An S corporation is sold as the "no-tax pass-through." Half right. Two corporate-level taxes can still ambush a former C corp: §1374 built-in gains at 21% on appreciated assets sold within five years of conversion, and §1375 excess net passive income at 21% when investment income tips above 25% of gross receipts. Layered on top is the AAA-versus-AE&P distribution stack, which decides whether a $100,000 check is tax-free, a dividend, a capital gain, or all three.
Assumes the basics from V-C: eligibility, Form 2553, basis ordering, loss limitations. Here we focus on what flows through, the distribution order, and the two corporate-level taxes.
Form 1120-S has two roads. Everything earned either lands on line 1 of Schedule K-1 as ordinary business income, or on a separate K-1 line because its character matters at the shareholder level.
Ordinary business income (loss) is the residual: gross receipts minus cost of goods sold (COGS), salaries, rent, utilities, depreciation, and other deductions that are NOT separately stated. One number per shareholder, allocated pro rata.
Common mistakes
- Lumping separately stated items into ordinary income. Adding a $10,000 charitable contribution to expenses and reporting $190,000 on K-1 line 1 lets the shareholder over-deduct charity. Charity belongs on line 12A so the 60% AGI cap applies.
- Using weighted-average ownership instead of daily allocation. "Average ownership %" matches daily only when income is perfectly uniform. The exam tests with a lumpy event: a December asset sale or Q1 write-down. Daily is mandatory absent §1377(a)(2) consent.
- Adding tax-exempt interest to AAA. Tax-exempt interest increases stock basis but never AAA, it flows through OAA. Inflating AAA misroutes later distributions away from the AE&P dividend layer.
Bottom line
- Ordinary business income (line 1) is the residual; separately stated items (capital gain/loss, §1231, charitable, §179, interest, dividends, rental, tax-exempt) keep their character on lines 2-17
- Pro rata daily allocation: each shareholder's share = (days held / 365) x ownership % x annual amount; the §1377(a)(2) interim closing election needs all-shareholder consent
- AAA tracks cumulative undistributed S-corp income since election; can go negative; excludes tax-exempt income, which flows through OAA
- Distribution stack without AE&P: tax-free up to stock basis, then capital gain
Exam shortcut
For a former C corp, ask first: "What is AE&P?" and "What is AAA?" Those two numbers drive every distribution answer. With no AE&P (always-S), the stack collapses to basis → capital gain. With AE&P, force yourself through the full ladder: A-E-P-B-G (AAA, AE&P-dividend, PTI, Basis, capital Gain). Skipping a layer is the most common error. For §1374, anchor on three: 21% rate, 5-year window, NUBIG cap.
The full lesson (about 2,856 words, 19 min read) adds 2 worked examples, all 8 common mistakes, a self-check, free in the app.
Learning objectives
- V.C2
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