Back to S Corporations

S Corporations

  • 7776. What is an S corporation?

    • Editor’s Note: See Q 7782 and Q 7783 for a discussion of the substantial changes to S corporation taxation made by the 2017 Tax Act.

      An S corporation is a corporation that elects to be treated, in general, as a pass-through entity, thus avoiding most tax at the corporate level.1 To be eligible to make the election, a corporation must meet certain requirements as to the kind and number of shareholders, classes of stock, and sources of income. An S corporation must be a domestic corporation with only a single class of stock and may have up to 100 shareholders (none of whom are nonresident aliens) who are individuals, estates, and certain trusts. An S corporation may not be an ineligible corporation. An ineligible corporation is one of the following: (1) a financial institution that uses the reserve method of accounting for bad debts; (2) an insurance company; (3) a corporation electing (under IRC Section 936) credits for certain taxes attributable to income from Puerto Rico and other U.S. possessions; and (4) a current or former domestic international sales corporation (DISC). Qualified plans and certain charitable organizations may be S corporation shareholders.2

      Members of a family are treated as one shareholder. “Members of the family” is defined as “the common ancestor, lineal descendants of the common ancestor, and the spouses (or former spouses) of such lineal descendants or common ancestor.” Generally, the common ancestor may not be more than six generations removed from the youngest generation of shareholders who would be considered members of the family.3

      Trusts that may be S corporation shareholders include: (1) a trust all of which is treated as owned by an individual who is a citizen or resident of the United States under the grantor trust rules (see Q 795); (2) a trust that was described in (1) above immediately prior to the deemed owner’s death and continues in existence after such death may continue to be an S corporation shareholder for up to two years after the owner’s death; (3) a trust to which stock is transferred pursuant to a will may be an S corporation shareholder for up to two years after the date of the stock transfer; (4) a trust created primarily to exercise the voting power of stock transferred to it; (5) a qualified subchapter S trust (QSST, see Q ); (6) an electing small business trust (ESBT, see Q 7778); and (7) in the case of an S corporation that is a bank, an IRA, or Roth IRA.4

      1 .See IRC Secs. 1361, 1362, 1363.

      2 .IRC Sec. 1361.

      3 .IRC Sec. 1361(c)(1).

      4 .IRC Secs. 1361(c)(2), 1361(d).

  • 7777. What is a qualified subchapter S trust (QSST)?

    • A QSST is a trust in which: (1) there is only one current income beneficiary (who must be a citizen or resident of the U.S.), (2) all income must be distributed currently, and (3) corpus may not be distributed to anyone else during the life of such beneficiary. The income interest must terminate upon the earlier of the beneficiary’s death or termination of the trust, and if the trust terminates during the lifetime of the income beneficiary, all trust assets must be distributed to that beneficiary. The beneficiary must make an election for the trust to be treated as a QSST.1

      1 .IRC Sec. 1361(d).

  • 7778. What is an electing small business trust (ESBT)?

    • An ESBT is a trust in which all of the beneficiaries are individuals, estates, or charitable organizations.1 Each potential current beneficiary of an ESBT is treated as a shareholder for purposes of the shareholder limitation.2 A potential current beneficiary is generally, with respect to any period, someone who is entitled to, or in the discretion of any person may receive, a distribution of principal or interest of the trust. In addition, a person treated as an owner of a trust under the grantor trust rules (see Q 795) is a potential current beneficiary.3 If for any period there is no potential current beneficiary of an ESBT, the ESBT itself is treated as an S corporation shareholder.4 Trusts exempt from income tax, QSSTs, charitable remainder annuity trusts, and charitable remainder unitrusts may not be ESBTs. An interest in an ESBT may not be obtained by purchase.5 If any portion of a beneficiary’s basis in the beneficiary’s interest is determined under the cost basis rules, the interest was acquired by purchase.6 An ESBT is taxed at the highest income tax rate under IRC Section 1(e) (39.6 percent for 2013-2017, 37 percent for 2018-2025).The 2017 Tax Act expands the definition of a qualifying beneficiary under an electing small business trust (ESBT) to include nonresident aliens.8 This provision is effective beginning January 1, 2018.

      1 .IRC Sec. 1361(e).

      2 .IRC Sec. 1361(c)(2)(B)(v).

      3 .Treas. Reg. §1.1361-1(m)(4).

      4 .Treas. Reg. §1.1361-1(h)(3)(i)(F).

      5 .IRC Sec. 1361(e).

      6 .Treas. Reg. §1.1361-1(m)(1)(iii).

      7 .IRC Sec. 641(c).

      8.IRC Secs. 1361(c)(2)(B)(v), 1361(b)(1)(C).

  • 7779. What is a qualified subchapter S subsidiary (QSSS)?

