Here is a simple and complete guide to how to prepare an s corporation tax return. It is written for beginners with limited tax preparation experience.
How to prepare an s corporation tax return – disclaimer:
First of all, I do not think that you should prepare your own s corporation tax return.
There, I said it.
S Corporation tax return preparation is super complicated and the ramifications for not filing properly can be egregious. There could be penalties, interest, professional fees, and endless time costs for mistakes and errors that will haunt the s corporation owners and shareholders for years and years if not done correctly.
All of this hassle and expense to save $750 of professional fees? You have got to be kidding me.
Don’t be the cheap fool who tries to save money and regretting it later.
If you insist on preparing your own s corporation tax returns, you must read the IRS form instructions and publications for every step and every entry. Don’t blame me if things go wrong and don’t say I didn’t warn you.
Attention tax preparers:
If you do not have experience with s corporations, you should not be charging clients to prepare them. It’s going to cause trouble down the road that you don’t need.
I’m sure you also don’t want to commit to what will end up to being a huge time cost to yourself when you could be making money filing the returns that you are comfortable with filing.
If you want to farm anything out to us, just let us know. I promise that we will not “steal” your 1040 client. It will be a win/win.
Introduction to preparing s corporation tax returns
Our goal here is to take a complex task and break it down into several simple tasks, one at a time, and all of that.
So we are going to break it down into smaller, simple tasks, including:
- Income and Expenses
- Schedule B
- Schedule K
- Schedule L (Balance Sheet)
- Schedule M2
- Schedule M1
- Schedule K1
- Form 8825
- Form M3
- Form 1125-A (Cost of Goods Sold)
- Form 1120E (Officer Compensation)
- Multi-State Allocations
Our first job is to head the s corporation tax return. Let’s take a quick look at it.
The first thing I fill out is the easy stuff. Get the s corporation name, address, and EIN in there. Next fill out the stuff to the right and the left.
As a tax preparer, I reference the articles of organization, the IRS FEIN letter, and the form 2553 s corporation election. I do this even if I have a copy of the previous year’s tax return.
I want to make sure that I’m filing correctly even if the prior preparer did not. Incorrect filings can haunt your for years with endless issues and time costs.
S corporation preparer tip:
If you are a tax preparer and your client cannot produce these documents, disclaim to your client that the filing may not be accurate and it could lead to these problems.
If you are a self-preparer, then it’s still a good idea to look at these docs and use them to fill out the header of the return.
Next up on the header is line F. Since I have tax preparation software, once I complete the balance sheet (Schedule L), this number gets entered automatically.
If you don’t have software, you will have to complete this number by looking at the business’ balance sheet for the year, or by computing it yourself. If I were preparing the tax return without software, I would leave this number blank for now, and make a note to fill it in when I’m done with Schedule L.
If you don’t do it this way, be sure to go back and correct this number if it changes by the time you get to that schedule.
I have to admit, I don’t really understand line G. By the time you need to file an s corporation tax return, it’s likely too late to make the election. Perhaps the IRS is looking for you to check this box for a short-year return or when making a late election? It doesn’t really make sense.
Anyway, don’t get too caught up on it.
The remainder of the boxes are pretty self-explanatory, but don’t forget to peak at the very top line above the name where you enter a fiscal OR a short year, as applicable.
S corporation preparer tip:
If you form an s corporation in the middle of the year, you should file a short-year return and enter something here. Usually the date the company was formed and the 31st of December (for s corporations that will be calendar year filers).
Income and Expenses
Cool, so we have the header pretty much done.
Let’s get to the meat of the tax return – the income and expenses.
The first thing I want you to notice here is that there are many listed expense categories, but not all of them. You might ask, “where do I put expense types like supplies, credit card merchant fees, phone, internet, computer, and software?”
The answer is on line 19, and then you attach a statement with the breakdown of these categories. Here, check this out. Mine looks like this.
Then the total goes on line 19, of course.
