C and S Corporations for Estate Planners: Tax Accounting

An introduction to the layer cakes driving taxation of a corporation and its shareholders

This is the third installment of C and S corporations for estate planners.

For the prior article in this series, click here.

For the first article in this series and a series index, click here.

Table of Contents

1. Intro

2. Accounting Terms

3. C Corporation Taxation

4. S Corporation Taxation

5. Unified Dividend Rules, and Conclusion

Intro

A lot of the tax effects of being a shareholder in a C or S corporation can be traced to the internal accounting of previously-taxed income, or tax-exempt income.  This accounting can also relate to the tax effects of contributing property to the C or S corporation.  So, as a next step, we will explore how these internal accounting methods differ between C and S corporations. 

Knowing these rules is important in the estate planning world, especially for trusts and estates that own stock or equity in a C or S corporation.  The rules discussed in this article drive the tax treatment of distributions to any shareholder, including an estate or trust.  There may also be some surprises for heirs, estates, and trusts that have shares or equity interests redeemed.  These rules sometimes relate to the basis of stock, as discussed in the last article, or may operate to disregard basis.   

To preface, the entity’s election between C corporation/association or S corporation will control this method of accounting and tracking.  It may be the case that an entity has an operating history first as a C corporation, then later as an S corporation, or vice versa.  It is important to note which entity election is in effect not just for current tax purposes, but also for purposes of historical tracking of previously-taxed income. 

Accounting Terms

To fully understand the entity’s tax status, we must understand what happens when an entity election is made.  For an entity that is a disregarded entity or a tax partnership, the election to become an S corporation or association (C corporation) has some trickle-down tax effects which will be covered in a later article.  Likewise, we will have a later article discussing what happens when a C corporation makes an S corporation election, or what happens when an S corporation election terminates (resulting in a reversion to C corporation and not to DRE or partnership). 

Likewise, we will later discuss IRC Section 351, which often controls the initial tax effects when a C or S corporation is (deemed) formed or when capital is contributed. 

But, for the time being, let’s look at which terms apply for each election.