    • An S corporation may own a qualified subchapter S subsidiary (QSSS). A QSSS is a domestic corporation that is not an ineligible corporation, if 100 percent of its stock is owned by the parent S corporation and the parent S corporation elects to treat it as a QSSS. Except as provided in regulations, a QSSS is not treated as a separate corporation, and its assets, liabilities, and items of income, deduction, and credit are treated as those of the parent S corporation.1 Regulations provide special rules regarding the recognition of a QSSS as a separate entity for tax purposes if an S corporation or its QSSS is a bank.2 A QSSS will also be treated as a separate corporation for purposes of employment taxes and certain excise taxes.3 For tax years beginning after 2014, a QSSS will be treated as a separate corporation for purposes of the shared responsibility payment under the Affordable Care Act.4

      If a QSSS ceases to meet the above requirements, it will be treated as a new corporation acquiring all assets and liabilities from the parent S corporation in exchange for its stock. If the corporation’s status as a QSSS terminates, the corporation is generally prohibited from being a QSSS or an S corporation for five years.5 Regulations provide that in certain cases following a termination of a corporation’s QSSS election, the corporation may be allowed to elect QSSS or S corporation status without waiting five years if, immediately following the termination, the corporation is otherwise eligible to make an S corporation election or QSSS election, and the election is effective immediately following the termination of the QSSS election. Examples where this rule would apply include an S corporation selling all of its QSSS stock to another S corporation, or an S corporation distributing all of its QSSS stock to its shareholders and the former QSSS making an S election.6

      1 .IRC Sec. 1361(b)(3).

      2 .Treas. Reg. §1.1361-4(a)(3).

      3 .Treas. Reg. §§1.1361-4(a)(7) and 1.1361-4(a)(8).

      4 .Treas. Reg. §1.1361-4(a)(8)(i)(E).

      5 .IRC Sec. 1361(b)(3).

      6 .Treas. Reg. §1.1361-5(c).

  • 7780. What is the requirement that an S corporation have only one class of stock and how is it met?

    • A corporation will be treated as having one class of stock if all of its outstanding shares confer identical rights to distribution and liquidation proceeds.1 “Bona fide agreements to redeem or purchase stock at the time of death, disability or termination of employment” will be disregarded for purposes of the one-class rule unless a principal purpose of the arrangement is to circumvent the rule. Similarly, bona fide buy-sell agreements will be disregarded unless a principal purpose of the arrangement is to circumvent the one-class rule and they establish a purchase price that is not substantially above or below the fair market value of the stock. The IRS confirmed that this was the case, so that a buy-sell agreement could be disregarded, even when an equity compensation plan was involved that called for a forfeiture price for shares that could have been as low as $0.2

      Agreements that provide for a purchase price or redemption of stock at book value or a price between book value and fair market value will not be considered to establish a price that is substantially above or below fair market value.3 Regulations provide that agreements triggered by divorce and forfeiture provisions that cause a share of stock to be substantially nonvested will be disregarded in determining whether a corporation’s shares confer identical rights to distribution and liquidation proceeds.4

      1 .Treas. Reg. §1.1361-1(l)(1).

      2. Let. Rul. 201918013.

      .Treas. Reg. §1.1361-1(l)(2)(iii). See IRC Secs. 1361, 1362.

      .Treas. Reg. §1.1361-1(l)(2)(iii)(B).

  • 7781. How is an S corporation taxed?

    • Editor’s Note: See Q 7782 to Q 7783 for a discussion of the substantial changes to S corporation taxation made by the 2017 Tax Act.

      An S corporation is generally not subject to tax at the corporate level.1 However, a tax is imposed at the corporate level under certain circumstances described below. When an S corporation disposes of property within ten years after the S election has been made, gain attributable to pre-election appreciation of the property (built in gain) is taxed at the corporate level to the extent such gain does not exceed the amount of taxable income imposed on the corporation as if it were not an S corporation.2 (ARRA 2009 provided that, in the case of a taxable year beginning in 2009 or 2010, no tax was to be imposed on built in gain if the seventh taxable year of the ten-year recognition period preceded such taxable year. The Creating Small Business Jobs Act of 2010 provided that, for a taxable year beginning in 2011, no built in gain tax was to be imposed if the fifth year of the recognition period preceded that year. The American Taxpayer Relief Act of 2012 extended that rule for taxable years beginning in 2012 and 2013 and the Protecting Americans Against Tax Hikes Act of 2015 (PATH) made the rule permanent.)

