 Hello and welcome to this session in which we will discuss the S corporation. S corporation is an example of something we called pass through or flow through entities. What does that mean? It means the entity is not taxed, not taxing paying entity. So who's taxed? Somebody will have to pay the tax. Well, guess what's gonna happen? All income losses and deduction flow. It means transfer to the shareholder on per day or per share basis. In this taxation is similar to a partnership. I'm not sure if you already learned the partnership chapter or not but it doesn't really matter. Let me show you in a simple example what does that mean. Let's assume we have a business. It doesn't matter what form of business we have but let's assume we have a business. What's gonna happen is this. We are going to generate revenues. We are going to incur expenses operating revenues and operating expenses. As a result we're gonna have profit or net income. We're gonna call it profit for tax purposes. So let's assume for simplicity revenues are 100,000, expenses are 30,000 operating expenses and the profit is 70,000. So here's what's gonna happen. If this is a regular corporation, regular means C as in Charlie corporation. What's gonna happen is this. This C corporation will have to pay 21% on this 70,000 dollar of profit and let's go ahead and compute that 70,000 times 0.21 so the corporation itself will pay 14,700. Now also to illustrate the point let's assume the owner or the owners of this corporation takes the money out withdraw takes the money out because they want to use this money they want to live. I'm sorry it takes the money what's left 70,000 minus what I meant to say they take the money after they pay the taxes 70,000 minus 14,700 what's left is 53,000 55,300 so that's the profit and let's assume they take this profit out. Now they're gonna have to pay taxes on this profit based on their tax rate whatever their tax rate is let's assume on average 25% they're gonna have to pay 25% times 0.25 and that's another tax bill of 13,825 so if we take 55,300 minus 13,825 what's left is 41,475 41,000 475 after we took the money out and the money is taxed. Now if this is an S corporation again this is just to make the point if this is an S corporation the corporation makes a generate revenues of 100,000 incur losses of 30,000 the business itself they have a profit of 70,000 from operating expenses and operating profit and now you're gonna see why I'm saying operating expenses and operating profit then what's gonna happen is this this 70,000 flow through pass through this is what we mean by flow through or pass through goes to the shareholder or holders it doesn't matter if it have one or many in the shareholders themselves they'll pay taxes so let's assume they're in the 25% tax bracket or 20 or whatever the tax bracket is I'm just making up a number because each individual has a different tax bracket so what's gonna happen it's assumed they pay 17,500 in taxes so if they take the 70,000 minus 17,500 in taxes so 70,000 minus the taxes paid on this what's left is 52,500 versus 41,475 so that's the idea of an S corporation that the S corporation itself doesn't pay taxes the profit goes to the shareholders now that's it's not only the profit you're also gonna have other gains and deductions which we'll talk about that later I'm just simplifying this to make the point before we proceed any further I have a public announcement about my company farhatlectures.com Farhat accounting lectures is a supplemental educational tool that's gonna help you with your CPA exam preparation as well as your accounting courses my CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles my accounting courses are aligned with your accounting courses broken down by chapter and topics my resources consist of lectures multiple choice questions true false questions as well as exercises go ahead start your free trial today no obligation no credit card required so the main the main advantage of an S corporation is the absence of double taxation and this is just what I showed you the double taxation don't exist for an S corporation however the S corporation the S corporation has limited liability but the C S corporation has a limited liability just like a C corporation so an S corporation gives you the best of both words it gives you a limited liability limited liability means what if the institution of the company is sued if the business is sued the shareholders will have protection personal protection so the liability lies and the corporation itself it doesn't go beyond the corporation that the shareholders so C corporation as I just said our tax paying entities the corporation are taxed on their income before any distribution of dividend then once the distribution of dividend takes place then the shareholder pay taxes again so this is what double taxation is once again S corporation are not subject to income taxes at the corporate level now I have this in yellow you're gonna see why in a moment the taxation of a corporate income occurs after the income flows through to the shareholders in fact as S shareholders are taxed on their share of the S corporation income even if it's not even if it's not distributed to them so whether that distribution takes place or not it does not really matter you pay taxes on that profit you remember the 70,000 profit whether that profit is distributed or not you have to pay taxes on that that's important now I said S corporation are not subject to income tax at the corporate level through however when S corporation start we're gonna see in a moment they start as a regular