Business Entities · S corporations

Income, expenses and separately stated items

An S corporation computes one year of trading and hands it to its shareholders in pieces. Almost every question here is a sorting question: does this item travel on its own, or disappear into a single ordinary figure? The statute answers with a principle, and the principle is worth more than any list.

The rule

No entity-level tax. except as otherwise provided in subchapter S, an S corporation is not subject to the taxes imposed by chapter 1^TY2026Verified 2026-08-21IRC § 1363(a), opened at law.cornell.edu/uscode/text/26/1363 (IRC § 1363(a)).

The corporation computes as an individual. the taxable income of an S corporation is computed in the same manner as in the case of an individual, except that the § 1366(a)(1)(A) items are separately stated, the § 703(a)(2) deductions are not allowed to the corporation, § 248 applies, and § 291 applies if the corporation or a predecessor was a C corporation in any of the 3 immediately preceding taxable years^TY2026Verified 2026-08-21IRC § 1363(b), opened at law.cornell.edu/uscode/text/26/1363 (IRC § 1363(b)) — not as a C corporation would, so no dividends-received deduction, no corporate charitable ceiling, no corporate rate schedule behind its numbers. IRC § 1363(b) reaches back for only two corporate provisions: the organizational expenditure rules of IRC § 248, and IRC § 291 where the corporation or a predecessor was a C corporation in any of the three immediately preceding taxable years.

What the corporation may not deduct. By IRC § 1363(b)(2) the deductions listed in IRC § 703(a)(2) are denied to it: personal exemptions under § 151, the § 164(a) deduction for foreign taxes described in § 901, charitable contributions under § 170, the net operating loss deduction under § 172, the additional itemized deductions for individuals in part VII of subchapter B, and depletion under § 611 on oil and gas wells^TY2026Verified 2026-08-21IRC § 703(a)(2), applied to S corporations by IRC § 1363(b)(2); both opened at law.cornell.edu/uscode/text/26/703 and /1363. They are denied here because they belong to the shareholders, who apply their own limits.

The split. A shareholder takes into account their pro rata share of items of income (including tax-exempt income), loss, deduction, or credit the separate treatment of which could affect the liability for tax of any shareholder, and, by the flush sentence, the charitable contributions described in § 702(a)(4) and the foreign taxes described in § 702(a)(6)^TY2026Verified 2026-08-21IRC § 1366(a)(1)(A) and flush text, opened at law.cornell.edu/uscode/text/26/1366; § 702(a) opened at /702 (IRC § 1366(a)(1)(A)), and of the remainder, which the statute calls nonseparately computed income or loss: gross income minus the deductions allowed to the corporation under chapter 1, determined by excluding all items described in § 1366(a)(1)(A)^TY2026Verified 2026-08-21IRC § 1366(a)(2), opened at law.cornell.edu/uscode/text/26/1366 (IRC § 1366(a)(2)). Every dollar falls into one bucket or the other; nothing stays behind.

Character is fixed at the corporate level. An item is characterised as if the shareholder had realised it directly from the source from which the corporation realised it, or incurred it as the corporation incurred it (IRC § 1366(b)). And where a provision needs a shareholder’s gross income, where it is necessary to determine the gross income of a shareholder, that gross income includes the shareholder's pro rata share of the gross income of the corporation^TY2026Verified 2026-08-21IRC § 1366(c), opened at law.cornell.edu/uscode/text/26/1366 (IRC § 1366(c)).

Current figures

How it works in practice

Read the regulation’s list, then throw it away. Reg. § 1.1366-1(a)(2) gives a working list: net capital gain or loss and net gain or loss on trade or business property, each grouped by holding period and applicable rate; charitable contributions, grouped by the percentage limitations; the foreign taxes described in IRC § 901; each item entering a credit; the expensing election and the other itemized deductions of individuals, including any to which IRC § 67 or IRC § 68 applies; portfolio income and its related expenses; tax-exempt income; and the alternative minimum tax adjustments and preference items. It is expressly not exhaustive.

The unifying test is that the item meets a limit, a rate or a character rule on the shareholder’s return that cannot be applied inside the corporation. Capital gain, because the shareholder’s own rate applies; charitable contributions, because the ceiling is measured against the shareholder’s contribution base; foreign taxes, because the shareholder chooses between the credit and the deduction. State the reason and you can place an item the regulation never mentions.

The two-step on charitable gifts. IRC § 1363(b)(2) denies the corporation the deduction, and the flush sentence of IRC § 1366(a)(1) then pulls the IRC § 702(a)(4) charitable contribution into the separately stated list. The item is not lost; it is moved. Foreign taxes take the same route through IRC § 702(a)(6).

