When Do I Have to Pay Income Tax on My S Corporation?

By: Stephen Nelson Click author's name for more of his/her articles

Small business owners generally choose to operate their business as an S corporation because they like to avoid the steep tax rates associated with traditional C corporations. S corporations are designed so taxes are levied on shareholder's incomes, not on the income of the corporation itself. However, there are some instances where an S corporation would need to pay income tax, situations that every small business owner should know.

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.

Many small business owners hope to avoid the BIG tax by converting their C corporation to an S corporation quickly after receiving built-in gains. Unfortunately, the tax man knows this trick and won't allow late-in-the-game conversions to 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 a small business owner should try on his own.

2. Converted S corporations must 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. Converted S corporations that using cash-basis accounting typically pay the BIG tax on a portion of their uncollected accounts receivable.

3. An S corporation only has to worry about the BIG tax during its first ten years. If an S corporation sells assets with all sorts of built-in gains 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 don't use Last-in, First-out 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. In instances where the LIFO recapture tax is an issue, converting a C corporation to an S corporation often 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.)

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About The Author: 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 when S corporations pay income taxes and S corporations and state inc