corporation and they could be for several years as a C corporation as a result we might have something called life or recapture rules built in gains passive investment income penalty tax don't worry we'll talk about those in the next session the point I'm trying to make is yes some time the S corporation pay taxes on a corporate level for certain items and these are the certain items and there is there is a reason why we do so and the reason we do so because this S corporation was a C for a for a period of time now what we're gonna do next I'm gonna show you what's called 1120 S then I'm gonna show you the K1 which will show you the how the revenue is reported how the expenses are reported and how they are transferred how the investor is informed about this information so this is what we called 1120 S which is 1120 it's a corporation as a shareholder or sub chapter S corporation well you have the name the address all that information up top then here's what's gonna happen you're gonna report your income whatever the business we are in such as assume reported income of 100,000 then we are going to report our expenses compensation salaries repairs and maintenance bed that blah blah blah all the expenses and the total deductions appears to be 30,000 we have an ordinary business income of 70,000 and we have nothing else left we have no excess net passive income for life or recapture we don't have any of this so it doesn't matter what we're left with is 70,000 of ordinary income now here's what's gonna happen this 70,000 of ordinary income it's gonna flow to the shareholders let's assume this is one shareholder and the shareholder owns for the sake of illustration 30% of the company 30% of the company so this 70,000 it's gonna go to the shareholder this is their form K1 and if we take 70,000 70,000 times 30% and this should be 21,000 times 30% should be 21,000 and this amount 21,000 will be reported to the shareholder in this box informing the shareholder that they are responsible for 21,000 it means 21,000 flow from the corporation to them and they're gonna have to report this 20,000 21,000 as income under 1040 maybe I should have also showed you the 1040 then this 20,000 go to their 1040 as think of it as think of it as income wages this is basically the K1 think of it also as an equivalent of a W2 for an S corporation this is what they report to you now there are more boxes here which I'm not going to discuss now I'm just gonna tell you what they are net real estate income net rental income interest income qualified dividend ordinary dividend qualified dividend royalties net short-term capital gain net long-term capital gain collectibles and recaptured gain net section 1231 section 179 all of those all of those all these items here they are called separately stated item don't worry about the concept now just want you to kind of just plan the seat for later separately stated means each individual get their share of these items sent to them separately and we'll see why later so the 21,000 we're gonna call it non separately stated item the remaining will be separately stated items now how do S corporation comes to life well we're gonna have to make a selection it's not selection it's an election or a selection it doesn't really matter so once a corporation is formed the assumption is the corporation is treated as a C corporation C as in Charlie then immediately after it's created we can choose to have an S corporation status however S shareholders can make an election to treat a qualifying corporation as an S corporation by filing a form called 2553 with the IRS I will show you this form on the next slide so simply put you start as a C corporation then immediately instantaneously you can say you can file this form says it doesn't have to be instantaneously but what I'm trying to tell you is you could treat it as an S corporation it's an election it's you selected to be treated this way the S status election requires everything you need the consent of all shareholders for example when I treated my company as an S corporation I was by myself I was by myself therefore I selected as corporation I'm the majority I'm everyone I own 100% including those voting and non-voting you could have voting and non-voting for this S election you need the consent of all in fact each shareholder owning stock during the election year must sign for the S election even if the stock is no longer owned at the election date so if you were a shareholder for that year and you left you sold you still have to sign if one or more owner do not consent the election is considered made the following year if that's the case it can does not consent the election is considered made made the following year now why that's the case because for a particular year remember the S corporation is a flow through flow through so if they let's assume we have a former shareholder here former S shareholder they don't want to select for year one or for year five well then we cannot treat the corporation as year five because their former shareholder and they don't want to have a flow through income well that's fine then the following year what they left now we are in year six and the others the remaining one to be an S corporation then it can be an S corporation but in year five even though they were a former they sold their shares during the year we still need their consent now once a corporation gets the S status once the S status is effective when a new person come in they have no saying because they have to accept that selection they have to accept the S corporation the corporation is treated as an S corporation