The S election combines corporate and pass-through tax and accounting rules with the legal rules of the underlying state entity. This causes confusion over the correct balance sheet presentation, especially the equity section.
What happens to a business’s balance sheet when it makes an S corporation election? Should financial statements reflect the new corporate tax structure or the original legal structure?
In this post, I explain the mechanics of an S election from the perspective of the company’s balance sheet, mainly the equity section. And I discuss how I interpret the tax rules and apply them to the accounting. In short, I align the books with the tax treatment to provide a consistent presentation for the taxpayer.
The S election triggers a corporate transfer
An S corporation, for federal tax purposes, is a corporation with some explicit modifications provided in Subchapter S, or §§1361–1379, of the Internal Revenue Code. IRC §1371(a) explicitly states that Subchapter C, which deals with corporations, applies to S corporations except where it is inconsistent with Subchapter S.
When an eligible entity elects to be an S corporation, it “is treated as having made an election… to be classified as an association.”1 And an association is, for federal tax purposes, a corporation.2
For the remainder of this article, I discuss S corporations as corporations, except where Subchapter S explicitly differentiates between the two. This is regardless of whether the entity electing to be an S corporation is a corporation or a limited liability company (LLC).
The corporation exchanges stock with the shareholder(s)
The initial transaction is an exchange for stock between the new corporation and its shareholder(s):
If the electing entity is a disregarded entity, e.g. a single member LLC, the owner contributes the entity’s assets and liabilities to the corporation in exchange for stock.3
If the electing entity is a partnership, e.g. a multimember LLC, the partnership contributes the entity’s assets and liabilities to the corporation in exchange for stock and immediately liquidates the partnership, distributing the stock to the partners.4
Example 1a Jessica operates her business as, and owns 100% of, Lighthouse LLC. Lighthouse LLC properly elects to be an S corporation effective January 1, 20X1. On that date, Jessica is deemed to have contributed the assets and liabilities of Lighthouse LLC to the corporation in exchange for 100% of its stock.
Example 1b Same as above, except Jessica and Seth each own 50% of Lighthouse LLC. On January 1, 20X1, the partnership is deemed to have contributed its assets and liabilities to the corporation in exchange for stock. The partnership immediately liquidates and distributes the stock to Jessica and Seth.
The exchange may qualify for §351 tax-free treatment
The exchange for stock is tax-free if it qualifies under IRC §351. No gain or loss is recognized as long as the transfer meets two criteria:
The transfer is solely in exchange for stock (IRC §351(a)), and
The shareholders control at least 80 percent of the voting power and 80 percent of the shares of all stock immediately after the transfer (IRC §368(c)).5
Assets maintain their holding periods and adjusted bases in a §351 exchange as long as the shareholder(s) did not receive boot.6 The assets are effectively disposed from the original activity with no gain (or loss) and contributed to the corporation at no gain (or loss).
The exchange must involve the corporation receiving property from the shareholder(s). Services rendered (or to be rendered) do not qualify.7 The IRS permits a narrow interpretation of intangible assets generated from personal services, such as know-how, trade secrets, and patent rights as qualifying property in a §351 exchange.8
Contributing liabilities may generate a taxable gain
If a shareholder transfers property subject to a liability, the shareholder usually does not recognize gain; however, the amount of the liability reduces the basis of the stock received.9
Example 2 Same as Example 1a above. Immediately prior to the election’s effective date, Lighthouse LLC’s balance sheet has $1,000 cash and a credit card balance of $200. Jessica is deemed to have contributed these to the corporation in exchange for stock with a basis of $800 ($1,000 of assets less the $200 of liabilities assumed by the corporation).
Two exceptions give rise to a taxable gain from contributing liabilities to a corporation:
If the principal purpose of the corporation’s assumption of the liability is the avoidance of federal income tax or otherwise not for a bona fide business purpose, the total amount of the liability assumed by the corporation is treated as taxable boot,10 and
If the sum of the liabilities assumed by the corporation exceeds the total adjusted basis of the property contributed in the exchange, the excess must be treated as gain.11
Example 3 Same as Example 2 above, except the credit card balance is $1,200. Jessica receives stock with a basis of $0, and reports a $200 gain from the transaction.