      For S elections made after December 17, 1987, a corporation switching from a C corporation to an S corporation may also be required to recapture certain amounts at the corporate level in connection with goods previously inventoried under a LIFO method.3

      In addition, a tax is imposed at the corporate level on excess “net passive income” of an S corporation (passive investment income reduced by certain expenses connected with the production of such income) but only if the corporation, at the end of the tax year, has accumulated earnings and profits (either carried over from a year in which it was a nonelecting corporation or due to an acquisition of a C corporation), and if passive investment income exceeds 25 percent of gross receipts. The rate is the highest corporate rate (currently 35 percent).4 “Passive investment income” for this purpose is rents, royalties, dividends, interest, and annuities.5

      However, passive investment income does not include rents for the use of corporate property if the corporation also provides substantial services or incurs substantial cost in the rental business,6 or interest on obligations acquired from the sale of a capital asset or the performance of services in the ordinary course of a trade or business of selling the property or performing the services. Also, passive investment income does not include gross receipts derived in the ordinary course of a trade or business of lending or financing; dealing in property; purchasing or discounting accounts receivable, notes, or installment obligations; or servicing mortgages.7 Regulations provide that if an S corporation owns 80 percent or more of a C corporation, passive investment income does not include dividends from the C corporation to the extent the dividends are attributable to the earnings and profits of the C corporation derived from the active conduct of a trade or business.8 If amounts are subject to tax both as built-in gain and as excess net passive income, an adjustment will be made in the amount taxed as passive income.9

      Also, tax is imposed at the corporate level if investment credit attributable to years for which the corporation was not an S corporation is required to be recaptured.10

      Furthermore, an S corporation may be required to make an accelerated tax payment on behalf of its shareholders if the S corporation elects not to use a required taxable year.11 The corporation is also subject to estimated tax requirements with respect to the tax on built in gain, the tax on excess net passive income, and any tax attributable to recapture of investment credit.12

      Like a partnership, an S corporation computes its taxable income similarly to an individual, except that certain personal and other deductions are allowed to a shareholder but not to the S corporation, and the corporation may elect to amortize organizational expenses.13 Each shareholder then reports on the shareholder’s individual return the proportionate share of the corporation’s items of income, loss, deductions, and credits; these items retain their character on pass-through.14 Certain items of income, loss, deduction, or credit must be passed through as separate items because they may have an effect on each individual shareholder’s tax liability. For example, net capital gains and losses pass through as such to be included with the shareholder’s own net capital gain or loss. Any gains and losses on certain property used in a trade or business are passed through separately to be aggregated with the shareholder’s other IRC Section 1231 gains and losses. (Gains passed through are reduced by any tax at the corporate level on gains.) Miscellaneous itemized deductions pass through to be combined with the individual’s miscellaneous deductions for purposes of the 2 percent floor on such deductions (these deductions were suspended from 2018-2025). Charitable contributions pass through to shareholders separately subject to the individual shareholder’s percentage limitations on deductibility. Tax exempt income passes through as such. Items involving determination of credits pass through separately.15

      Before pass-through, each item of passive investment income is reduced by its proportionate share of the tax at the corporate level on excess net passive investment income.16 Items that do not need to be passed through separately are aggregated on the corporation’s tax return and each shareholder reports his or her share of such nonseparately computed net income or loss on his or her individual return.17 Items of income, deductions, and credits (whether or not separately stated) that flow through to the shareholder are subject to the “passive loss” rules (see Q 8007 through Q 8018) if the activity is passive with respect to the shareholder. See Q 8008. Apparently, items taxed at the corporate level are not subject to the passive loss rule unless the corporation is either closely held or a personal service corporation. See Q 8007.

      Thus, whether amounts are distributed to them or not, shareholders are taxed on the corporation’s taxable income. Shareholders take into account their shares of income, loss, deduction, and credit on a per-share, per-day basis.18 The S corporation income must also be included on a current basis by shareholders for purposes of the estimated tax provisions. See Q 646.19

      The Tax Court determined that when an S corporation shareholder files for bankruptcy, all the gains and losses for that year flowed through to the bankruptcy estate. The gains and losses should not be divided based on the time before the bankruptcy was filed.20

      1 .IRC Sec. 1363(a).

      2 .IRC Sec. 1374.

      3 .IRC Sec. 1363(d).

      4 .IRC Sec. 1375(a).

      5 .IRC Secs. 1362(d)(3), 1375(b)(3).

      6 .See Let. Ruls. 9837003, 9611009, 9610016, 9548012, 9534024, 9514005.

      7 .Treas. Reg. §1.1362-2(c)(5).

      8 .Treas. Reg. §1.1362-8(a).

      9 .IRC Sec. 1375(b)(4).

      10 .IRC Sec. 1371(d).

      11 .IRC Sec. 7519.

      12 .IRC Sec. 6655(g)(4).

      13 .IRC Sec. 1363(b).

      14 .IRC Secs. 1366(a), 1366(b).

      15 .IRC Sec. 1366(a)(1).

      16 .IRC Sec. 1366(f)(3).

      17 .IRC Sec. 1366(a).

      18 .IRC Sec. 1377(a).

      19 .Let. Rul. 8542034.

      20 .Williams v. Comm., 123 TC 144 (2004).

  • 7782. How are S corporation shareholders taxed under the 2017 Tax Act?