Elections belong to the corporation. any election affecting the computation of items derived from an S corporation is made by the corporation, except the § 617 mining exploration election and the § 901 foreign tax credit election, which each shareholder makes separately^TY2026Verified 2026-08-21IRC § 1363(c), opened at law.cornell.edu/uscode/text/26/1363 (IRC § 1363(c)). The accounting method, the inventory method, the expensing election and the discharge-of-indebtedness basis reduction election are all made on Form 1120-S. Compare IRC § 703(b), which pushes the discharge elections down to each partner — subchapter K and subchapter S part company there.

Allocate by day, then by share. each shareholder's pro rata share of any item is found by assigning an equal portion of the item to each day of the taxable year and then dividing that portion pro rata among the shares outstanding on that day^TY2026Verified 2026-08-21IRC § 1377(a)(1), opened at law.cornell.edu/uscode/text/26/1377 (IRC § 1377(a)(1)). There is no special allocation in subchapter S: the single-class-of-stock requirement and this mechanical rule make the arithmetic follow ownership and nothing else. The one relief valve is IRC § 1377(a)(2), under which where a shareholder terminates their interest during the taxable year and all affected shareholders and the corporation agree, the per-day rule is applied to the affected shareholders as if the taxable year consisted of 2 taxable years, the first of which ends on the date of the termination^TY2026Verified 2026-08-21IRC § 1377(a)(2)(A), opened at law.cornell.edu/uscode/text/26/1377. the shareholder whose interest is terminated and all shareholders to whom that shareholder transferred shares during the taxable year; where the transfer was to the corporation, every person who is a shareholder during the taxable year^TY2026Verified 2026-08-21IRC § 1377(a)(2)(B), opened at law.cornell.edu/uscode/text/26/1377 — the corporation and every affected shareholder must agree.

Report by activity, and aggregate before applying a limit. the corporation must report, and each shareholder must take into account, the shareholder's pro rata share of the separately stated and nonseparately computed items for each of the corporation's activities as defined in § 469^TY2026Verified 2026-08-21Reg. § 1.1366-1(a)(4), opened at law.cornell.edu/cfr/text/26/1.1366-1 (Reg. § 1.1366-1(a)(4)); a shareholder aggregates their own deductions or exclusions with their pro rata share of the corporation's separately stated deductions or exclusions in applying any limitation imposed on that deduction or exclusion^TY2026Verified 2026-08-21Reg. § 1.1366-1(a)(5)(i), opened at law.cornell.edu/cfr/text/26/1.1366-1 (Reg. § 1.1366-1(a)(5)(i)).

Fringe benefits go to the partnership rules. for purposes of the fringe benefit provisions of subtitle A the S corporation is treated as a partnership and any 2-percent shareholder is treated as a partner of that partnership^TY2026Verified 2026-08-21IRC § 1372(a), opened at law.cornell.edu/uscode/text/26/1372 (IRC § 1372(a)), and a 2-percent shareholder means more than 2 percent — a person who owns, or is considered to own within the meaning of § 318, on any day during the taxable year more than 2 percent of the outstanding stock or stock possessing more than 2 percent of the total combined voting power^TY2026Verified 2026-08-21IRC § 1372(b), opened at law.cornell.edu/uscode/text/26/1372 (IRC § 1372(b)). Two features trip people: ownership is tested on any day during the year, so a mid-year sale does not undo the status, and IRC § 318 applies, so a spouse, child, grandchild or parent owning nothing directly can still qualify (IRC § 318(a)(1)(A)).

Entity-level taxes come back as pass-through adjustments. a § 1374 built-in gains tax imposed on the corporation is treated as a loss sustained by the corporation in that year, allocated proportionately among the recognised built-in gains giving rise to it; a § 1375 tax instead reduces each item of passive investment income in proportion to that item^TY2026Verified 2026-08-21IRC § 1366(f)(2) and (f)(3), opened at law.cornell.edu/uscode/text/26/1366 (IRC § 1366(f)(2), (f)(3)) — each surviving tax is fed back into the allocation so shareholders bear it once, not twice.

