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In this question about s-corp distributions, the answer was given that an s-corp taxes all profit as personal income. That is, there are neither distributions nor dividends which can be taxed at a capital gains tax-rate.

However, I've easily found web sites that say the opposite.

  • This one talks about long-term capital gains with an S-Corp. A loan is one example chosen.
  • This one mentions long-term capital gains of the S-corp become long-term cap gains by shareholders
  • This one explains that a non-dividend distribution, beyond your "tax basis", is treated as a capital gain (rather than personal income, which other sites mention). The specific quote is:

If a shareholder receives a non-dividend distribution from an S corporation, the distribution is tax-free to the extent it does not exceed the shareholder's stock basis. If the distribution exceeds the shareholder's stock basis, the excess amount is a capital gain (short-term or long-term depending on how long the stock was held. If one year or less, it's a short-term capital gain, if held more than one year, it's a long-term capital gain

I am particularly interested in that last point; I understand the capital gains rate is often lower than the personal income tax rate. How do I tap into this?

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    You might look into a CPA with experience in this field as it CAN be very complicated and if done improperly it can cost you big. – GµårÐïåñ Mar 11 '14 at 0:00
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These are all factually correct claims. S-Corporation is a pass-through entity, so whatever gain you have on the corporate level - is passed to the shareholders. If your S-Corp has capital gains - you'll get your pro-rata share of the capital gains. Interest? The same. Dividends? You get it on your K-1.

Earned income? Taxed as such to you. I.e.: whether you earn income as a S-Corp or as a sole proprietor - matters not. That's the answer to your bottom line question.

The big issue, however, is this: you cannot have more than 25% passive income in your S-Corp. You pass that limit (three consecutive years, one-off is ok) - your S-Corp automatically converts to C-Corp, and you're taxed at the corporate level at the corporate rates (you then lose the capital gains rates, personal brackets, etc).

This means that an S-Corp cannot be an investment company. Most (75%+) of its income has to be earned, not passive.

Another problem with S-Corp is that people who work as self-proprietors incorporated as S-Corp try to abuse it and claim that the income they earned by the virtue of their own personal performance shouldn't be taxed as self-employed income. IRS frowns upon such a position, and if considerable amounts are at stake will take you all the way up to the Tax Court to prove you wrong. This has happened before, numerously.

You should talk to a licensed tax adviser (EA/CPA/Attorney licensed in your state) to educate you about what S-Corp is and how it is taxed, and whether or not it is appropriate for you.

  • I have been operating my engineering services S-Corp for years. I pay myself 100k salary and I also take owner-draws which exceed my stock-basis. The amount beyond my stock-basis has always been taxed at my personal income marginal rate of 35%. I would like the owner-draws instead to be taxed at the lower capital gains rate of 15%. How do I qualify to make that transition and thereby receive a tax rate reduction? – Brent Arias Mar 11 '14 at 18:06
  • @Brent you don't. As I said - earned income is taxed at earned income rates. When you sell it, you can claim that the sale price is capital gains. The only benefit you get is that the owner draws are not taxed for FICA, but even that, if you're the sole employee, can be questioned by the IRS and land you in trouble. Since your salary is very close to the SSA limits, it will not be all that significant, mainly the medicare, but still - if IRS come after you, you may have to shed several additional thousands of dollars in taxes. – littleadv Mar 11 '14 at 22:11
  • The automatic conversion to C-corp only happens if the company both generates more than 25% of passive income and has accumulated earnings & profits. The important thing is that after 1983 S-corps cannot accumulate earnings & profits. All earnings pass directly through to shareholder on K-1 while retaining their character. The only time this rule comes into play is if you convert a C-corp with substantial accumulated earnings into an S-corp. – Pete Keen Oct 9 '17 at 13:39
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Lets just get to the point...Ordinary income (gains) earned from S-Corp operations (i.e. income earned after all expenses for providing services or selling products) is passed through to the owners/shareholders and taxed at the owner's personal tax rate. Separately, if an S-Corp earns capital gains (i.e. the S-Corp buys and sells stock, earns dividends from investments, etc), those gains are passed through to the owners and taxed at a capital gains rate Capital gains are not the same as ordinary income (gains). Don't get the two confused, they are as different for S-Corp taxation as they are for personal taxation.

In some cases an exception occurs, but only when the S-Corp was formally a C-Corp and the C-Corp had non-distributed earnings or losses. This is a separate issue whereas the undistributed C-Corp gains/losses are treated differently than the S-Corp gains/losses. It takes years of college coursework and work experience to grasp the vast arena of tax. It should not be so complex, but it is this complex. It is not within the scope of the non-tax professional to make sense of this stuff. The CPA exams, although very difficult and thorough, only scrape the surface of tax and accounting. I hope this provides some perspective on any questions regarding business tax for S-Corps and any other entity type. Hire a good CPA... if you can find one.

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A nondividend distribution is typically a return of capital; in other words, you're getting money back that you've contributed previously (and thus would have been taxed upon in previous years when those funds were first remunerated to you). Nondividend distributions are nontaxable, so they do not represent income from capital gains, but do effect your cost basis when determining the capital gain/loss once that capital gain/loss is realized.

As an example, publicly-traded real estate investment trusts (REITs) generally distribute a return of capital back to shareholders throughout the year as a nondividend distribution. This is a return of a portion of the shareholder's original capital investment, not a share of the REITs profits, so it is simply getting a portion of your original investment back, and thus, is not income being received (I like to refer to it as "new income" to differentiate). However, the return of capital does change the cost basis of the original investment, so if one were to then sell the shares of the REIT (in this example), the basis of the original investment has to be adjusted by the nondividend distributions received over the course of ownership (in other words, the cost basis will be reduced when the shares are sold).

I'm wondering if the OP could give us some additional information about his/her S-Corp. What type of business is it? In the course of its business and trade activity, does it buy and sell securities (stocks, etc.)? Does it sell assets or business property? Does it own interests in other corporations or partnerships (sales of those interests are one form of capital gain). Long-term capital gains are taxed at rates lower than ordinary income, but the IRS has very specific rules as to what constitutes a capital gain (loss). I hate to answer a question with a question, but we need a little more information before we can weigh-in on whether you have actual capital gains or losses in the course of your S-Corporation trade.

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