Legal Question in Tax Law in Florida

Re: S-Corps and K-1 Statements

A corporation may �elect� subchapter S status. An S corp does not pay any income tax. Instead, the corporation's income and expenses are constructively divided among, and passed through to, its shareholders (as reported to the shareholders on the K-1 form you asked about). The shareholders, in turn, report the income and expenses on their own tax returns.

Because an S corp is a pass through entity, it does not generally incur federal taxes. The corporation's income is taxed to its shareholders whether distributed or not. Each shareholder separately accounts for his or her pro rata share of corporate income, deduction, loss, and credit in the tax year in which the corporation's tax year ends. (IRC 1366(a)(1)) These items must be separately stated whenever they could affect the shareholder's individual tax liability.

Deductions and losses limited to basis. A shareholder's share of each item is computed on a daily basis according to the number of shares held on each day of the corporation's tax year. But a shareholder's currently deductible share of the corporation's losses and deductions is limited to the total of his or her adjusted basis in the corporation's stock and any debt the corporation may owe the shareholder. Losses and deductions that are disallowed may be carried forward to any later year in which the shareholder has a restored basis in the stock or debt. (IRC 1366(d))

Whether distributions of cash or property are taxed to the shareholder depends on whether the S corporation has earnings and profits.

If an S corporation has no earnings or profits, distributions are treated first as a nontaxable return of capital to the extent of the shareholder's stock basis, then as a gain from the sale or exchange of property. (IRC 1368(b); Reg. 1.1368-1(c))

With earnings and profits, distributions are treated as follows:

� A nontaxable return of capital to the extent of the corporation's "accumulated adjustments account

� Dividends to the extent of the S corporation's accumulated earnings and profits;

� A nontaxable return of capital to the extent of the shareholder's remaining stock basis; and

� Gain from the sale or exchange of property. (IRC 1368(c); Reg. 1.1368-1(d))

For more information, see IRS Pub. 589 � Tax Information on S Corporation (go to www.irs/ustreas.gov).

The IRS has nothing to say about whether you are entitled to an actual distribution of cash representing any portion of the corporation�s profits. That is governed entirely by the corporate organizational documents and the decision of the corporation�s directors and officers, subject to any requirements of state law.

Taxation of S corporations and their shareholders is exceedingly complicated. For an explanation, try talking to the accountant who prepared the corporation�s returns, or find yourself a good, competent CPA in your area.