While S corporations (S-corps) do not pay federal income taxes, they do pay payroll taxes, built-in gains tax, and excess net passive income (ENPI) tax. They also pay penalties if their annual information return Form 1120S is not filed on time. Both the ENPI and the built-in gains tax are only applicable if the S-corp previously operated as a C corporation (C-corp). However, all S-corps are liable for payroll taxes and late filing penalties.
1. Payroll Tax
As an S-corp owner, you need to list yourself as an employee and pay yourself a reasonable S-corp salary through a typical payroll system. This means you’ll also have to pay payroll taxes and complete Form 941 even if you are the only employee of your S-corp.
IRS’s Form 941 is a quarterly tax form that tracks FICA (Social Security and Medicare) payments made by employers throughout the year. FICA tax payments from employers are usually due every month or every two weeks, and Form 941 is filed every three months for most employers.
2. Built-in Gains Tax
If your corporation has always been an S-corp, the built-in gains tax does not apply. However, if you have a C-corp and decide to become an S-corp, the built-in gains tax might come into play.
This 21% tax applies when, at the time of the conversion from C-corp to S-corp, the assets of the corporation had a higher fair market value (FMV) than book value. There is no tax due immediately upon the conversion, but if the assets are sold within the first five years after conversion while their FMV still exceeds their book value, built-in gains tax will be due in the year of the sale.
Step 1: Calculate Your Net Unrealized Built-in Gain
At the beginning of your first period as an S-corp, add the total FMV of all the assets owned by the S-corp. Subtract from this FMV the total book value of all assets, which is the asset amount shown on your balance sheet.
The excess of FMV over book value is your net unrealized built-in gain, and this is the maximum amount of built-in gain you’ll ever have to pay tax on. If the FMV is less than book value, you have no net unrealized built-in gain and will never be subject to the built-in gains tax.
Net unrealized built-in gain = FMV of assets – Book value of assets
Step 2: Prepare a Schedule of the Built-in Gains & Losses for Each Asset
If you have a net unrealized built-in gain, you need to create a schedule with an asset-by-asset breakdown of that gain. Your schedule should show both gains and losses, and they should total up to your net unrealized built-in gain. You’ll use this schedule to identify when assets are sold in the next five years, which will need to go into your built-in gain calculation for that year.
Step 3: Calculate Your Annual Recognized Built-in Gain or Loss
For each of the next five years, you’ll need to calculate a recognized built-in gain or loss for all assets sold that were owned when you converted to an S-corp. Use the schedule prepared in Step 2. The recognized built-in gain or loss for each asset sold cannot exceed the built-in gain or loss from your schedule.
For instance, if an asset has a built-in gain in your schedule of $10,000 but is sold the next year at a gain of $12,000, only the original $10,000 gain from the schedule is a built-in gain.
Net all the gains and losses together. If you have a net built-in gain, the S-corp will need to pay a 21% tax on that gain.
Let’s assume a C-corp owns a building with a basis of $100,000 and FMV of $300,000 in 2023 and no other assets. If the C-corp sells the building, then it would pay tax on a $200,000 gain.
The built-in gain tax prevents the corporation from avoiding this tax by converting to an S-corp. If this C-corp converts to an S-corp, it must keep track of this $200,000 built-in gain. When the building is sold, the S-corp will pay built-in gains tax on the $200,000. If the building further goes up in value while owned by the S-corp, only the $200,000 built-in gain is subject to the special tax.
Let’s look at the steps to figure out the built-in gain tax.
Step 1: Calculate the unrealized gains:
$300,000 (FMV) – $100,000 (book value) = $200,000
Step 2: Prepare a schedule of the built-in gains or losses for each asset.
| Rental Property Built-in Gain Schedule | |
|---|---|
| Building | |
| Fair Market Value | $300,000 |
| Tax Basis | $100,000 |
| Net Unrealized Built-in Gain | $200,000 |
Step 3: Calculate your annual recognized built-in gain or loss.
Let’s assume that the rental property is sold for $350,000 in 2023—this would result in the C-corp recognizing a gain of $250,000. However, since the net unrealized built-in gain from Step 2 is $200,000, only $200,000 of the gain is subject to a built-in gains tax of 21%.
Let’s look at the calculation to see how this will work out:
$200,000 x 21% = $42,000
The product would be the built-in gain tax and will be reported and paid on the S-corp’s Form 1120S tax return.
3. Excess Net Passive Income Tax
The purpose of the tax on ENPI is to discourage a C-corp with accumulated earnings and profits (E&P) from becoming (or functioning as) a holding company to obtain favorable tax treatment under Subchapter S.