The next line I want to bring your attention to is line 7.
We all know that s corporation shareholders who provide more than minimal services must pay themselves a reasonable salary for that work, right? Well this is where to put it. This line should mostly (but not exclusively) include the gross W2 wages paid to the owners.
if you are not familiar with the W2 wages requirement for owners providing services for their s corporations, you better look that up. It’s super critical.
When you add this number, be sure not to also include it in line 8. That would be double dipping. You might have to look at the owner(s)’ W2(s) and subtract this amount from the wages that are shown on the P&L. Get it?
Finally, please note on line 2 that if you have cost of goods sold expenses, then you also must include form 1125a.
On the bottom of page 1 of form 1120s, you have the signature, designee, and paid preparer info to fill out. This should be self-explanatory.
Schedule B – Other Information
Page 2 and the very top of page 3 of the form 1120s make up Schedule B.
My advice is to go really slow here and take in word for word, line by line. This part of the tax return is not rocket surgery. Take your time and go through each question slowly and carefully.
How to prepare an s corporation tax return – Schedule K
How is it going so far. Exciting stuff, huh? Are you sitting on the edge of your seat? I am. Let’s keep going.
The Schedule K part of an s corp tax return reports the full amount of income and deductions that flow through to the shareholders by the percent of ownership.
Many s corporations will only have one item and that’s mostly going to be in line 1. Some s corps, however, will have several entries on this schedule.
Just as an easy example, let’s say John and Jane Doe are both 50% shareholders of John Doe Inc.
John Doe Inc makes $50,000 in ordinary income.
$50,000 is then reported on line one of Schedule K and John and Jane will be assigned $25,000 each when we get to Schedule K1.
They will each have to report this amount as ordinary income on their personal tax returns.
So why are there many items on this Schedule? It’s because each “type” of income might have different tax rates, limitations, and other characteristics.
For example, qualified dividends are generally tax at the long term capital gains rate and not the ordinary income rate. This must be tracked separately because we don’t want John and Jane to pay tax at the wrong rate for this specific income.
The same is true for section 179 deductions. These deductions are handled differently than others and the limitations are on the shareholder’s end and not the s corporation’s.
Sorry to be harsh, but if you are having trouble following along here, you really should contact us and hire us to do this for you.
You can’t get years of tax experience from one web page.
No offense, but if you do not understand these concepts, you are likely to screw up this filing royally and it’s probably going to cost you more than a reasonable preparation fee.
If you are following along, then that’s great. Fill out Schedule K, line by line, with sums of each of the different types of income, deductions, and credits.
S corporation preparer tip:
Don’t forget to fill out line 18!
Schedule L – The Balance Sheet
As of 2020, the schedule L s corporation balance sheet is not required for s corps with less than $250,000 in gross sales and assets (see Schedule B, line 11).
But you should file one anyway.
Why? Two reasons.
- The s corporation must keep track of its basis.
- Historically, s corporation tax returns prepared with a balance sheet have been audited much less often.
The audit thing makes sense. If the IRS sees that you are tracking and being transparent about your basis and equity activity, they would naturally be less inclined to make sure that you are doing it right and not cheating.
One web page does an accounting class not make. Or something like that. So it’s going to be difficult for me to teach you how to fill out the balance sheet.
Again, I’m going to nag you and I’m not sorry about it…
Let someone with years of experience and who has put the time in to take these classes do this for you. it will save you so many headaches – I can’t begin to even tell you.
I know this costs money – but that because an experienced tax professional who knows how to do these already spent the time, money, and effort taking accounting classes and learning how to do these returns.
Pay him or her for it – it’s how the world works and it’s worth it.
Spend your time improving your business and making money – not flubbing up your tax situation.
With that said, here are a couple of pointers I can help with when it comes to the Schedule L balance sheet.
Balance sheet line 22, capital stock
This should equal the dollar value of shares that the corporation has issued. In many cases, the “corporation” is just an LLC taxes as an s corporation, and for all practical purposes, you can deem pretty much whatever number you want. In other cases, this requires much more effort and accuracy.
