How pass-through items are allocated to shareholders

• S corporation items are separately stated and reported to shareholders on Schedule K-1 (Form 1120-S), who include their shares on their individual returns. 2024 Instructions for Form 1120‑S; 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

• Allocation is on a per‑share, per‑day basis; when an interest terminates mid‑year, affected shareholders may elect to treat the year as two short years for more accurate allocation. 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

• The corporation must separately state items affecting shareholder tax liability (e.g., capital gains, charitable contributions, credits) and pass them through accordingly. 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

Shareholder stock and debt basis: adjustments and ordering

• Shareholder basis is the foundation for deductibility of passed‑through losses and for tax treatment of distributions. Basis is adjusted annually: increases include pass‑through income and certain tax‑exempt income; decreases include non‑deductible expenses, passed‑through losses (but not below zero), and non‑dividend distributions. Instructions for Form 7203

• Ordering for tax years beginning on or after August 18, 1998 generally follows: increase for income; decrease for distributions; decrease for non‑deductible expenses; then decrease for losses/deductions. An elective alternative allows losses to reduce basis before non‑deductible items by attaching a statement per the regulations. Instructions for Form 7203

• Adjustments are generally measured at year‑end; if stock is disposed mid‑year, adjustments occur immediately prior to the disposition. Instructions for Form 7203

• Debt basis exists only for bona fide shareholder loans to the corporation; guarantees do not create basis until payment is made. Loan basis is reduced when losses exceed stock basis and later restored with net increases before increasing stock basis. Instructions for Form 7203

Cash and property distributions: AAA, E&P, and taxability

• If the S corporation has no accumulated earnings and profits (E&P), distributions reduce stock basis (to the extent of basis) and any excess is capital gain. 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

• If there is accumulated E&P, distributions are sourced first to the accumulated adjustments account (AAA) and treated like no‑E&P distributions; any remainder is a dividend to the extent of E&P; the rest (if any) is a return of capital then capital gain. LB&I Transaction Unit—Distributions with Accumulated Earnings & Profits

• The AAA is a corporate‑level account tracking S‑period income/loss (similar to shareholder basis but with different ordering); there are elections to (i) distribute E&P first, (ii) deem a dividend, or (iii) forego previously taxed income, each requiring shareholder consents and a timely statement attached to Form 1120‑S. LB&I Transaction Unit—Distributions with Accumulated Earnings & Profits

• Distributions are taken into account on the date paid, and AAA/basis adjustments for the year are considered when determining distribution tax treatment. 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

Property distributions and bargain sales to shareholders

• Distributing appreciated property triggers corporate‑level gain as if sold at fair market value; losses are generally disallowed, and gains/losses cannot be netted across multiple property distributions. A bargain sale to a related party is treated as part‑sale (gain recognition to FMV) and part‑distribution (the below‑FMV element), impacting AAA and potentially dividend treatment if E&P exists. LB&I Transaction Unit—Property Distribution

Shareholder-level limitations on losses and credits

• Basis limitation: deductible losses/deductions cannot exceed aggregate stock and loan basis; excess is suspended and carried forward. Instructions for Form 7203

• At‑risk limitation: losses are limited to amounts at risk in the activity; nonrecourse or protected amounts are not at risk; use Form 6198 when required. Publication 925; Instructions for Form 6198

• Passive activity limitation: passive losses/credits are limited; material participation rules apply; use Forms 8582/8582‑CR to compute allowable amounts. Publication 925; 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

Reasonable compensation vs. distributions

• Officer‑shareholders who provide services must receive reasonable wages (subject to payroll taxes); distributions are not a substitute for compensation. The IRS instructs that payments for services be treated as wages to the extent they represent reasonable compensation and provides guidance in the 1120‑S instructions. 2024 Instructions for Form 1120‑S

Built‑in gains tax and passive investment income tax at the entity level

• Despite pass‑through treatment, S corporations can face entity‑level taxes. Built‑in gains (BIG) tax applies when a C corporation converts to S status (or an S corporation acquires assets with carryover basis from a C corporation) and recognizes built‑in gains during the recognition period; the tax is at the highest corporate rate, limited by net unrealized built‑in gain and taxable income rules. 26 CFR § 1.1374‑10

• Passive investment income tax applies if the S corporation has accumulated E&P and passive investment income exceeds 25% of gross receipts; excess net passive income is taxed at corporate rates. 2024 Instructions for Form 1120‑S

Qualified Business Income (QBI) deduction (§ 199A)

• Many S corporation shareholders may be eligible for a QBI deduction up to 20% of qualified business income (subject to thresholds, wage/property limits, and SSTB rules). The deduction is claimed by the shareholder and computed using Forms 8995/8995‑A and related instructions. 2024 Instructions for Form 8995; 2024 Instructions for Form 8995‑A

Reporting and compliance: key filings and deadlines

• Form 1120‑S: due the 15th day of the 3rd month after year‑end (for calendar‑year 2024, March 17, 2025); electronic filing is required if the corporation files 10 or more returns of any type. 2024 Instructions for Form 1120‑S

• Schedules K and K‑1: report pass‑through items and each shareholder’s pro rata shares; K‑1 recipients must consider all limitations and attach required forms (7203, 6198, 8582) as applicable. 2024 Instructions for Form 1120‑S; 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

• Form 7203: generally required when claiming losses, receiving non‑dividend distributions, disposing of stock, or receiving loan repayments; helps track basis changes and limitations. Instructions for Form 7203

Special elections and allocation mechanics

• Year termination elections: if a shareholder disposes of a substantial amount of stock (qualifying disposition), the corporation may elect to split the year into two short years to allocate items, adjust AAA/E&P/basis, and compute distribution effects more fairly. 2024 Instructions for Form 1120‑S

• Shareholder termination elections: affected shareholders and the corporation may elect to treat the year as two short years for per‑share, per‑day allocation when a shareholder’s interest terminates. 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

LLCs taxed as S corporations (classification)

• A domestic LLC can elect to be treated as a corporation (and then as an S corporation if eligible) by filing the appropriate classification and S election forms; otherwise, default classification rules apply. 2024 Instructions for Form 1120‑S

Practical takeaways for S corporation owners

• Track basis annually and use Form 7203; you’ll need it to substantiate losses and distribution taxability. Instructions for Form 7203

• Pay reasonable compensation to owner‑employees; don’t rely on distributions to compensate for services. 2024 Instructions for Form 1120‑S

• Understand distribution sourcing (AAA/E&P) and election options; document shareholder consents for distribution elections. LB&I Transaction Unit—Distributions with Accumulated Earnings & Profits

• Watch for BIG and passive investment income rules if converting from C status or if E&P exists. 26 CFR § 1.1374‑10; 2024 Instructions for Form 1120‑S

• Consider K‑1 SSTB disclosures and wage/property data needed for QBI computations. 2024 Instructions for Form 8995‑A

References

• S corporation taxation and allocations: 2024 Instructions for Form 1120‑S; 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

• Basis adjustments and ordering: Instructions for Form 7203

• Distributions and AAA/E&P: LB&I Transaction Unit—Distributions with Accumulated Earnings & Profits

• Property distributions: LB&I Transaction Unit—Property Distribution

• Entity‑level taxes: 26 CFR § 1.1374‑10

• Shareholder limitations: Publication 925; Instructions for Form 6198; 2024 Shareholder’s Instructions for Schedule K‑1 (Form 1120‑S)

• QBI deduction: 2024 Instructions for Form 8995; 2024 Instructions for Form 8995‑A