IRC 1366: Pass-Through for S Corporation Shareholders

Internal Revenue Code (IRC) Section 1366 establishes the pass-through principle for S corporation taxation. Unlike C corporations, S corporations avoid double taxation because the entity itself does not pay federal income tax. Instead, the corporation’s financial outcomes, such as income, losses, deductions, and credits, flow directly to the shareholders.

These items are then reported on each shareholder’s personal tax return, and tax is paid at their individual rate. This structure treats the S corporation as a conduit, simplifying the tax process for the corporation while directly linking its financial performance to the tax liabilities of its owners.

Determining a Shareholder’s Pro Rata Share

The allocation of an S corporation’s financial items is governed by the “per-share, per-day” rule, detailed under IRC Section 1377. This method ensures each shareholder receives a portion of the company’s financial items based on their ownership stake for each day of the corporation’s tax year. This provides a consistent framework for determining each owner’s share.

For example, if an S corporation with 100 shares earns $365,000, its daily income is $1,000, or $10 per share. A shareholder who owns 50 shares for the entire year would be allocated $182,500 ($10 x 50 shares x 365 days). If that shareholder sells their stock on July 1st (the 182nd day), their allocation is based on the first 181 days. The new owner is allocated the income for the remaining 184 days, ensuring a fair distribution when ownership changes.

As an alternative to the per-share, per-day method, if a shareholder’s interest in the company completely terminates, an election can be made to use a “closing of the books” method. This election splits the tax year into two separate periods: one ending on the termination date and a second covering the remainder of the year. This method allocates income and losses to each period based on when they were actually incurred, which can result in a more equitable distribution.

Pass-Through of Income, Deductions, and Credits

Once a shareholder’s pro rata share is determined, the financial items are separated into two categories for pass-through. This distinction ensures correct tax treatment on the shareholder’s personal return and is based on whether an item has special tax characteristics that could affect an individual’s tax liability.

Non-Separately Stated Income and Loss

The most common pass-through item is the S corporation’s non-separately computed income or loss, which is the net profit or loss from its primary business activities. This is calculated by subtracting allowable business deductions from gross income. For instance, if a company has $500,000 in sales and $300,000 in ordinary expenses, its non-separately stated income is $200,000. This amount is allocated to shareholders and reported as ordinary income on their personal tax returns.

Separately Stated Items

Separately stated items are elements of income, loss, deduction, or credit that must be reported individually to shareholders. This is because these items are subject to different rules and limitations at the individual level, such as capital gains being taxed at different rates than ordinary income. By separating these items, their unique tax character is preserved from the corporation to the shareholder.

Common separately stated items include:

• Net long-term and short-term capital gains and losses
• Section 1231 gains or losses from the sale of business property
• Charitable contributions
• Dividend and interest income
• Tax-exempt income
• Deductions claimed under Section 179 for depreciable business equipment

Limitations on Deducting Losses

Although S corporations pass through losses, a shareholder’s ability to deduct them is limited by IRC Section 1366. This basis limitation rule prevents shareholders from deducting losses that exceed their financial stake in the company. A shareholder’s deductible loss is capped at the sum of their stock basis and their debt basis.

Stock basis begins with the amount paid for the stock, while debt basis is created when a shareholder lends money directly to the corporation. Guaranteeing a corporate loan from a third party does not create debt basis. For example, if a shareholder has a total basis of $4,000 and their share of the corporate loss is $10,000, they can only deduct $4,000 that year.

The remaining $6,000 loss is not permanently lost but is suspended and carried forward indefinitely. This suspended loss can be deducted in a future year if the shareholder increases their basis through capital contributions, direct loans, or a share of future income. This carryforward provision allows shareholders to eventually recognize the full loss, provided they restore their basis.

Shareholder’s Basis Adjustments

A shareholder’s basis in an S corporation is adjusted annually to reflect the corporation’s performance and transactions. These adjustments, governed by IRC Section 1367, are necessary for determining the tax consequences of distributions. Treasury Regulations prescribe a specific order for these adjustments to ensure accurate reporting.

The process begins by increasing the shareholder’s stock basis for all income items passed through, including both non-separately stated income and separately stated items like capital gains. Basis is also increased by any additional capital contributions made by the shareholder.

After accounting for all increases, the basis is reduced. The first reduction is for any distributions made to the shareholder. Next, basis is decreased by non-deductible corporate expenses that are not capital expenditures, and finally by all loss and deduction items passed through from the corporation.

This ordering ensures that shareholders can receive distributions tax-free up to the amount of their basis after it has been credited with the year’s earnings. An election is available to alter this sequence by reducing basis for deductible loss items before reducing it for non-deductible expenses. This can be advantageous, as it may allow a shareholder to deduct a larger portion of the S corporation’s losses.