for income tax purposes only for the days on which the eligibility requirement for the S status are met and the election becomes effective so you are an S corporation once you become effective now this is the form 2553 matter of fact I had to fill out this form when I did my selection actually I did not do it I would let your accountant or your lower lawyer take care of that so my accountant send it to me I just signed it and send it back to them but that's what the form is effectiveness of the S corporation when does it become effective in general the S status election should be filed within two and a half month following the end of the taxable year to be effective at the beginning of the year so for looking at 20x5 okay to be eligible for 20x5 you have to file two and a half month before before that time so as long as you elect the select the S corporation which is basically what March 15th as long as you make the selection 20x5 March 15th you are an S corporation as of the beginning of the year if you wait after what's going to happen then you become an S corporation S corporation at the beginning of 2006 and basically what I did we didn't do the paperwork until November therefore I'm gonna be an S corporation starting 20 oh here I'll be the following year accordingly for a calendar year corporation if the S status is election by March 15th of the tax year it's considered effective as the as of the beginning of that particular year otherwise it will be effective the following year shareholder may obtain an extension of time for filing their consent provided the form 253 was timely filed and the interests of the government are not jeopardized so simply put if you don't have to sign it that particular year they give you more time to sign it as long as the purpose is not to avoid paying taxes so let's assume a shareholder was away now these days it doesn't really matter because you can scan it send them they can sign it and scan it back but back in the days maybe that wasn't as easy but now it's okay so they give you more time to for everyone to sign qualifying corporation for a corporation to be eligible for S status corporation all of the following requirement must be met so this is what a qualifying corporation is why are we talking about this because as shareholders you want to qualify as if you want to qualify as an S status you have a motive and the motive is double taxation so if you don't you are not a qualified corporation so that guess what if you are not qualified corporation for an S then you become a C and what happened was C you there is a double taxation so you want to make sure so so you want to make sure you qualify as an S corporation and you remain an S corporation you don't want to lose your qualification so what are the requirement one the corporation should be a domestic well why because you have to pay taxes we have to you have you have you have to pay taxes in the US therefore it's a domestic corporation remember if you're a foreign corporation they don't want you to avoid double taxation if you're a foreign corporation and you're operating then you have C corporation we want the double taxation but if you're a domestic corporation we're giving you the whole purpose of an S corporation is to give a break to mom and pop so it has to be a domestic corporation mom and pop business the corporation must have a maximum number of shareholders of 100 again we're talking about relatively small corporation now family members have the option to be treated one shareholder so if you have a family member and six generation which is grandfather son grandson so on and so forth they can they if they can be they want to be treated as one they can be treated as one shareholder so you could have more than one individual because a family is treated could be treated as one shareholder the corporation should have only have one class of stock which is common stock now within common stock you can have voting and non-voting and this is this is very normal why I'll tell you for example my brother he he gave some of his S corporation share to his kids but he doesn't want his kids to make any decisions so he gave them the shares but they gave them non-voting shares they have voting share and non-voting non-voting shares that's okay those are not two different types of classes but you cannot have a preferred stocks preferred stock is a different type of stock so if you should prefer stock guess what you could lose your S status and I saw this happen before where one corporation because they needed more money they negotiated with someone and someone told them okay I will I if you should be preferred stock I will invest and what they did they did and they lost their qualifying status so this could happen the shareholder of the share of the S corporation can include resident individual again you have to be resident resident resident individual single member LLC LLC company that's fine a state certain qualified trust and certain tax exempt organization that's fine they can be shareholder in an S corporation however non-resident alien again again back to that point partnership corporation which is C corporation most limited liability companies and most IRAs are not to own stock in an S corporation they cannot be owners of stock in an S corporation in an S corporation and sometime you might get a questions like this just be aware that what you what you can and you cannot be especially about non-resident alien in a partnership this comes all the time basically one individual their soldier share to a partnership you can't do that or their soldier share to their