TCP, Tax Compliance and Planning

Sources for Tax Planning for S Corporations

Last reviewed 2026-09-14

The standards and authorities behind PocketCPA's TCP lessons on Tax Planning for S Corporations. The topic rests on IRC Sec. 1361-1363 / 1366-1368 / 1371-1375 / 1377-1378 / 199A / 1401-1402 / 1411 / 3101-3121.

About this topic

Only one line on an S corporation owner's return carries employment tax, and the owner writes it. A materially participating shareholder's share of the business income is not wages, and it is not a partner's distributive share, so neither the payroll system nor the self-employment system reaches it. Nor does the net investment income tax, which reaches only a passive activity or a trading business. That gap is why S corporation planning exists. Reasonable compensation is the Service's answer to it.

What the exam grades most often is order. Basis adjustments run in a sequence the statute never writes down, and every step of it moves an answer. Taking the loss ahead of the distribution overstates the current deduction and manufactures a capital gain that does not exist. A distribution from a corporation still carrying C-era earnings comes out in layers, and the layers do not treat stock basis alike. The error that costs most is running a whole distribution down the basis column. The dividend layer never touches basis, so a candidate who subtracts it ends the year too low by exactly the dividend and then invents capital gain on the next distribution.

Key points

• S corporation tax planning must preserve eligibility: one class of stock, eligible shareholders, and the 100-shareholder limit.
• Reasonable compensation paid to shareholder-employees is subject to employment taxes; distributions above that are not.
• The built-in gains tax can be minimized by delaying asset dispositions until after the recognition period.
• Converting from C to S status requires planning for the AAA, accumulated E&P, and the LIFO recapture tax.

What the lessons cover

1. Qualifying and timing the election
2. Reasonable compensation, the mirror of the C corp
3. Stock and debt basis planning
4. Built-in gains and distribution ordering
5. Wages versus distributions: the Sec. 199A interaction
6. Pro rata allocation and the one-class-of-stock discipline
7. Passive investment income: the Sec. 1375 tax and the three-year termination
8. Revocation, termination and the post-termination transition period
9. Fringe benefits and the more-than-2-percent shareholder

Authoritative references

Where these rules sit in the Code. Research questions ask for the citation, so read the reference back rather than paraphrasing the rule.