This example resembles many small, closely-held businesses that operate on lines of credit or continue to hold pandemic-era debt while distributing most of the cash flow to their owners. Tax advisors considering an S election in these cases should carefully examine the balance sheet, or reconstruct one using available data if the business does not have adequate books and records, before making a recommendation.
S corporations should keep adequate books and records
Each taxpayer must “keep such permanent books of account or records, including inventories, as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax or information.”12 Fulfillment of the requirement could range from the proverbial shoebox full of receipts to professional-grade general ledger software.
Some S corporations must prepare Schedule L
Form 1120-S, U.S. Income Tax Return for an S Corporation, includes Schedule L, Balance Sheets per Books. According to the Form 1120-S instructions, “The balance sheets should agree with the corporation’s books and records.” The Schedule includes columns for beginning of tax year amounts and end of tax year amounts for assets, liabilities, and equity accounts.
An S corporation must complete Schedule L if either its total receipts for the tax year or total assets at the end of the tax year exceeded $250,000.13 If neither is the case, then the S corporation is not required to complete Schedule L.
However, I agree with Tom Gorczynski, EA, USTCP, that S corporations should maintain accurate books and report the beginning and ending balance sheets on the return, even when the corporation is not required to complete Schedule L. Completing the balance sheet helps demonstrate accounting prudence and provides data that could prove helpful in tracking and (re)constructing AAA and shareholder basis.
Schedule L beginning balances for a new S corporation are zero
The §351 transfer occurs immediately after the election. In effect, the S corporation has nothing until the shareholder(s) contribute(s) to it; therefore, the beginning balances of the initial year as an S corporation are zero. The shareholder(s) then contribute(s) assets and liabilities to the corporation.
The Schedule L offers two standard equity accounts: Capital stock (Line 22) and Additional paid-in capital (Line 23). Capital stock normally reflects the value of the corporation’s stock at par value as set in the corporate charter or articles of incorporation.14 Additional paid-in capital (APIC) reflects any amounts contributed beyond par value.
The corporation’s equity accounts should reflect Schedule L
In what may be a controversial take, I recommend adjusting the corporation’s balance sheet equity accounts to match the presentation of Schedule L. Capital stock and APIC should replace owner/partner capital, “owner investment,” or whatever other equity account labels were used.15
The preparer, with the taxpayer, should establish and substantiate an amount for capital stock in the absence of explicit par values in a corporate charter or other governing document. For example, I typically use a relatively small, even amount, such as $1,000. Any remaining initial value of stock appears as APIC.
Treas. Reg. §301.7701–3(c)(1)(v)(C).
Treas. Reg. §301.7701–2(b)(2).
Treas. Reg. §301.7701–3(g)(1)(i).
Treas. Reg. §301.7701–3(g)(1)(iv).
IRC §1223(2); §362(a). Gain from boot increases the corporation’s basis in the asset(s).
Meeting the second criterion should be easy, as all shareholders must consent to the election under IRC §1362(a)(2).
IRC §351(d)(1); Treas. Reg. §1.351–1(a)(1)(i).
See Rev. Ruls. 64–56 and 71–564. Under Rev. Rul. 64–56, the performance of services that are “merely ancillary and subsidiary to the property transfer” are also tax-free.
IRC §358(d)(1).
IRC §357(b).
IRC §357(c). Certain exceptions apply, such as liabilities that would give rise to a deduction or a capital expenditure; see IRC §357(c)(3).
Treas. Reg. §6001–1(a).
See Form 1120-S, Schedule B, Line 11.
U.S. Generally Accepted Accounting Principles (U.S. GAAP) requires corporations to “state, on the face of the balance sheet, the number of shares [of common stock] issued or outstanding, as appropriate… and the dollar amount thereof” (ASC 210–10-S99–1).
I have seen the argument that the legal structure of the entity, if an LLC, has not changed as a result of the S election, so neither should the presentation of equity on the balance sheet. Similarly, I have heard the argument that an LLC does not issue stock. Given that virtually all states automatically recognize the federal S election, neither argument holds water for me. It is possible for, as an example, a New York or New Jersey LLC to opt not to elect to be treated as an S corporation at the state level. I am unsure what I would recommend in these cases.