cousin in Europe you can't do that or their soldier share to their friend in Mexico you can't do that once that happens you can if you want to that's not a problem but the corporation loses its S status because you could to qualify you have to meet those requirement and once you lose it you're going to be subject to double taxation also an S corporation can be partner in a partnership that's fine S corporation can be a partner but not the other way around or a shareholder in a corporation notice they can be but those they cannot own the S corporation the partnership or the C corporation however it cannot file the consolidated return with the C corporation and you will see why that could be an issue later tax year S corporation are generally required to adopt a calendar tax year and that's one of the reasons why it doesn't consolidate because they want you to file for a tax year now why they want you to file for a tax year generally required now you could always have an exception why do they want you a tax year remember a C an S corporation the profit flows to the shareholders so at the end of the year you have to compute the profit and you have to file the profit get get get done with this before the shareholder which is april 15 filed their taxes so you have to report they have to report the profit under individual tax return C corporation they could have fiscal year so they may not match okay so other fiscal year may also be adopted if the corporation establishes a business purpose that the IRS finds valid so you could have a fiscal year but 99% of C S corporation are calendar year for that reason okay a fiscal year can be automatically approved if the corporation satisfied we don't have to kind of worry about this the 25% gross test under this test more than 25% of the gross receipt have occurred in the last two months of the proposed over a period of three years so you have basically a seasonal seasonal type of business or the fiscal year is used by shareholders owning more than 50% of the corporate tax remember what I told you earlier I told you earlier that that the reason it's a calendar year because shareholders also they have a calendar year so you so they have to match well what happened if the shareholders at the majority of the shareholders don't have don't use a calendar year they use a fiscal year then under under those circumstances well there is a reason to do it but again those are the exception to the rule in addition under section 444 of the of the internal revenue code S corporation are allowed to elect an acceptable fiscal year which should be September 30th October 31st and November 30th provided that some required payment related to the deferred taxes are made assuming you make payment on the deferred taxes they don't want you to defer taxes from year to year by selecting a fiscal year now although an S corporation are not tax paying entities they still have to file an informational return which is 1120 S I showed you earlier so yes they don't pay taxes themselves but they have to file what we called an informational return showing the revenues showing their expenses because they have to report the ordinary income to the shareholders in all cases the income tax return are required to file by the 15th of the third month following the close of the tax year so we're talking the 15th of the third month which is March 15th and by March 15th you have one month to give the K1 to the shareholders so the shareholders can file the return so simply put something like this so if we are in 20x5 and now in 20x5 we have to file our return in 20x6 for 20x5 so the S corporation will have to complete this work by March 15th and the individual filed the return on April 15th so once the corporation finalized their paperwork they have one month to send the K1 to the shareholder where the shareholder reported the income or the deduction or the losses on their return and they filed their tax return in 20x6 so that's why the the S corporation when I was in practice up to March 15th we would focus on S corporation why because we want to finish those so the shareholders of this corporation get their K1 so they can file a month later 415th so start after March 15th you know we stop work on an S or we just file an extension if we haven't filed it and we start to focus on individual why because by 415th we have to file the individual termination of an S election this is when basically when you lose it the election of an S status remain enforced until revoked revoked or lost sometime again you can lose it once term when it's a terminating event an S an S becomes ineffective and the corporation becomes a C corporation and for some it's a nightmare now you lost it because now you're going to have to pay double taxes now when do you lose it well in any of the following situation the first one is pretty simple you select to do it voluntarily the shareholders owning a majority which is more than 50 percent it doesn't have to be 100% they say you know what they voted and they voluntarily decide we don't want this S election anymore it's not in our best interest that's fine more than 50% elect it's not like when you approve it when you become an S 100% voting and non-voting to revoke only the majority in this situation the revocation must be filed by the 15th of the third month of the year to be eligible for the entire year otherwise it becomes effective as of the first day of the following year so we were talking about March 15th here the entity no longer qualify as an S you could lose it this is kind of involuntarily where you kind of lost your status lost it in