entities. Instead, they pass through to their shareholders’ income, deductions, gains, losses, and tax credits. The shareholders report these amounts on their individual returns. The S corporation files a return with the IRS – Form 1120S, U.S. Income Tax Return for an S Corporation– to report the total pass-through amounts. The S corporation also completes Schedule K-1 of Form 1120S, a copy of which is given to each shareholder. The K-1 tells the shareholder his or her allocable share of S corporation amounts. The K-1 for S corporation shareholders is similar to the K-1 for partners and LLC members.
Unlike partnerships and LLCs, however, S corporations may become taxpayers if they have certain types of income. There are only 3 types of income that result in a tax on the S corporation. These 3 items cannot be reduced by any deductions:
1. Built-in gains. These are gains related to appreciation of assets held by a C corporation that converts to S status. Thus, if a corporation is formed and immediately elects S status, there will never be any built-in gains to worry about. The built-in gains tax ends once the S corporation has held the appreciated assets for more than 5 years.
2. Passive investment income. This is income of a corporation that has earnings and profits from a time when it was a C corporation. A tax on the S corporation results only when this passive investment income exceeds 25 % of gross receipts. Again, if a corporation is formed and immediately elects S status, or if a corporation that converted to S status does not have any earnings and profits at the time of conversion, then there will never be any tax from this source.
3. LIFO recapture. When a C corporation using last-in, first-out or LIFO to report inventory converts to S status, there may be recapture income that is taken into account, partly on the C corporation's final return, but also on the S corporation's return. Again, if a corporation is formed and immediately elects S status, there will not be any recapture income on which the S corporation must pay tax.
To sum up, if a corporation is formed and immediately elects S status, the corporation will always be solely a pass-through entity and there will never be any tax at the corporate level. If the S corporation was, at one time, a C corporation, there may be some tax at the corporate level.
C Corporations and Their Shareholder-Employees
A C corporation is an entity separate and apart from its owners; it has its own legal existence. Though formed under state law, it need not be formed in the state in which the business operates. Many corporations, for example, are formed in Delaware or Nevada because the laws in these states favor the corporation, as opposed to the investors (shareholders). However, state law for the state in which the business operates may still require the corporation to make some formal notification of doing business in the state. The corporation may also be subject to tax on income generated in that state.
According to IRS data, there are about 2.2 million C corporations, more than 94 % of which are small or midsize companies (with assets of $10 million or less).
For federal tax purposes, a C corporation is a separate taxpaying entity. It files its own return (Form 1120, U.S. Corporation Income Tax Return) to report its income or losses. Shareholders do not report their share of the corporation's income. The tax treatment of C corporations is explained more fully later in this chapter.
Professionals who incorporate their practices are a special type of C corporation called personal service corporations (PSCs).
Personal service corporation (PSC) A C corporation that performs personal services in the fields of health, law, accounting, engineering, architecture, actuarial science, performing arts, or consulting and meets certain ownership and service tests.
Personal service corporations are subject to special rules in the tax law. Some of these rules are beneficial; others are not. Personal service corporations:
● Cannot use graduated corporate tax rates; they are subject to a flat tax rate of 35 % (check the Supplement for a possible rate change).
● Are generally required to use the same tax year as that of their owners. Typically, individuals report their income on a calendar year basis (explained more fully in Chapter 2), so their PSCs must also use a calendar year. However, there is a special election that can be made to use a fiscal year.
● Can use the cash method of accounting. Other C corporations cannot use the cash method and instead must use the accrual method (explained more fully in Chapter 2).
● Are subject to the passive loss limitation rules (explained in Chapter 4).
● Can have their income and deductions reallocated by the IRS between the corporation and the shareholders if it more correctly reflects the economics of the situation.
● Have a smaller exemption from the accumulated earnings penalty than other C corporations. This penalty imposes an additional tax on corporations that accumulate their income above and beyond the reasonable needs of the business instead of distributing income to shareholders.
The C corporation reports its own income and claims its own deductions on Form 1120, U.S. Corporation Income Tax Return. Shareholders in C corporations do not have to report any income of the corporation (and cannot claim any deductions of the corporation). Figure 1.6 shows a sample copy of page 1 of Form 1120.
Figure 1.6 Form 1120, U.S. Corporation Income Tax Return
C corporations pay taxes according to corporate tax rates that run from 15 % on taxable income up to $50,000, to 35 % on taxable income over $15 million (with very large corporations subject to a higher marginal rate that has the effect of eliminating the graduated rates so that they are eventually taxed at a flat 35 % unless the rates are changed as noted in the Supplement) (see Table 1.1). These brackets are not adjusted annually for inflation as are the tax brackets for individuals.
There has been sentiment in Congress to significantly reduce the top corporate rate in order to make U.S. corporations more competitive with foreign corporations. According to a report by the Congressional Budget Office that compared U.S. corporate rates and other factors with those in other G20 member countries, the U.S. had the highest statutory rate, the third-highest average corporate rate, and the fourth-highest effective corporate rate. Check the Supplement for an update on corporate tax rate reduction.
Distributions from the C corporation to its shareholders are personal items for the shareholders. For example, if a shareholder works for his or her C corporation and receives a salary, the corporation deducts that salary against corporate income. The shareholder reports