ENPI tax applies to an S-corp if it has:
- Accumulated E&Ps from C-corp years at the close of its current tax year
- Passive investment income for the tax year of over 25% of gross receipts
- Excess net passive income
ENPI Tax Waiver
The IRS may waive the ENPI tax if your S-corp can demonstrate its eligibility for the waiver and do so in writing to your district director of the IRS.
The waiver only applies if the S-corp originally concluded that it would have no accumulated E&Ps at the end of the current year, but then later determined that they do have accumulated E&Ps and thus are subject to the ENPI. You’ll also have to distribute those accumulated E&Ps within a reasonable time after learning of their existence.
If you make the request for a waiver, you’ll have to prove two elements:
- Element 1. You’ll need to show that the S-corp in good faith and using due diligence initially determined that it had no subchapter C E&P at the end of the tax year; and
- Element 2. You’ll need to provide a description of how and when it was determined that the S-corp had subchapter C E&Ps at the close of the year and a description (including dates) of any steps taken to distribute such E&Ps.
The ENPI Tax is 21% of the excess net passive income. ENPI can be calculated through two steps.
Step 1: Calculate the Percentage of Passive Investment Income
First, you must calculate the percentage of your passive investment income that exceeds 25% of your gross receipts, which we’ll call excess passive percentage (EPP).
| EPP | = | Passive Investment Income – (25% × Gross Receipts) | × | 100 |
|---|---|---|---|---|
| Passive Investment Income |
Passive investment income includes gross receipts from royalties, rents, dividends, interest, and annuities. This definition does not include the sale of securities. For purposes of passive investment income, gains and losses recognized for the built-in gains tax are excluded.
Step 2: Multiply Net Passive Income By EPP
Then, you can calculate your ENPI by multiplying your net passive income by your EPP:
| ENPI | = | Net Passive Income × Excess Passive Percentage |
|---|---|---|
| 100 |
Net passive income is passive investment income minus any deductions connected to the production of passive income.
In 2022, the following applied to A&A, Corp., an S-corp:
- A&A, Corp., has accumulated E&P of $1 million from prior years when they were a C-corp
- Generated $400,000 in gross receipts without taking into account any passive income
- Generated $350,000 in passive investment income
- Incurred an interest expense of $100,000
Given this information, A&A, Corp.’s determined that the ENPI tax applies to the corporation since its passive income is more than 25% of its gross receipts. Let’s take a look at how A&A, Corp. figured the percentage.
Step 1: Calculate A&A, Corp.’s Percentage of Passive Investment Income
EPP = [$350,000 – (25% × $400,000) ÷ $350,000] × 100
EPP = 71.43%
Step 2: Multiply A&A, Corp.’s Net Passive Income by EPP
ENPI = [($350,000 – $100,000) × 71.43%] ÷ 100
EPNI = $178,575
Late Filing Penalty for Form 1120S
Despite no income tax liability on the IRS’s Form 1120S, there is a stiff penalty for filing it late. The penalty is $215 per shareholder, per month, or part of a month that the return is late. The maximum penalty can be up to 12 months, resulting in a maximum penalty of $2,580 per shareholder.
If tax is due, such as built-in gains or undistributed ENPI tax, then the penalty is $215 per shareholder up to a maximum of $2,580 plus 5% of the unpaid tax for each month or part of a month the return is late, up to a maximum of 25% of the unpaid tax. The minimum penalty for a return that is more than 60 days late is the smaller of the tax due or $450.
To avoid late filing penalties, it’s crucial to file Form 1120S by its due date—or request an extension of time to file. You can request an extension using Form 7004. The extension will extend your deadline to file your tax return, so you can avoid penalties, but it does not provide an extension of time to pay any taxes owed.
Frequently Asked Questions (FAQs)
Do S-corp shareholders need to make estimated tax payments?
Often, S-corp shareholders need to make estimated quarterly tax payments to cover their personal tax liabilities generated by the income flowing through from the S-corp. These payments help prevent underpayment penalties at the end of the tax year.
Are S-corp shareholders subject to self-employment taxes?
No, shareholders never pay self-employment taxes. They are paid as an employee and must pay themselves a reasonable salary and pay payroll taxes on that. Then, their share of S-corp profits is subject to their marginal income tax rate, but not self-employment tax.
Are S-corp shareholders liable for state and local taxes?
S-corp shareholders may be subject to state and local taxes based on their jurisdiction. It is important for shareholders to understand and comply with the tax requirements of the state and locality in which the S-corp operates and the state in which the shareholder resides.
Bottom Line
S-corps don’t pay federal taxes. Typically, an S-corp’s income, deductions, and credits are passed through to the shareholders. While this is so, S-corps are responsible for tax on certain built-in gains and passive income at the entity level. So, if you are operating an S-corp this tax year, you should be aware of these potential taxes.
