When Does an S Corporation Pay Income Tax?

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 when an S corporation may end up paying tax on its income. Accordingly, smart S corp 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, or BIG, tax may be levied.

Probably the best way to explain how the BIG tax works is by an example. Suppose you have a C corporation that owns a building. Further suppose that building was purchased many years ago for $100,000 but is now worth $1,000,000.

If the C corporation sells this building, the $900,000 of profit will be taxed at the C corporation tax rates (roughly 34%). That means an initial $306,000 of corporate income taxes. If the leftover amount (roughly $600,000) is distributed to shareholders as a dividend, that $600,000 is subject to another tax that'll run at least $90,000 and may, if the shareholders earn more than $400,000 (or more than $450,000 if married and filing joint returns) be about $235,000.

Out of the $900,000 profit, then, the C corporation structure means that at least roughly $400,000 of the $900,000 profit will be siphoned off for taxes. And if your income is too high to use the qualified dividends tax rate (because you're single and you make more than $400,000 or because you're married and you make more than $450,000) as much as roughly $540,000 of the $900,000 profit could be siphoned off in taxes. Ouch.

With what you already know about S corporations based on your reading at this site, however, you may think you see a clever work around.

What if the C corporation in this example immediately prior to selling the $1,000,000 building elects to be treated as an S corporation? That would seem to work, right? If the $900,000 of profit is subject only to one tax, the 15% or 20% capital gains tax, the total tax equals $135,000 for most taxpayers (a 15% capital gains rate) or $180,000 (a 20% capital gains rate) for taxpayers who make more than $400,000 or more than $450,000 if married and filing joint returns. An S corporation, in other words, might just be able to reduce the taxes paid on the building appreciation by hundreds of thousands of dollars!

Unfortunately, there's a problem. A late-in-the-game conversion from a C to an S Corporation would not produce the hoped-for savings. In a situation like we've just described, the built-in gain tax kicks in. And, essentially, with the built in gains tax 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 more complicated than we've described here. For example, you actually net built-in gains from appreciation in asset values with net built-in losses from depreciation in asset values. If the C corporation is carrying forward net operating losses from its C corporation years, these carry-forwards reduce the amount of built-in gain subject to the BIG tax. And there are some other complexities you have to deal with, too. Which leads us to this suggestion: The complexities of the BIG tax calculations mean you want an experienced tax practitioner to make these calculations for you. BIG tax accounting is not something you whip up on your own using, for example, TurboTax®.

  2. The calculations require converted S corporations to pay the built-in gains 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. Finally, 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 doesn't get 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 tax similar to the BIG tax is sometimes levied when an S corporation both previously operated as a C corporation and 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 Xero Accounting don't even support the LIFO system. But LIFO can save a business taxes. In an inflationary environment, LIFO calculations cause a business to report slightly higher cost of goods sold each year on its income statement compared to other inventory costing methods (thus meaning it reports a lower net income), while the business correspondingly reports a slightly lower ending inventory on its balance sheet.

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 times 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, and rather terrible tax/penalty is potentially levied when an S corporation was 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 the 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. Which is a bummer.

And, unfortunately, the excessive passive income penalty gets even worse. If an S corporation suffers from the excessive passive income tax three years in a row, the S corporation's "S corp status" automatically terminates.

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