S-Corporations need to maintain accurate and meticulous records
of income, expenses, and capital investments. Overall, the
S-Corporation reports total income and expenses at the company
level, and passes-through a share of net profit or loss to
individual shareholders. The S-Corporation needs to maintain
excellent records regarding each shareholder's investment of cash or
property. These records are crucial for establishing each
shareholder's percentage of ownership in the company.Accounting
for Income and Expenses
Generally, S-Corporation accounting is the same as C-Corporation
accounting. Income and expenses are reported at the corporate level,
and the nature of various types of income and expense are identified
at the corporate level as well. S-Corporations can choose an
accounting method best suited to report the income and expenses of
the company. S-Corporations are not required to use the accrual
method of accounting; they may choose the cash method or a hybrid
method of accounting if those methods of accounting.Income and
expense items retain their character when they are passed-through to
S-corporation shareholders. Long-term capital gains, for example,
earned by the S-corporation are passed through as long-term capital
gains to shareholders. S-Corporations therefore need to identify
types of income and types of expenses for the benefit of their
shareholders.
Accounting for Shareholder Capital
The biggest problem by far is accounting for the capital accounts of
each and every single shareholder. The company must maintain
meticulous records of each shareholder's equity investments of cash
and property, as well as any loans that each shareholder advances to
the company.Unlike limited partnerships and limited liability
companies, shareholders of S-corporations must divide the
corporation's net income in strict proportion to their share of
ownership. If a shareholder has contributed exactly one-third of the
company's capital, then exactly one-third of the company's net
profit or loss must be allocated to that shareholder.
The capital accounts come into play in two crucial parts of an
S-Corporation's financial and tax reporting. First, the capital
accounts are reported on the company's balance sheets as shareholder
equity and loans from shareholders. Second, each shareholder's
capital account can be summarized on Form 1120S Schedule K-1.
Insufficient capital investments can cause shareholders to fail to
meet the At-Risk rules for losses and can cause business losses to
become non-deductible.
Investing Cash and Property
Shareholders can invest cash or property to an S-Corporation. A
shareholder might contribute a computer, desk, reference books, and
software programs to her newly formed S-Corporation in addition to
her cash investment. The value of the shareholder's property is the
lower of (a) the fair market value of the property, or (b) the
shareholder's adjusted basis in the property. (More information:
Donating Property to an S-Corporation.)Shareholder Basis,
Adjusted Basis, and Loan Basis
A shareholder's capital account needs to reflect the shareholder's
investments and current basis in the S-Corporation's equity or
liabilities. A shareholder is invested in the S-Corporation to the
extent that a shareholder has made an equity investment or advanced
a loan to the company.Shareholder's Equity is reflected in the
shareholder's capital account. This account should show the dollar
amount of cash investments, and value of property donated to the
company. A shareholder who contributed cash of $10,000, a computer
worth $2,000, and software worth $400 would have a capital account
showing a total investment of $12,400.
The capital account is adjusted from time to time to reflect
additional equity investments. Additionally, the capital account is
adjusted at the end of the year to reflect each shareholder's
pro-rata share of income and expenses.
The adjusted basis of a shareholder's stock is calculated
as follows:
- Adjusted basis at the beginning of the year
- + Share of all income items that are separately stated,
including tax-exempt income
- + Share of all non-separately stated income items
- + Share of deduction for excess depletion of oil & gas
properties
- - Distribution of cash or property to the shareholder that
was not included in the shareholder's wages
- - Share of all loss and deduction items that are separately
stated, including Section 179 deductions and capital losses
- - Share of all non-separately stated losses
- - Share of non-deductible expenses, such as the
non-deductible portion of meals & entertainment expense or
non-deductible fines and penalties
- - Share of depletion for oil & gas properties not in excess
of the property's basis.
- = Adjusted basis in S-Corporation stock at the end of the
year
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