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Pass-Through Entity.

The income and losses of an S corporation generally flow through to, and are taxed to or deducted by, the shareholders, retaining the character they had to the S corporation. Nonresidents are subject to California income tax on the amount of California source income they receive from S corporations doing business in California. The basis in the shareholder's stock is increased by the shareholder's share of income and decreased by the shareholder's share of losses. The shareholder's loss deduction is limited to the basis in the shareholder's stock and the basis of any debt owed by the corporation to the shareholder. However, pass-through items from an S corporation are not included in net earnings from self-employment. Therefore, taxpayers may not deduct pass-through losses from an S corporation in determining their self-employment taxes under IRC A?1401. Likewise, shareholders may not deduct pass-through income from an S corporation contributed to the shareholder's Keogh account.

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Requirements to Qualify as an S Corporation.

To qualify as an S corporation, a corporation cannot (IRC A?1361) 1) have more than 75 shareholders; 2) have anyone other than an individual, an estate, or certain trusts and certain tax-exempt organizations, as shareholders (corporate and partnership shareholders are not permitted); 3) have a nonresident alien as a shareholder; 4) have more than one class of stock, except that differences in voting rights are permitted; 5) be an insurance company; 6) be a foreign corporation; 7) be a domestic international sales corporation; or 8) have an IRC A?936 election in effect (involving Puerto Rico and possession tax credit).

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Distributions to Shareholders.

A shareholder is taxed on his or her share of S corporation income, regardless of whether the shareholder receives that income. Distributions are not taxable to a shareholder except to the extent the money and fair market value of property distributed exceeds the shareholder's basis in his or her stock and the basis of debt owed by the corporation to the shareholder. IRC A?1368. However, the S corporation will recognize any gain on the distribution of property under IRC A?311(b), but, except in liquidation, no loss. Normally, as with other S corporation income, the gain will flow through and be taxed to the shareholders. The amount of money and the fair market value of property distributed to a shareholder reduce the basis of his stock. IRC A?1367. The shareholder takes a fair market value basis in distributed property under IRC A?301(d).