    • The 2017 Tax Act made substantial changes to the treatment of pass-through business income, which was previously simply “passed through” and taxed at the business owners’ individual ordinary income tax rates as discussed in Q 7781.  Partnerships (and entities that elect partnership taxation, such as certain LLCs), S corporations and sole proprietorships are subject to the new pass-through taxation rules, which will apply for tax years beginning after December 31, 2017 and before December 31, 2025.[1]  The new rules are extremely complicated, and the IRS and related agencies continue to release interpretive materials explaining how the basic provisions will be applied.

      S corporation shareholders may now generally deduct 20 percent of “qualified business income”[2] (which largely excludes “specified service business” income (see below)).

      S corporations that are categorized as service businesses and have income below the applicable threshold level plus $50,000 ($100,000 for joint returns) also qualify for the 20 percent deduction.  The applicable threshold levels for 2021 are $329,800 (married filing jointly) or $164,900 (single filers), so service business owners with income that exceeds $429,800 (married filing jointly) or $214,900 (single filers) will not receive the benefit of the new deduction in 2019.[3] The entirety of the taxpayer’s income must be taken into account (not only the business’ income).[4]

      The deduction is available regardless of whether the S corporation shareholder itemizes, and is applied based on ownership interest (i.e., a shareholder who owns 25 percent of an S corporation is entitled to apply the deduction to 25 percent of his or her qualified business income).  The calculation is made on an entity-specific basis, meaning that the deduction must be applied separately to each entity rather than based upon the cumulative income of all entities owned by the taxpayer , although the regulations provide rules regarding aggregation of entities (see Q 8581).

      Qualified business income is generally the net amount of qualified items of income, gain, deduction and loss with respect to qualified trades or businesses of the taxpayer, excluding qualified REIT dividends, qualified cooperative dividends and qualified publicly traded partnership income (but see Q 7782).[5]  Income, gain, deduction and loss items are generally qualified if they are connected with a U.S. trade or business and are included or allowed in calculating taxable income.  Amounts related to the following investment items are excluded: capital gains, qualified dividend income (or equivalent), non-business interest income, foreign base company income taken into account under IRC Section 954(c) and non-business annuity distributions.[6]

      For alternative minimum tax purposes, qualified business income is calculated without regard to otherwise allowable adjustments.[7]

      When the taxpayer’s income exceeds the annual threshold, the deduction is capped at the greater of (1) 50 percent of W-2 wage income or (2) the sum of 25 percent of the W-2 wages of the business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all “qualified property” (but see Q 7783 for a discussion of the so-called “phase-in” for certain taxpayers whose income only exceeds the threshold by $50,000 ($100,000 for joint returns)).[8]

      Planning Point: IRS guidance provides that the term “W-2 wages” includes online income properly reported to the Social Security Administration on Form W-2 within sixty days of the deadline for filing the form, including extensions.  The filing deadline is generally January 31, giving most businesses until April 1 to file the form in order to count the wages for Section 199A purposes.[9]

      “Qualified property” generally includes depreciable property that is used in the taxpayer’s trade or business for the production of income as of the end of the tax year, as long as the depreciation period has not expired before the end of that year.  The depreciation period is a period that begins on the first day that the taxpayer places the property in service and ends the later of (1) ten years after that date or (2) the last day of the last full year in the applicable recovery period that would apply to the property under IRC Section 168 (without regard to Section 168(g)).[10]

      A “specified service business” is a trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset of the business is the reputation or skill of one or more employees or workers, or one which involves the performance of services consisting of investing and investment management trading or dealing in securities, partnership interests or commodities (see Q 8572).

      To determine the “qualified business income” with respect to a specified service trade or business, the taxpayer takes into account only the applicable percentage of qualified items of income, gain, deduction, or loss, and of allocable W-2 wages.[11] With respect to S corporations, qualified business income does not include any amounts that are treated as reasonable compensation of the taxpayer.  Similarly, qualified business income does not include guaranteed payments or amounts paid or incurred by a partnership to a partner, when the partner is providing services and is not acting in his or her capacity as a partner.[12]

      If the qualified business income for the year is a loss, it is carried forward as a loss for the next tax year.  Any deduction allowed for that subsequent tax year is reduced by 20 percent of any carried forward business loss from the previous year.[13]

      The deduction is allowed in reducing taxable income (functioning more like an exclusion), rather than as a deduction in computing adjusted gross income (i.e., the deduction does not impact limitations based on adjusted gross income).  Further, trusts and estates are also eligible for the 20 percent deduction.

      For partnerships and S corporations, these rules apply at the partner or shareholder level (each shareholder is treated as having W-2 wages for the year equal to that shareholder’s allocable share of the S corporation).

      See Q  7785 for a detailed discussion of how a pass-through entity’s deduction for qualified business income is determined. See Q 8567Q 8586 for a discussion of the Section 199A regulations.