• Sec. 1361(b)(1) defines a small business corporation, and its conditions apply together:
  • A domestic corporation, and not an ineligible corporation.
  • No more than 100 shareholders.
  • No shareholder who is not an individual, other than an estate, a Sec. 1361(c)(2) trust or a Sec. 1361(c)(6) organization.
  • No nonresident alien shareholder.
  • No more than one class of stock.
• Sec. 1361(c)(1) collapses a family to one shareholder within six generations of a common ancestor.
• Sec. 1361(c)(4) disregards differences in common stock voting rights.
• Sec. 1361(c)(5) is the straight debt safe harbor, and it requires all four of:
  • A written unconditional promise to pay a sum certain.
  • Non-contingent interest.
  • No convertibility.
  • A qualifying creditor.
• Sec. 1362(b) sets the election deadline at the 15th day of the 3d month, and three subsections qualify it:
  • Sec. 1362(b)(2) treats an otherwise timely election as made for the following year if eligibility lapsed earlier in the year or an earlier holder did not consent.
  • Sec. 1362(b)(3) moves a late election to the following year.
  • Sec. 1362(b)(5) allows reasonable cause relief.
• Sec. 1362(d) is the exhaustive list of terminations:
  • Revocation under (d)(1) by holders of more than one-half of the shares, with the effective-date rules in (d)(1)(C) and the prospective-date override in (d)(1)(D).
  • Ceasing to be a small business corporation under (d)(2), effective on the date of cessation.
  • Accumulated E&P under (d)(3) at the close of each of 3 consecutive years together with passive investment income above 25 percent of gross receipts in each, effective the first day of the following year.
• Sec. 1362(e) governs the S termination year, splitting it into an S short year and a C short year:
  • Items are allocated per day under (e)(2).
  • An election to use normal tax accounting rules is available under (e)(3), with the consent of both shareholder groups.
  • The C short-year tax is annualized under (e)(5).
  • The pro rata method switches off entirely under (e)(6)(D) when 50 percent or more of the stock is sold.
• Sec. 1362(f) grants inadvertent termination relief on four conditions together.
• Sec. 1362(g) bars re-election before the corporation's 5th taxable year beginning after the first year for which the termination is effective, unless the Secretary consents.
• Sec. 1366(a) passes items through pro rata.
• Sec. 1366(b) carries character as if realized directly by the shareholder from the corporation's source.
• Sec. 1366(d)(1) limits losses to stock basis plus the shareholder's adjusted basis in indebtedness of the corporation to the shareholder, and four subsections handle what the limit leaves behind:
  • Sec. 1366(d)(2)(A) suspends the excess indefinitely.
  • Sec. 1366(d)(3) carries it to the last day of the post-termination transition period capped at stock basis.
  • Sec. 1366(f)(2) treats the Sec. 1374 tax as a loss.
  • Sec. 1366(f)(3) reduces each passive income item for the Sec. 1375 tax.
• Sec. 1367(a) lists the stock basis increases and decreases.
• Sec. 1367(b)(2)(A) pushes the overflow of losses and nondeductible items onto debt basis (never distributions).
• Sec. 1367(b)(2)(B) restores debt basis before stock basis out of any later net increase.
• Sec. 1368(b) governs distributions with no accumulated E&P: tax-free to the extent of stock basis, then gain from the sale or exchange of property.
• Sec. 1368(c) governs distributions with accumulated E&P in the order AAA, dividend, remaining basis, capital gain, and its flush sentence allocates the AAA proportionately among the year's distributions.
• Sec. 1368(e)(1)(A) defines the AAA and lets it go negative, and two further subsections adjust it:
  • A net negative adjustment for the year's distributions is ignored under (e)(1)(C).
  • An election to distribute earnings and profits first is available under (e)(3), with the consent of all affected shareholders.
• Sec. 1371(b)(1) blocks carryovers between C years and S years.
• Sec. 1371(c)(1) freezes the corporation's earnings and profits except as provided, with (c)(3) using them up through a Sec. 1368(c)(2) dividend.
• Sec. 1371(e)(1) applies a money distribution during the post-termination transition period against stock basis to the extent of the AAA, with an election out in (e)(2).
• Sec. 1372 treats the S corporation as a partnership and a 2-percent shareholder as a partner for employee fringe benefit provisions, measuring the 2 percent with Sec. 318 attribution on any day of the year and testing value or voting power.
• Sec. 162(l)(5) extends the self-employed health insurance deduction to that shareholder, treating their Sec. 3121 wages from the corporation as earned income, subject to two limits:
  • The earned income cap in Sec. 162(l)(2)(A).
  • The other-coverage bar in Sec. 162(l)(2)(B).
• Sec. 1374 taxes net recognized built-in gain at the highest Sec. 11(b) rate of 21 percent for years beginning in the 5-year recognition period of Sec. 1374(d)(7)(A), and its subsections size and limit the tax:
  • Sec. 1374(d)(1) fixes NUBIG at conversion.
  • Sec. 1374(d)(3)(B) and (d)(4)(B) cap per-asset gains and losses at conversion-date amounts.
  • Sec. 1374(d)(2)(A)(ii) imposes the taxable-income limitation, with a carryover in (d)(2)(B).
  • Sec. 1374(c)(2) caps the cumulative total at NUBIG.
  • Sec. 1374(b)(2) allows C-year NOL and capital-loss carryforwards.
  • Sec. 1374(c)(1) exempts an always-S corporation.
  • Sec. 1374(d)(8) reaches assets taking a transferred basis from a C corporation notwithstanding that exemption.
• Sec. 1375 taxes excess net passive income at the Sec. 11(b) rate when the corporation has accumulated E&P at the close of the year and passive investment income above 25 percent of gross receipts, and four subsections work the computation:
  • Subsection (b)(1)(A) carries the ratio formula.
  • Subsection (b)(1)(B) carries the taxable-income cap.
  • Subsection (b)(4) carries the built-in gain carve-out.
  • Subsection (d) carries the good-faith waiver.
• Sec. 1377(a)(1) allocates every item per day and per share.
• Sec. 1377(a)(2) permits a closing of the books when a shareholder terminates their entire interest and all affected shareholders and the corporation agree.
• Sec. 1377(b)(1) defines the post-termination transition period as running to the later of one year after the last S day or the extended due date of the final S return, plus two 120-day audit and determination windows.
• Sec. 1378 requires a permitted year, meaning a December 31 year end or an accounting period supported by a business purpose, and states that deferral of income to shareholders is not a business purpose.
• Sec. 199A(b)(2) computes the deductible amount for each qualified trade or business as the lesser of:
  • 20 percent of QBI.
  • The greater of 50 percent of W-2 wages, or 25 percent of W-2 wages plus 2.5 percent of UBIA.
• Sec. 199A(b)(3)(A) switches that limitation off below the threshold, and (b)(3)(B) phases it in over 75,000 (150,000 joint).
• Sec. 199A(c)(4)(A) removes reasonable compensation from QBI.
• Sec. 199A(d)(3) phases out the SSTB rescue over the same band.
• Sec. 199A(e)(2) sets the threshold amount at 157,500 (double for a joint return) with inflation indexing.
• Sec. 199A(f)(1)(A) applies the section at the shareholder level and gives the shareholder an allocable share of the corporation's W-2 wages and UBIA.
• Sec. 199A(i) floors the deduction at 400 for a taxpayer with at least 1,000 of aggregate QBI from actively conducted qualified trades or businesses.
• Sec. 3101 and Sec. 3111 impose the employee and employer FICA taxes at 6.2 percent for OASDI and 1.45 percent for hospital insurance, with the employee-only 0.9 percent Additional Medicare Tax in Sec. 3101(b)(2).
• Sec. 3121(a)(1) stops OASDI at the contribution and benefit base determined under Sec. 230 of the Social Security Act.
• Sec. 3121(a)(2)(B) excludes from wages employer payments for medical expenses under a plan for employees generally.
• Sec. 1401 imposes self-employment tax at 12.4 percent and 2.9 percent plus the 0.9 percent additional tax, on self-employment income.
• Sec. 1402(a) builds net earnings from self-employment out of a trade or business carried on by the individual plus a partner's distributive share, and reaches no further.
• Sec. 1411 imposes the 3.8 percent net investment income tax.
• Sec. 1411(c)(1)(A)(ii) sweeps in other gross income from a trade or business described in Sec. 1411(c)(2), which is limited to a Sec. 469 passive activity and a trading business.

How PocketCPA uses these sources

Every lesson is written in original words and cites the paragraph each rule comes from. No standard's text is reproduced. How lessons and questions are written and checked is set out in our methodology.

See also

• Sources for every TCP topic
• Free TCP sample questions
• The CPA exam glossary