REG S corporation coverage for eligibility, elections, basis, built-in gains, passive income, and distributions.
This chapter explains the S corporation rules that combine corporate form with pass-through taxation. REG questions in this area usually hinge on eligibility, owner basis, and the special taxes or termination risks that can disrupt the intended pass-through result.
S corporation questions should start with status and basis. The pass-through result only works if the corporation is eligible, the shareholder has basis for losses and distributions, and special taxes or accumulated-account rules do not change the outcome.
| S corporation issue | First question | Common REG trap |
|---|---|---|
| Ordinary and separately stated items | Which items pass through separately and preserve character? | Treating all S corporation income as ordinary business income. |
| Eligibility and election | Does the corporation have eligible shareholders, one class of stock, and a valid election? | Assuming S status exists because the entity is closely held. |
| Stock and debt basis | Does the shareholder have enough basis to deduct losses or receive distributions tax-free? | Treating corporate borrowing as shareholder debt basis. |
| Built-in gains and passive income | Did prior C corporation history or passive income exposure create entity-level tax or termination risk? | Applying pure pass-through logic to a mixed-history S corporation. |
| Shareholder distributions | Which account and basis ordering controls the tax result? | Treating every distribution as immediately tax-free. |
| Step | What to do | Why it matters on REG |
|---|---|---|
| 1. Confirm S status | Check eligible shareholders, one class of stock, timely election, and termination risks. | Pass-through treatment depends on valid S corporation status. |
| 2. Classify pass-through items | Separate ordinary income from separately stated items and shareholder-level limitations. | Character preservation affects each shareholder’s return. |
| 3. Update shareholder basis | Apply income, losses, deductions, distributions, stock basis, and qualifying debt basis in order. | Basis controls loss use and distribution taxability. |
| 4. Test special entity-level taxes | Consider built-in gains tax, passive investment income exposure, and prior C corporation history. | S corporations are not always pure pass-through entities. |
| 5. Apply distribution ordering | Use accumulated accounts, E&P, basis, dividend treatment, return of capital, and gain rules. | Distribution character often decides the final taxable result. |