      [1].     Under IRC Sec. 199A.

      [2].     IRC Sec. 199A(a).

      [3].     Rev. Proc. 2020-45.

      [4].     IRC Secs. 199A(b)(3), 199A(d)(2).

      [5].     IRC Sec. 199A(c).

      [6].     IRC Secs. 199A(c)(3), 199A(d)(3).

      [7].     IRC Sec. 199A(f)(2).

      [8].     IRC Sec. 199A(b)(2). In the case of short tax years, only the W-2 wages paid during the short tax year are counted.

      [9].     Rev. Proc. 2019-11.

      [10].     IRC Sec. 199A(b)(6).  IRC Section 168 provides accelerated cost recovery system rules. IRC Section  168(g) provides an alternate depreciation system that may be used with respect to certain property, including tangible property used predominantly outside the U.S., tax-exempt use property and tax-exempt bond financed property.

      [11].     As defined in IRC Sec. 199A(b)(4).

      [12].    IRC Sec. 199A(c)(4).

      [13].    IRC Sec. 199A(c)(2).

  • 7783. How is an S corporation’s deduction for qualified business income determined?

    • Entities that are taxed under the rules governing pass-through taxation are generally entitled to a 20 percent deduction for qualified business income (QBI, see Q 7782).  This deduction is equal to the sum of:

      (a) the lesser of the combined QBI amount for the tax year or an amount equal to 20 percent of the excess of the taxpayer’s taxable income over any net capital gain and cooperative dividends, plus

      (b) the lesser of 20 percent of qualified cooperative dividends or taxable income (reduced by net capital gain).[1]

      The sum discussed above may not exceed the taxpayer’s taxable income for the tax year (reduced by net capital gain).  Further, the 20 percent deduction with respect to qualified cooperative dividends is limited to taxable income (reduced by net capital gain).

      The deductible amount for each qualified trade or business is the lesser of:

      (a) 20 percent of the QBI with respect to the trade or business or

      (b) the greater of (x) 50 percent of W-2 wage income or (y) the sum of 25 percent of the W-2 wages of the business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property (see Q 7782).[2]

      Planning Point: The regulations provide guidance on how UBIA should be calculated in the case of a like-kind exchange or involuntary conversion.  The regulations follow the Section 168 regulations in providing that property acquired in a like-kind exchange, or by conversion, is treated as MACRS property, so that the depreciation period is determined using the date the relinquished property was first placed into service unless an exception applies.  The exception applies if the taxpayer elected not to apply Treasury Regulation §1.168(i)-6.  As a result, most property acquired in a like-kind exchange or involuntary conversion under the new rules will have two relevant placed in service dates.  For calculating UBIA, the relevant date is the date the taxpayer places the property into service.  For calculating its depreciable period, the relevant date is the date the taxpayer placed the original, relinquished property into service.

      Concurrently with the proposed regulations, the IRS released Notice 2018-64, which contains a proposed revenue procedure with guidance for calculating W-2 wages for purposes of the Section 199A deduction for qualified business income. This guidance was finalized in Revenue Procedure 2019-11.  The guidance provides three methods for calculating W-2 wages, including the “unmodified box method”, the “modified Box 1 method”, and the “tracking wages method”. The guidance further specifies that wages calculated under these methods are only taken into account in determining the W-2 wage limitations if properly allocable to QBI under Proposed Treasury Regulation  Section 1.199A-2(g).

      The unmodified box method involves taking the lesser of (1) the total of Box 1 entries for all W-2 forms or (2) the total of Box 5 entries for all W-2 forms (in either case, those that were filed with the SSA by the taxpayer for the year).  Under the modified Box 1 method, the taxpayer subtracts from its total Box 1 entries amounts that are not wages for federal income tax withholding purposes, and then adds back the total of Box 12 entries for certain employees.  The tracking wages method requires the taxpayer to actually track employees’ wages, and (1) total the wages subject to income tax withholding and (2) subtract the total of all Box 12 entries of certain employees.

      Revenue Procedure 2019-11 clarifies that, in the case of short taxable years, the business owner is required to use the “tracking wages method” with certain modifications.  The total amount of wages subject to income tax withholding and reported on Form W-2 can only include amounts that are actually or constructively paid to the employee during the short tax year and reported on a Form W-2 for the calendar year with or within that short tax year.  With respect to the amounts reported in Box 12, only the portion of the total amount reported that was actually deferred or contributed during the short year can be included in W-2 wages.

      If the taxable income is below the applicable threshold levels (in 2021, $164,900 for single filers and $329,800 for joint returns), the deduction is simply 20 percent.[3]

      If the taxable income exceeds the relevant threshold amount, but not by more than $50,000 ($100,000 for joint returns), and the amount determined under (b), above, is less than the amount under (a), above, then the deductible amount is determined without regard to the calculation required under (b).  However, the deductible amount allowed under (a) is reduced by the amount that bears the same ratio to the “excess amount” as (1) the amount by which taxable income exceeds the threshold amount bears to (2) $50,000 ($100,000 for joint returns).

