By James Kehl
Weil, Akman, Baylin & Coleman, P.A., Timonium, MD
Because an S corporation is an entity that passes its items of income and deduction through to its shareholders, it is easy to lose sight of the fact that S corporations can be subject to penalties for not filing timely returns, not paying taxes, etc. Furthermore, an S corporation's items of income and deductions may cause its shareholders to be subject to penalties at the individual level, including penalties for the underpayment of estimated income taxes. This Insight will discuss some of the penalties that could apply at the S corporation level and penalties that could result from underpayment of estimated federal income taxes at the individual, shareholder level.
Return Filing Requirement
With respect to an S corporation's obligation to file a tax return, "every S corporation shall make a return for each taxable year."1 It could be argued that §6012(a)(2) brings some ambiguity to this requirement with its statement that an income tax return is required for "every corporation subject to taxation under Subtitle A." However, a proper interpretation of the latter sentence is that an S corporation is subject to taxation because an S corporation may be required to pay built-in gains taxes and the tax on excess passive investment income. The initial sentence of Regs. §1.6012-2(a)(2) clarifies the return filing requirement for an S corporation by stating that "a corporation in existence during any portion of a taxable year is required to make a return." The only exception to this rule is for a corporation that can demonstrate to the IRS that it satisfies all of the following conditions: (1) it has received a corporate charter, but has not "perfected its organization;" (2) it transacts no business; and (3) it does not have income from any source.2 There also have been situations where corporations in bankruptcy have been relieved of the duty to file a return.3 But, subject to these limited exceptions, all S corporations must file returns.
In contrast, a partnership that does not have any items of income, deduction, or credit for a taxable year is not required to file a partnership return of income for that particular year.4
There are penalties imposed on an S corporation that fails to file a return without reasonable cause, if the S corporation owes tax.5 As S corporations rarely are required to pay income taxes, this penalty will not frequently apply to an S corporation that does not file a required return. However, there is another penalty that may be imposed on an S corporation that fails to file a required return. A monthly penalty of $195 per shareholder (for any part of the tax year) is imposed on an S corporation that either fails to file a timely return (including extensions) or that files a return that does not contain all of the required information.6 This is the penalty that is most likely to be imposed on an S corporation that does not have any tax liability but that fails to file the required return in a timely manner.
An S corporation must make estimated payments or be subject to a penalty if its estimated income tax liability for a tax year is expected to be $500 or more.7 However, an S corporation is required to make estimated tax payments only for certain taxes that are imposed on its income. These taxes are: (1) the built-in gains tax; (2) the tax imposed on S corporations that have accumulated earnings and profits and that have excess passive investment income; and (3) certain recapture taxes.8 However, an S corporation is not required to take into account any obligation to pay an installment of tax resulting from the LIFO recapture amount.9
An S corporation may avoid the penalty for underpayment of estimated taxes if it pays the lesser of: (1) 100% of the current year's tax liability; or (2) 100% of the current year's built-in gains tax plus 100% of the prior year's tax imposed on excess passive investment income.10 In order to avail itself of the rule described in item (2) of the preceding sentence, the S corporation's tax year that immediately precedes the current tax year must be a taxable year of 12 months;11 however, it is not necessary for the corporation to have shown a tax liability on its prior year's tax return.12
Holder Corporation is an S corporation that expects to pay a tax of $20,000 for its current tax year. This tax is expected to consist of $12,000 of built-in gains tax and $8,000 of tax attributable to excess passive investment income. On its return for its preceding tax year of 12 months, Holder Corporation reported taxable income of $500,000 but had no liability for corporate income tax. Holder Corporation must make estimated tax payments of $12,000 because that is the portion of its current year's tax attributable to built-in gains. It does not have to make estimated tax payments of the portion of its anticipated tax for the current tax year on excess passive investment income because Holder Corporation had no tax of that nature in its prior year.
Penalties at Shareholder Level
Most of the penalties with respect to an S corporation's items of income are imposed at the shareholder level. For example, if an S corporation substantially understates its income, the individual shareholders of that S corporation may be subject to the 20% accuracy related penalty attributable to that understatement.13
However, the penalty that the majority of S corporation shareholders should be concerned about is the penalty for underpayment of individual estimated taxes. This may be especially true for 2013 because this year is the first year the tax imposed by §1411 on net investment income is in effect. If an individual shareholder of an S corporation wishes to avoid the penalty for underpayment of estimated tax by either paying 100% of the tax shown on his/her 2012 return or by paying 90% of the current year's tax computed on an annualized basis, the shareholder must include the §1411 tax in the estimated tax computations for the current tax year. An S corporation shareholder must consider his/her share of items of income from the S corporation in the calculation of the estimated tax installments for the current year.14 It may be difficult for the shareholder to obtain this information on a quarterly basis. The difficulty of obtaining current information about the items of an S corporation that may affect the shareholder's tax liability for the current tax year and the possible imposition of the §1411 tax in 2013 may be reasons a taxpayer should avoid the penalty for underpayment of tax by paying estimated taxes equal to 100% of the tax shown on the individual's tax return for the preceding taxable year.15 If the individual's adjusted gross income shown on the preceding year's tax return exceeds $150,000, the individual must make estimated tax payments equal to 110% of the prior year's tax.16 Relying on this exception will result in the individual shareholder making estimated income tax payments based on a known amount versus an estimate of the current year's tax.
S corporation penalties are often forgotten by practitioners because S corporations are pass-through entities that do not usually pay tax. Items of income of an S corporation may also affect the tax liability of individual shareholders and create penalties that may be imposed at the shareholder level. It is important to be aware of these penalties.
For more information, in the Tax Management Portfolios, see Starr, Smith, and Sobol, 730 T.M., S Corporations: Formation and Termination, and in Tax Practice Series, see ¶4410, Returns, Penalties and Other Administration Matters.
1 §6037(a). Unless otherwise stated, all references to statutory sections in this Insight are to sections of the Internal Revenue Code. All references to regulations are to income tax regulations pertaining to various sections of the Internal Revenue Code.
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