Many small businesses start with the help of friends, family members and intrepid investors who are willing to invest startup funds and be shareholders. Some of these partial owners want no part in the daily operations of the business. Their decision to remain passive shareholders has significant implications for the tax treatment of their share of the income. Shareholders of S corporations face a number of tax considerations, because the corporation passes its income and deductions through to the shareholder.

Share of Income

Shareholders of an S corporation each receive a Schedule K-1 every year. The S corporation prepares the Schedule K-1 to report each shareholder’s share of income, deductions and credits. Typically the shareholder treats the tax items the same as the corporation would, so income from business activities produces ordinary income and gain on the sale of capital assets produces capital gains. The shareholder includes the information from the K-1 on his personal return when calculating taxable income.

Net Investment Income Tax

The Health Care and Education Reconciliation Act of 2010 introduced a new 3.8 percent tax on net investment income. The tax functions like the Medicare tax levied on compensation income, but it applies to income that hasn’t been taxed because it was unearned -- interest, dividends and passive activity income for example. Income allocation from an S corporation might be subject to the net investment income tax if the shareholder is not actively engaged in the business.

Passive Activity Losses

As long as the S corporation generates a profit, a passive shareholder pays taxes on her share of the income in the normal way, possibly paying the net investment income tax in addition. If the S corporation operates at a loss for the tax year, things get more complicated for the shareholder. Passive shareholders cannot offset their other income with losses from the S corporation. The losses carry forward to reduce the shareholder’s share of S corporation income in a subsequent year. Shareholders can deduct unused losses when they sell off all their stock.

S Corporation Distributions

Shareholders pay taxes on the S corporation’s income as the corporation earns it. When the corporation holds on to profit for future use, shareholders wind up paying tax on income they don’t receive. Adjustments to the shareholder’s basis prevent that income from being taxed again when the company distributes it. Distributions greater than the shareholder's basis are treated as capital gains, which qualify for the preferential tax rate if the shareholder owned the stock for at least a year.

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