      The “excess amount” means the excess of the amount determined under (a), above, over the amount determined under (b), above, without regard to the reduction described immediately above.

      “Combined qualified business income” for the year is the sum of the deductible amounts for each qualified trade or business of the taxpayer and 20 percent of the taxpayer’s qualified REIT dividends and qualified publicly traded partnership income.[4]

      Qualified REIT dividends do not include any portion of a dividend received from a REIT that is a capital gain dividend or a qualified dividend.[5]

      “Qualified cooperative dividends” includes a patronage dividend, per-unit retain allocation, qualified written notice of allocation, or any similar amount that is included in gross income and received from (a) a tax-exempt benevolent life insurance association, a mutual ditch or irrigation company, cooperative telephone company, like cooperative organization or a taxable or tax-exempt cooperative that is described in Section 1381(a), or (2) a taxable cooperative governed by tax rules applicable to cooperatives before the enactment of subchapter T of the Code in 1962.[6]

      “Qualified publicly traded partnership income” means the sum of:

      (1) the net amount of the taxpayer’s allocable share of each qualified item of income, gain, deduction, and loss from a publicly-traded partnership that does not elect to be taxed as a corporation (so long as the item is connected with a U.S. trade or business and is included or allowed in determining taxable income for the year and is not excepted investment-type income, also not including the taxpayer’s reasonable compensation, guaranteed payments for services or Section 707(a) payments for services), and

      (2) gain recognized by the taxpayer on disposing its interest in the partnership that is treated as ordinary income.[7]


      [1].     IRC Sec. 199A(a)

      [2].     IRC Sec. 199A(b)(2).

      [3].     IRC Sec. 199A(b)(3).

      [4].     IRC Sec. 199A(b)(1).

      [5].     IRC Sec. 199A(e)(3).

      [6].     IRC Sec. 199A(e)(4).

      [7].     IRC Sec. 199A(e)(5).

  • 7784. What is the safe harbor that allows rental real estate businesses to claim the Section 199A deduction?

    • Only pass-through entities that qualify as a “trade or business” are entitled to claim the new 20 percent deduction for qualified business income under Section 199A.  Many business owners engaged in rental real estate activities had questioned whether their businesses would qualify for the deduction.  In response, the IRS released proposed Revenue Procedure 2019-07, finalized by Revenue Procedure 2019-38, which provides a safe harbor so that rental real estate businesses will qualify as “trades or businesses” and can claim the 199A deduction if they satisfy certain criteria.  For purposes of the safe harbor, “rental real estate enterprise” is defined to include any interest in real property held to generate rental or lease income, and can be comprised of an interest in a single property or multiple properties.

      To qualify under the safe harbor, the following requirements must be met:

      (1) Separate books and records for each rental enterprise must be maintained,

      (2) If the rental real estate enterprise has been in existence for less than four years, 250 or more hours of rental real estate services must be performed each year,

      (3) If the rental real estate enterprise has been in existence for more than four years, at least 250 hours of rental real estate services must have been performed in at least three of the past five years (these services can be performed by employees or independent contractors of the business),

      (4) The taxpayer must maintain contemporaneous records regarding the rental real estate services that are performed each year, including time reports, logs or similar documents, with respect to (a) description of all services performed, (b) dates on which the services were performed and (c) who performed the services, and

      (5) The taxpayer must attach a statement to the relevant tax return indicating that the safe harbor is being relied upon.

      To qualify under the safe harbor, the interest in real property must also be held directly by the taxpayer or through an entity disregarded as an entity separate from the owner (i.e., a single-member LLC).[1]

      [1]      Rev. Proc. 2019-38.

  • 7785. Are any businesses excluded from using the Section 199A rental real estate safe harbor?

    • Yes.  While the safe harbor generally does apply to residential rental real estate, taxpayers are not entitled to rely upon the safe harbor if the taxpayer uses the property as a residence during the tax year.  This exclusion applies to vacation properties that the taxpayer rents when not using the property for personal reasons.  Notably, if the real estate is rented or leased under a triple net lease, the safe harbor remains unavailable under the final rule.

      When satisfying the “hours of rental real estate services” criteria, only certain activities are counted toward the 250-hour threshold that must be met in order to qualify to use the safe harbor rule.  Activities such as rent collection, advertising the rental, property maintenance, negotiating leases and managing the real property generally count toward the threshold.  However, financing activities and the construction of capital improvements to the property, as well as hours spent traveling to and from the real property, are excluded (in other words, the taxpayer’s activities as an “investor” are not counted).

