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When do I have to pay income tax on my S corporation?

By Stephen Nelson

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Published: 27Aug2009
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Most of the time, an S corporation does not pay federal income taxes. The essential feature of an S corporation is that shareholders pay the taxes on income?not the corporation. However, three situations exist whereby an S corporation may end up paying tax on its income. Accordingly, smart S corporation owners and managers need to know about and work to avoid these stealth S corporation taxes.

Situation #1 - Built-in Gains Tax

When an S corporation realizes built-in gains stemming from the period the corporation operated as a C corporation, a built-in gains (BIG) tax may be levied.

Some small business owners attempt to avoid the BIG tax by switching from a C corporation to an S corporation before filing their taxes. Unfortunately, a late-in-the-game conversion from a C to an S Corporation would not produce the hoped-for savings. Essentially, the S corporation is forced to pay the "C corporation" taxes the shareholders hoped to sidestep.

Three other quick comments about the built-in gains tax:

1. The calculations are a bit more complicated than I've described here, so you will want an experienced tax practitioner to make these calculations for you. BIG tax accounting is not something you whip up on your own using TurboTax.

2. The calculations require converted S corporations to pay the BIG tax on some surprising items. For example, an S corporation that uses the cash method of accounting includes unrealized accounts receivable and unrealized accounts payable in its BIG tax calculations. Accordingly, a converted S corporation that uses cash-basis accounting would probably pay BIG tax on some chunk of its uncollected accounts receivable.

3. The BIG tax only comes into play during the first ten years of an S corporation's life. In other words, if an S corporation sells assets with all sorts of built-in gains--but more than ten years after converting to S corporation status--the BIG tax isn't levied. (Often the way a business owner gets around the BIG tax problem is by converting to an S corporation, waiting 10 years and then selling appreciated assets.)

Situation #2 - LIFO (last-in, first-out inventory accounting) Recapture Tax

Another, BIG-like tax is potentially levied when an S corporation previously operated as a C corporation uses the LIFO (last-in, first-out) inventory accounting method.

Most small businesses won't use LIFO inventory accounting; popular small business accounting programs like QuickBooks and Microsoft Small Business Accounting don't even support the LIFO system. But LIFO can save a business taxes. In an inflationary environment, LIFO lets a business slightly overstate its cost of goods sold each year and then slightly understate its ending inventory by a corresponding amount.

If an S corporation used to be a C corporation and uses the LIFO inventory accounting method, a LIFO recapture tax is applied to the tax benefits that accrue from using LIFO accounting.

If you're in a situation where the LIFO recapture tax might apply, you need to confer with a knowledgeable tax practitioner. Often the LIFO recapture tax means that converting your C corporation to an S corporation isn't economical.

Situation #3 - Excessive Passive Income Tax and Penalty

One final penalty is potentially levied on an S corporation previously operated as a C corporation if two requirements are met: One, that the S corporation has net passive income (dividends, interest, capital gains, rental income and so on) and, two, that the corporation has retained some of the profits from its old "C corporation years."

In this situation, if the S corporation's net passive income exceeds 25% of its gross receipts for the year, the S corporation pays the highest corporate income tax rate on the net passive income. (If an S corporation suffers from the excessive passive income tax three years in a row, the S corporation status automatically terminates.)

Stephen L. Nelson has been a CPA for over twenty-seven years, holds an MBA in finance and an MS in taxation, and is the author of numerous best-selling books about accounting. He also writes an S corporation FAQ where recent columns include discussions of late S corporation elections and S corporation fringe benefits.

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