How this has changed

The overall limitation on itemized deductions was rewritten, and 2026 is the first year it operates. Reg. § 1.1366-1(a)(2)(vi) requires separate statement of any itemized deduction to which IRC § 67 or IRC § 68 applies. From 2018 through 2025 the reference to IRC § 68 was inert: the former IRC § 68(f) suspended the section for taxable years beginning after 31 December 2017 and before 1 January 2026. Pub. L. 119-21 § 70111(a), enacted 4 July 2025, amended IRC § 68 generally, replacing the old adjusted-gross-income phase-out with a different mechanism — itemized deductions reduced by 2/37 of the lesser of those deductions or the taxable income above the point where the 37 percent bracket begins, first applying to taxable years beginning after 31 December 2025^TY2026Verified 2026-08-19IRC § 68(a); Pub. L. 119-21 § 70111(a), (c) — https://www.law.cornell.edu/uscode/text/26/68 — and § 70111(c) applies it to taxable years beginning after 31 December 2025. A separately stated itemized deduction worth its face amount to a shareholder in 2025 may be worth less in 2026, on an identical Schedule K-1. The change sits entirely on the shareholder’s side of the line.

Miscellaneous itemized deductions are permanently gone, and the subsection moved. Pub. L. 119-21 § 70110(a) made the suspension permanent, and § 70110(b)(2) redesignated it from IRC § 67(g) to IRC § 67(h), putting a new provision on educator expenses at IRC § 67(g). A source citing “IRC § 67(g)” for the suspension is citing a subsection that now says something else.

The family-group cross-reference was conformed; the partnership regulation was not. where a member of the family, within the meaning of § 704(e)(2), of one or more shareholders renders services or furnishes capital without receiving reasonable compensation, the Secretary shall make the adjustments in the items taken into account necessary to reflect the value of those services or that capital^TY2026Verified 2026-08-21IRC § 1366(e), opened at law.cornell.edu/uscode/text/26/1366 (IRC § 1366(e)). Pub. L. 114-74 § 1102 renumbered IRC § 704(e), and Pub. L. 115-141 § 401(a)(192) then substituted “section 704(e)(2)” for “section 704(e)(3)” in IRC § 1366(e) so the reference still lands on the definition of family. The corresponding partnership regulation was never conformed — see the family partnerships topic.

Exam focus

Questions here are almost always sorting questions: given a list, which items are separately stated and which fall into ordinary business income. Do not memorise the regulation’s list — ask whether the item meets a rate, a limit or a character rule on the shareholder’s return.

The second pattern is the mid-year change in ownership: the default is per-day and per-share, the IRC § 1377(a)(2) election requires the agreement of the corporation and all affected shareholders, and “affected shareholders” expands to every shareholder when the transfer is to the corporation itself.

The third is the 2-percent shareholder, where the answer often turns on attribution under IRC § 318 or on the “any day during the taxable year” measuring period rather than on the percentage. Throughout, keep the two levels straight: the corporation’s computation, its denied deductions and its elections are one question, what the shareholder may then do is another. Many wrong answers are true statements about the wrong level.

Check yourself

1. An S corporation pays $12,000 of foreign income tax on income earned through a branch. How is that amount reported, and why?

Answer: It is a separately stated item. IRC § 1363(b)(2) denies the corporation the deduction because IRC § 703(a)(2)(B) is on the denied list, and the flush sentence of IRC § 1366(a)(1) pulls the IRC § 702(a)(6) foreign taxes into the separately stated items — because each shareholder chooses independently between the credit and the deduction.

2. A shareholder owns 1.5 percent of an S corporation. Her husband owns 6 percent. The corporation pays her group-term life insurance premium. Is she a 2-percent shareholder?

Answer: Yes. IRC § 1372(b) applies IRC § 318, and IRC § 318(a)(1)(A)(i) attributes a spouse’s stock, so her ownership for this purpose is 7.5 percent and the premium is measured under the partnership rules rather than excluded as an employee fringe benefit.

3. An S corporation has a $40,000 loss for the year. One shareholder sold half of his shares to another existing shareholder on 1 September. No election is made. How is the loss allocated to him?

Answer: Per day and per share under IRC § 1377(a)(1) — an equal portion of the $40,000 to each day, then divided among the shares outstanding that day, so he takes the loss on all his shares before the sale and on his retained shares after it. The IRC § 1377(a)(2) election is unavailable in any event, because he did not terminate his entire interest.

4. The corporation excludes $80,000 of discharge of indebtedness income. Is that a separately stated item of tax-exempt income?

Answer: No. Reg. § 1.1366-1(a)(2)(viii) defines tax-exempt income as income permanently excludible in all circumstances in which the provision applies, and names discharge of indebtedness income as an example that does not qualify. It matters because tax-exempt income increases stock basis and excluded discharge income does not.

5. A shareholder buys $600,000 of equipment for her own sole proprietorship in the same year her S corporation makes an expensing election and passes her a $200,000 share. May she claim both amounts in full?

Answer: Not automatically. Reg. § 1.1366-1(a)(5)(i) makes her aggregate her own deduction with her share of the corporation’s and apply the annual ceiling to the combined figure on her own return, even though the corporation applied the limits at its own level first.