How do South Carolina pass-through entities and owners report the new entity-level active trade or business income election on 2021 tax forms?

Plain-English summary

This Information Letter is 2021 filing-season guidance for South Carolina's new entity-level "active trade or business income" (ATBI) election — including how to work around several SC form and tax-software problems, most notably a Section 179 deduction issue on the S corporation return. It does not decide any taxpayer's liability.

The two ways ATBI can be taxed at 3%

South Carolina taxes "active trade or business income" (ATBI) from a pass-through business at a reduced 3% rate rather than the standard rate of up to 7%. Effective for tax years beginning in 2021, there are two paths:

• New entity-level election (Code Section 12-6-545(G)). A qualifying pass-through entity can elect to report ATBI on its own return and pay a 3% entity-level tax, computed on Form I-435. If the entity elects, its owners exclude that ATBI from their own South Carolina income. General guidance on this election is in SC Revenue Ruling #21-15.
• Owner-level election (Code Section 12-6-545(B)(1)). If the entity does not elect, an owner can still choose annually to have his ATBI taxed at the reduced 3% rate, computed on Form I-335. (This is a mathematical computation on the SC 1040; see SC Revenue Ruling #08-2.)

The form and software issues it fixes

The letter identifies five reporting issues for the 2021 season across Forms SC 1120S, SC 1040, I-435, and I-335 (for example: determining the ATBI vs. passive-investment split for the I-435; handling active-trade-or-business losses from other non-electing entities; proper SC K-1 credit disclosure; and a state-tax-addback reporting issue on the SC 1040 for owners).

The headline fix is Issue 1 — the Section 179 expense deduction on Form SC 1120S. Because SC Form 1120S starts from federal 1120S Schedule K, Lines 1–10, it does not pick up the federal Section 179 amount (reported on federal Schedule K, Line 11), and the SC 1120S has no line to subtract it. The Section 179 deduction is captured on Form I-435 (Line 12). To reach the correct South Carolina net taxable income, the Department instructs preparers and software companies to enter the Section 179 deduction amount on SC Form 1120S, Line 7, "Income taxed to shareholders" — an entry that is not actually income taxed to shareholders and should be disregarded except as this workaround.

What this means for you

Pass-through entities weighing the entity-level election

If your S corporation or partnership elects to pay ATBI tax at the entity level, compute the tax on Form I-435, carry it to the SC 1120S, and confirm your software handles the Section 179 workaround (Line 7) so you do not overstate South Carolina taxable income. Owners of an electing entity should not also report that ATBI on their own returns.

Owners of non-electing entities

You can still claim the reduced 3% rate on your own ATBI using Form I-335. Watch the state-tax-addback issue on the SC 1040 the letter flags.

This is season-specific

The guidance targets 2021 forms and software. Later-year forms may have corrected these mechanics, so use the current forms and instructions for other years.

Common questions

Q: What is the entity-level ATBI election?
A: Under Code Section 12-6-545(G), a qualifying pass-through entity can elect to report active trade or business income on its own return and pay a 3% entity-level tax (Form I-435); its owners then exclude that income from their South Carolina income.

Q: What is the Section 179 workaround on the SC 1120S?
A: Because the SC 1120S doesn't pick up the federal Section 179 deduction, the Department says to enter the Section 179 amount on Line 7 ("Income taxed to shareholders") so the entity reaches the correct South Carolina net taxable income. That Line 7 entry is not really income taxed to shareholders.

Q: If my entity doesn't elect, can I still get the 3% rate?
A: Yes. An owner can elect the reduced 3% rate on active trade or business income using Form I-335 under Code Section 12-6-545(B)(1).

Source

• Landing page: https://dor.sc.gov/advisory-opinion-search
• Original PDF: https://dor.sc.gov/sites/dor/files/policies/IL22-4.pdf

Original ruling text

STATE OF SOUTH CAROLINA

DEPARTMENT OF REVENUE
300A Outlet Pointe Blvd., Columbia, South Carolina 29210
P.O. Box 125, Columbia, South Carolina 29214-0575

SC INFORMATION LETTER #22-4
SUBJECT:

Active Trade or Business Income – SC Tax Forms and Reporting Issues for
Tax Year 2021
(Income Tax)

DATE:

March 11, 2022

AUTHORITY:

S.C. Code Ann. Section 12-4-320 (2014)
SC Revenue Procedure #09-3

SCOPE:

An Information Letter is a written statement issued to the public to announce
general information useful in complying with the laws administered by the
Department. An Information Letter has no precedential value.