When the former is true, I generally assign 1000 shares for $1 each to the shareholders. This is a nice number because it helps to break down the percentage of ownership for each K1.
For example, John and Jane doe, considering they are 50/50 shareholders of their mom and pop business, would each own 500 shares.
If the situation between shareholders and capital investments is complex, however this area needs more attention and it’s way too advanced for me to teach it here. You are going to need a 3-month course for that – not a quick online guide.
Line 19 (loans from shareholders and line 23 (additional paid in capital)
I see many s corporation tax return balance sheets prepared with” loans from shareholders” inputs as a “plug” number to show how the shareholder(s) put money into the company and to make the balance sheet “balance”.
I could be wrong but I hate this.
A loan from a shareholder requires a real “note” to be written and interest to be imputed. The interest would be income to the shareholder and an expense to the s corporation.
Don’t get me wrong, sometimes this is appropriate, but in many simple cases, equity flowing into the corporation for operations is better to be put on line 23.
Investments might even go on line 22, especially if the investment is in exchange for shares of ownership.
But, in my opinion, if John and Jane Doe are simply injecting funds into their company so it can buy a nice piece of equipment, for example, then additional paid-in capital is the way to go.
For the record, I also hate to see line 7 (loans to shareholders) as a plug number to use when money was taken out of the company. This is generally a distribution, not a loan. If it’s a loan, it should act like a loan and have a note and an exchange of interest.
S Corporation balance sheet – line 24 (retained earnings) and Schedule M2
These are the schedules that most s corporation preparers have the most trouble with.
You can’t just put any number into the retained earnings. This number generally must tie with Schedule M2, line 8.
To make things more confusing, the nature and impact of retained earnings for an s corporation is different of that form a c corporation.
Also, getting this number correct is extremely important because it indicates and tracks crucial basis information.
Still, the companies cash flow and income/loss history can be clearly stated by using cash, paid in capital, capital stock, retained earnings, distributions, and the ending accumulated adjustment account. This tells, pretty much, the entire story of money flow in and out of the company.
Let’s look at a simple example. Focus on the Schedule M2, line 1, 2, 7.
Line 1 shows that we just started and that we have no adjusted account or retained earning to begin with ($0).
We can see that when we prepared the tax return, we ended up with $29,084 in net operating profit and the shareholders took $19,543 in distributions (this is in addition to their payroll).
The result on line 8 is $9541 and that is the earnings that were retained.
Think of it in terms of common sense. A business makes $29,084 and the owners take $19,543. How much was retained?
Now we have to tie it to the balance sheet (put the line 8 result into the ending retained earnings). Then we must balance the balance sheet.
Balancing the balance sheet
Here we see the completed balance sheet.
The Doe family made $29,084 in profit, took out $19,543, and paid in $1000 in capital stock. Therefore the retained earnings must equal $9541 (figured out on Schedule M2) and the total assets MUST equal $10,541.
If they don’t something is wrong somewhere in the bookkeeping.
You might question, “Hey Tod, what if there was only $9000 in the bank? Now what?”
My answer would be that it’s impossible to start with zero assets and zero retained earnings, make this much profit, take out this much in distributions, and have that amount of cash. One of the numbers must be incorrect somewhere.
Either the ending cash is wrong, the distribution number is wrong, or the earnings are wrong. It has to be, otherwise it will balance.
I must be candid with you. If you are stuck, I’m sorry, but I can’t look at if for you.
Either you have our office prepare it – or you do it yourself – there’s no in between. It’s not that we don’t want to help, but the liability of us helping and then there being a misunderstanding would be monumental. Also, our small firm’s expenses are around $180,000 per year. If we are not preparing taxes for a fee, then we are losing money, and that’s not a business model that works for anybody.
If it doesn’t tie in, and you wish to hire us to prepare the return and fix an issue in the process, just let us know.
