tax-exempt income)
2. Decrease for distributions
3. Decrease for non-deductible, non-capitalizable expenses
4. Decrease for the shareholder's pro-rata share of loss and deduction items

Stock basis cannot go below zero. Losses that exceed stock basis are suspended and carry forward until the shareholder restores basis.

Debt Basis

When stock basis is exhausted, a shareholder can use debt basis to absorb additional losses — but only for actual loans the shareholder made directly to the corporation. Shareholder guarantees of corporate debt do not create debt basis; the shareholder must have made a genuine economic outlay.

Losses reduce debt basis after stock basis hits zero. When the corporation later generates income, it first restores debt basis, then restores stock basis.

Distribution Ordering Rules

S-corporation distributions to shareholders with accumulated earnings and profits (AE&P) from prior C-corporation years go through a specific ordering:

1. Accumulated adjustments account (AAA): Distributions from AAA are tax-free to the extent of stock basis.
2. Accumulated earnings and profits (AE&P): If AE&P exists from C-corp years, distributions from AE&P are treated as dividends — ordinary income regardless of basis.
3. Other adjustments account (OAA): Distributions from OAA are tax-free to the extent of basis.
4. Return of basis: Any remaining distribution reduces stock basis. Distributions in excess of basis are capital gain.

For corporations with no AE&P (those that were always S-corps or never had C-corp history), distributions simply reduce stock basis and are taxable as capital gain once basis is exhausted.

Built-In Gains Tax

An S-corporation that was formerly a C-corporation — or acquired assets in a transaction where the assets took a carryover basis from a C-corporation — may owe the built-in gains (BIG) tax on sales of appreciated assets. The tax equals 21% of the recognized built-in gain and is assessed at the corporate level, not passed through.

The recognition period is five years from the date of the S election. Assets sold after five years are free from BIG tax regardless of how much they appreciated while the entity was a C-corp.

Reasonable Compensation Requirement

S-corp shareholder-employees must receive reasonable compensation for services rendered. This rule prevents shareholders from avoiding FICA taxes by taking all of their return as a distribution (which is not subject to employment taxes) rather than wages.

The IRS uses various factors to assess reasonableness: comparable salary for similar services in the industry, qualifications, the corporation's revenues, and what the company would pay an unrelated party. Recharacterization of distributions as wages can trigger back employment taxes and penalties.

S-Corp vs. C-Corp Key Differences

Feature	S-Corporation	C-Corporation
Federal income tax	Paid at shareholder level	Paid at corporate level (21%)
Maximum shareholders	100	Unlimited
Stock classes	One class	Multiple classes allowed
NOL treatment	Flows to shareholders	Stays at corporate level
Built-in gains risk	Yes (if converted from C)	Not applicable

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