      If any property within the rental real estate enterprise is classified as a specified service trade or business, the safe harbor is unavailable for the entire business.  Further, if the taxpayer rents the real property to a trade or business that is operated either by the taxpayer or an entity under common control, the safe harbor is unavailable.

      Notably, if the real estate is rented or leased under a triple net lease, the safe harbor is unavailable.[1]


      [1]      Rev. Proc. 2019-38.

  • 7786. How is the basis of stock in an S corporation determined? How are the earnings, profits, distributions and redemptions of an S corporation treated?

    • Editor’s Note: The 2017 Tax Act modified the treatment of S corporations that convert to C corporations.  See Q 7787 for details.

      The basis of each shareholder’s stock is increased by the shareholder’s share of items of separately stated income (including tax-exempt income), by his or her share of any non-separately computed income, and by any excess of deductions for depletion over basis in property subject to depletion.1 An S corporation shareholder may not increase basis due to excluded discharge of indebtedness income.2 The basis of each shareholder’s stock is decreased (not below zero) by items of distributions from the corporation that are not includable in the income of the shareholder, separately stated loss and deductions and non-separately computed loss, any expense of the corporation not deductible in computing taxable income and not properly chargeable to capital account, and any depletion deduction with respect to oil and gas property to the extent that the deduction does not exceed the shareholder’s proportionate share of the property’s adjusted basis.

      For tax years beginning after 2005, if an S corporation makes a charitable contribution of property, each shareholder’s basis is reduced by the pro-rata share of the basis in the property.3 If the aggregate of these amounts exceeds the basis in the stock, the excess reduces the shareholder’s basis in any indebtedness of the corporation to the shareholder.4 A shareholder may not take deductions and losses of the S corporation that, when aggregated, exceed the basis in the S corporation stock plus the basis in any indebtedness of the corporation to the shareholder.5 Such disallowed deductions and losses may be carried over.6 In other words, the shareholder may not deduct in any tax year more than what is “at risk” in the corporation.

      Generally, earnings of an S corporation are not treated as earnings and profits. A corporation may have accumulated earnings and profits for any year in which a valid election was not in effect or as the result of a corporate acquisition in which there is a carryover of earnings and profits under IRC Section 381.7 Corporations that were S corporations before 1983 but were not S corporations in the first tax year after 1996 are able to eliminate earnings and profits that were accumulated before 1983 in their first tax year beginning after May 25, 2007.8

      A distribution from an S corporation that does not have accumulated earnings and profits lowers the shareholder’s basis in the corporation’s stock.9 Any excess is generally treated as capital gain.10

      If the S corporation does have earnings and profits, distributions are treated as distributions by a corporation without earnings and profits, to the extent of the shareholder’s share of an accumulated adjustment account (i.e., post-1982 gross receipts less deductible expenses, which have not been distributed). Any excess distribution is treated under the usual corporate rules. That is, it is a dividend up to the amount of the accumulated earnings and profits. Any excess is applied to reduce the shareholder’s basis. Finally, any remainder is treated as a gain as if the stock had been sold.11 However, in any tax year, shareholders receiving the distribution may, if all agree, elect to have all distributions in the year treated first as dividends to the extent of earnings and profits and then as return of investment to the extent of adjusted basis and any excess as capital gain.12 If the IRC Section 1368(e)(3) election is made, it will apply to all distributions made in the tax year.13

      Certain distributions from an S corporation in redemption of stock receive sale/exchange treatment. (Generally, only gain or loss, if any, is recognized in a sale.) In general, redemptions that qualify for “exchange” treatment include redemptions not essentially equivalent to a dividend, substantially disproportionate redemptions of stock, complete redemptions of stock, certain partial liquidations, and redemptions of stock to pay estate taxes.14

      If the S corporation distributes appreciated property to a shareholder, gain will be recognized to the corporation as if the property had been sold at fair market value; the gain will pass through to shareholders like any other gain.15

      The rules discussed above generally apply in tax years beginning after 1982. Nonetheless, certain casualty insurance companies and certain corporations with oil and gas production will continue to be taxed under the rules applicable to Subchapter S corporations in effect prior to these rules.16

      1 .IRC Sec. 1367(a)(1).

      2 .IRC Sec. 108(d)(7)(A).

      3 .IRC Sec. 1367(a)(2), as amended by TEAMTRA 2008, TRUIRJCA 2010, ATRA 2012 and PATH 2015.

      4 .IRC Sec. 1367(b)(2)(A).

      5 .IRC Sec. 1366(d)(1).

      6 .IRC Sec. 1366(d)(2).

      7 .IRC Sec. 1371(c).

      8 .SBWOTA 2007 Sec. 8235.

      9 .IRC Sec. 1367(a)(2)(A).

      10 .IRC Sec. 1368(b).

      11 .IRC Sec. 1368(c).

      12 .IRC Sec. 1368(e)(3).

      13 .Let. Rul. 8935013.

      14 .See IRC Secs. 302, 303.