Anyway, thanks for understanding.
One more thing I want you to check out on that image of thebalance sheet is Schedule K, line 16d. Don’t forget to report the distributions as appropriate.
Use Schedule M1 to state the differences in bookkeeping to the tax return. Scroll up a bit to see it, because an example can be seen a couple of images just above.
One example of this reconciliation is meals. Let’s say a business spends $100 on a meal while with a potential new client. The expense is $100, but the tax deduction is $50. The Schedule M1 reconciles this issue.
I’m not sure why a 2018 tax form still reads “entertainment”. That’s no longer deductible in 2018 under the new tax law.
But anyway, much of the time, depreciation per books will not match the tax return either. So that sometimes requires an entry.
In actuality, the M1 does an “OK” job of reconciling things. Really, it’s very tough to match all of the tax return numbers exactly to the books.
To make things worse, in the 1120s instructions, the first thing the IRS says about the tax return balance sheet is that it should match the company’s books and records.
Yeah, good luck with that.
How to prepare an s corporation tax return – Schedule K1
The Schedule K1 basically takes all of the Schedule K items an divides them up between shareholders and on a per share basis. It also keeps track of basis and a detailed basis worksheet should be prepared and provided along with it.
Since an s corporation (generally) does not pay taxes, it’s up to the K1 to show each shareholder exactly what is “passing through” and how it passes through.
You need to prepare a K1 and a basis worksheet for each and every shareholder. Then you must be sure to provide it to each shareholder with enough time for them to include the contents thereof on their personal tax returns.
If you are a paid tax preparer, be sure to emphasize this when you deliver the return to the representing shareholder. Make it very clear that it is their job to give them out to each shareholder.
Let’s look at form K1. We can see that in the first several boxes, there are different types of income. As you continue down and through the K1, you can see the different types of deductions, credits, and basis items (such as distributions) as well.
Look at my K1 entries for John Doe Corp and compare it to the example. Do you see form where I got the numbers?
On line 17, I made a statement that we have $14,542 that can apply to the qualified business deduction.
The qualified business deduction is the tax break for small businesses under the 2018 tax law changes. More information shows up on line 20 of the K1. and it is a whole other can of worms. You better look up how to compute this, and also please take note of the “specified service company” rules and limitations.
It’s pretty complicated.
More S Corporation Schedules and Forms
If an s corporation has cost of goods sold, be sure to fill out Form 1125-A (Cost of Goods Sold). The big thing here to look out for is beginning and ending inventory – as the difference between these two items has an impact on net profit.
When an s corporation has gross receipts greater than $500,000 (as of 2020), then form 1125E will be required to report officer compensation. I think the IRS is after self employment tax enforcement here and they want to see who is doing what and how they are getting paid for it.
An s corporation that has rental property to report used form 8825 and NOT page 1. Let me repeat that. If an s corporation is a landlord, you do not put the rental income, expense, and depreciation activity on page one of the 1120s! It goes on form 8825 which is kind of like the s corp equivalent to the Schedule E on personal tax returns.
I have had landlord clients review their tax returns prior to signing them and tell me I forgot to put any numbers on it. I tell them to dig deeper into the return and look at 8825.
When the total assets on the balance sheet exceed $10,000,000, then Schedule M3 must be prepared. I’m assuming, and hoping, that a company with this much in assets is not self preparing the 1120s tax return. OMG.
S Corporation State Tax Returns
Most states, but not all, also require that you file an s corporation income tax return so be sure and look up the correct form for your state. Not only must an s corporation file in it’s own state as appropriate, but it also must file in many of the others states in which it operates. So don’t forget these
Non S corporation filings
Many s corporation shave additional tax filing requirements such as sales tax, excise tax, and payroll tax. There are also annual state reports and registrations to consider, depending on your state.
That’s all I’ve got for you. Please be sure to go over the 1120s instructions carefully as you prepare each section and each line of the tax return.
Thanks for reading, pleas leave a comment.