CFP® Practice Question: Disadvantages of S Corporations

The correct answer is E. A loss flowing through to an S Corporation stockholder is limited to his or her adjusted basis at the end of the tax year in which the loss occurred. If the stockholder’s adjusted basis is reduced to zero, any additional losses cannot be utilized until his or her basis is increased. Loans made to the corporation serve to increase the stockholder’s basis. The receipt of passive income by an S Corporation can result in revocation of the S status, but only if the passive income exceeds 25% of its gross receipts, and then only if the corporation has previously accumulated C Corporation earnings and profits. If it has never been a C Corporation, it will not lose its S status because of receiving passive income. The same 1987 Act that eased the passive income effect on the S status clamped down on S Corporations’ provision of the same types of corporate benefits to their employee-owners as a C Corporation. S Corporations can no longer provide free meals and lodging for the convenience of owner-employees but, even more importantly, the $5,000 death benefit, accident insurance, health insurance, and group term life insurance are no longer available on a tax-free basis.