other words it's no longer meet the S status eligibility requirement to remember we talked about those requirement for example you could have more if you have more than 100 shareholders that's it you can no longer qualify you would lose your status once again the owners of the company they don't want to lose their status because you have interest a benefit in that flow through entity there's no double taxation you don't want to be double tax that's why you went for an S corporation when that's the case the election is terminated at the date at which the disqualification disqualification occurs so let's assume it happened January 5th then January 6th you no longer a an S corporation or the corporation does not meet the passive investment income limitation which applies to S corporation what is the passive investment income you could have a certain amount of passive investment in the S corporation but not too much if the passive investment income exceed 25 percent of gross receipts for the past three years so they look at the past three years and if you have passive investment income which is basically portfolio income dividend dividend royalties interest in the past three years if your income for any particular year more than 25 percent is passive income then on the fourth year you would lose your status as an S corporation again you lost your status in some cases the IRS may waive determination of an S corporation provided determination was unintentional and corrected within a reasonable period of time so what when would that happen just kind of give you an idea let's assume you own some shares in a mutual fund and it's and that mutual fund made made a large distribution and because of that large distribution you went over the 25 percent the IRS can always waive because that's that that's the right the government can always say no worries we're gonna keep you an S corporation now in the past the the IRS were kind of mean and they wanted you to lose the S corporation because they wanted the double taxation they want more money but what's happening in the past few years or the past decade the IRS are nicer and they don't want you to lose your S corporation so they could always you could explain to them what happened and they will make an exception now for example let's assume delta an S corporation with 100 under the data shareholder Emily one of the shareholder decided to sell 10 of her shares to a partnership in which she's a general partner what would happen under those circumstances a partnership cannot be an order in an S corporation the S corporation would lose their status now what can you argue I'm just saying I'm just kind of just to make a comment here well you can tell you can tell the IRS look Emily did not know what she was doing it's a mistake it was not intentional and you know maybe you can sell it back you will try but I'm not saying it will work but what I'm saying is you will try but if if Emily knows exactly what she's doing and she sold it then then that's a different story otherwise you would lose your status or let's assume Emily has a cousin in Europe and she sold 10 shares to her cousin in Europe well same concept it's a non-resident alien then guess what I'm sorry you lost your status short tax year if due to the S status election or termination a corporation was treated as a C corporation and an S corporation during some time of the year so we have a year for part of the year we were an C C Corp and part of the year we were an S Corp that's fine then the income is allocated between the C and the S Corp based on the relative number of days under each status let's take a look at this example Maya as a calendar year S corporation that's fine has maintained as status ever since its formation on April 1st of the current year admitted a partnership as a 20% shareholder what happened if you admitted a 20% partnership shareholder you lost your status okay assuming the corporation reported an ordinary income of 200,000 what is the amount of income allocated to the S tax so basically we were S here up until S Corp up until April 1st and after April 1st we were a C Corp so we have a short tax year short tax year on April 1st of the current year upon the admission the S status election was immediately terminated and the corporation became a C the corporate income is allocated to the short S corporation tax year is computed as follow we're going to take 200,000 multiplied by 312 so 50,000 is allocated to the S corporation and what happened to the remaining 150 it's allocated to the C so 50 to the S 50 to the S the first three month January February March and starting in April we became a C and we allocate the remaining of the income to the C corporation re-election of the S status let's assume you want to become an S status again after you have lost it you have to wait five years so the new S status election cannot be made within five years after the termination and that termination you could be voluntarily terminated or involuntarily it doesn't matter you have to wait for five years you have to wait can the IRS give you a waiver of course they can that's the boss the IRS may consent that an earlier election is waived and they would allow you to do it so what should you do now go to far hat lectures whether you are a CPA candidate enrolled agent candidate or an accounting student S corporation is an important topic for the CPA exam for the enrolled agent exam for an accounting student go ahead look at multiple choice through false additional exercises that's going to help you do better on your exam good luck study hard and of course stay safe