      15 .IRC Secs. 1371(a), 311(b).

      16 .Subchapter S Revision Act of 1982, Sec. 6.

  • 7787. How did the 2017 Tax Act modify the treatment of S corporations that convert to C corporations?

    • Under prior law, if an S corporation converted to a C corporation, distributions of cash by the C corporation to the shareholders during the post-termination transition period were tax-free to the extent of the amount in the company’s accumulated adjustment account. These distributions also reduced the shareholders’ basis in the company’s stock. The “post-termination transition period” was the one-year period after the S corporation election terminated.

      The 2017 Tax Act provides that any accounting adjustments under IRC Section 481(a) that are required because of the revocation of the S corporation election of an “Eligible Terminated S Corporation” (ETSC) (such as changing from the cash to accrual method of accounting) must be taken into account ratably during the six tax years beginning with the year of the change.[1] Under the 2019 proposed regulations, former S subsidiaries, often referred to as QSubs, frequently cannot qualify for the six-year spread (or take actions to avoid the issue), and will have to recognize income pick-ups in the year following the parent’s revocation of its S corporation status as a consequence, based upon the proposed regulations.   Unfortunately, the IRS did not provide any relief on this issue for QSubs in the final regulations issued in September of 2020.   In the Preamble to the final regulations, the IRS indicated that it did not have the statutory authority under the 2017 Tax Act to give relief from income recognition.[2]

      An “Eligible Terminated S Corporation” (ETSC) is defined as any C corporation which (1) was an S corporation the day before the enactment of the 2017 Tax Act (i.e., December 22, 2017), (2) during the two-year period beginning on December 22, 2017 revokes its S corporation election under IRC Section 1362(a), and (3) where all of the owners of the corporation on December 22, 2017 are the same as on the date the election is revoked (in identical proportions).[3] The corporation’s S status cannot be terminated in any other way—it must be revoked. The IRS released proposed regulations late in 2019 intended to codify this rule.[4]  The final amended regulations, which generally largely adopted the 2019 proposed regulations, expanded the definition of an ETSC somewhat to include former S corporations that experienced a change in stock ownership after the effective date of their revocation, but prior to the filing the filing of the revocation.  As a consequence of this amendment, such S corporations can qualify as an ETSC and thereby, can also gain the transition benefits.[5]

      Under Revenue Procedure 2018-44, an eligible terminated S corporation is required to take a positive or negative Section 481(a) adjustment ratably over six years beginning with the year of change if the corporation (1) is required to change from the cash method to accrual method and (2) makes the accounting method change for the C corporation’s first tax year. An eligible terminated S corporation is permitted (but not required) to take a positive or negative Section 481(a) adjustment ratably over six years beginning with the year of change if the eligible terminated S corporation (1) is permitted to continue using the cash method of accounting after termination of its S status, and (2) changes to the overall accrual method of accounting for the C corporation’s first tax year.

      Under the new rules, if there is a distribution of cash by an eligible terminated S corporation, the accumulated adjustments account will be allocated to that distribution, and the distribution will be chargeable to accumulated earnings and profits, in the same ratio as the amount of the accumulated adjustments account bears to the amount the accumulated earnings and profits.[6] Under the proposed regulations, the corporation uses a “snapshot approach” to determining this ratio—meaning that it is determined only once and the same ratio is used until the relevant balance is reduced to zero. Ratios are determined on the day the S corporation revokes its S election.[7]

      Planning Tip:  These final regulations are effective for tax years beginning after the date of publication in the Federal Register.  However, taxpayers may also rely on these final regulations for guidance for tax years beginning on or prior to the publication date, assuming that all corporate shareholders consistently report and apply the new rules in their entirety to the corporation for subsequent tax years.[8]

      In a 2019 revenue ruling, the IRS clarified that cash distributions made by a former S corporation during the entity’s post-termination period in redemption of its stock reduce the adjusted basis in the stock to the extent that the distribution does not exceed the accumulated adjustments account value. This is the case if the distribution is treated as subject to Section 301, rather than as a distribution in exchange of stock. The amount of the distribution value that exceeds the accumulated adjustments account is treated as a dividend. In the case at hand, the S corporation’s S election terminated so that the entity became a C corporation. A single taxpayer owned all outstanding shares, and the corporation redeemed half of those shares for cash during the post-termination transition period.[9]

      [1].     IRC Sec. 481(d)(1).

      [2]     TD 9914 (Sept., 2020)

      [3].     IRC Sec. 481(d)(2).

      [4].     REG-131071-18.

      [5]     Prop TR Reg. § 1.481-5(c)(2), as modified by TD 9914,  Sept., 2020.

      [6].     IRC Sec. 1371(f).

      [7]     Prop. REG-131071-18.

      [8]     Compare Prop. REG-131071-18.and Final Regulation 9914.

      [9].     Rev. Rul. 2019-13.