NOTICE TO PASS-THROUGH ENTITIES ELECTING TO PAY ACTIVE
TRADE OR BUSINESS INCOME AT THE ENTITY LEVEL, ENTITY
OWNERS, TAX PREPARERS, AND TAX SOFTWARE COMPANIES
TAX YEAR 2021 ACTIVE TRADE OR BUSINESS INCOME (ATBI) ELECTION –
SC INCOME TAX FORM ISSUES (SC 1120S, SC 1040, I-435, and I-335)
Background and Guidance
New South Carolina ATBI Entity Election – Reporting Tax at Entity Level. Effective for tax
years beginning 2021, Code Section 12-6-545(G) provides an optional election for certain passthrough entities to report “active trade or business income” (as defined in Code Section 12-6545(A)(1)) directly on the entity’s tax return and pay an entity level income tax on it at 3%. This
calculation is made by the electing entity on SC Form I-435, “Active Trade or Business Income
for Electing Partnerships and S Corporations.” For owners of electing entities, active trade or
business income taxed at the entity level is not included in the owners’ South Carolina income.

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ATBI Entity Election Not Made – Reporting Tax at Owner Level. If a pass-through entity does
not make the election to have its income taxed at the entity level for the tax year, then Code
Section 12-6-545(B)(1) continues to provide that an owner of a pass-through business may
decide annually (“owner’s election”) 1 to have his active trade or business income taxed at the
reduced rate of 3% or the standard rate of up to 7% for any one or more pass-through entities he
owns. This calculation continues to be made by the electing owner on SC Form I-335, “Active
Trade or Business Income Reduced Rate Computation.”
Guidance. SC Revenue Ruling #21-15, “Active Trade or Business Income – Annual Election by
Pass-Through Entity to Pay Tax at Entity Level,” addresses general technical and compliance
questions regarding the new election in Code Section 12-6-545(G) by a qualified entity to report
and pay tax on active trade or business income at the entity level. A copy is available on the
Department’s Law and Policy page at dor.sc.gov/policy.
Purpose. The purpose of this Information Letter is to provide guidance and clarification with
respect to several important South Carolina income tax form reporting or tax software issues
identified on South Carolina Forms 1120S, 1040, I-435, I-335, credit forms, and instructions for
this filing season.
Issue 1: Section 179 Expense Deduction - Reporting Issue on SC Form 1120S for S
Corporations 2
Current Reporting Issue. The mechanics of Form SC 1120S, as described below, are creating a
tax reporting question for Internal Revenue Code Section 179 amounts reported by an S
corporation making the new ATBI entity election. Specifically, SC 1120S, Line 1, does not
include the Section 179 deduction since the starting point of SC Form 1120S (Line 1) is Federal
1120S Schedule K, “Shareholders’ Pro Rata Share Items” Lines 1 – 10. Federal 1120S Schedule
K, Line 11, is used by an S corporation to report the federal Section 179 amount.
Further, SC Form 1120S, page 1, does not contain a necessary line to make the computation to
allow the Section 179 deduction from income reported on the federal Schedule K. However,
Form I-435, “Active Trade or Business Income for Electing Partnerships and S Corporations,” is
used by the electing entity to compute the South Carolina active trade or business income and
entity tax. The computation of the active trade or business income on the I-435 contains a
separate line (Line 12) that allows for the Section 179 deduction. After computation on the I-435,
the entity’s active trade or business income is then entered on SC 1120S, Line 5, and the tax is
entered on SC 1120S, Line 6.

There is no formal “owner election” for the owner to make. The 3% reduced rate or the standard tax rate are simply
mathematical computations made on the tax return (SC 1040) when filed. See SC Revenue Ruling #08-2, “Tax Rate
Reduction on Active Trade or Business Income from a Pass Through Business” for guidance to persons eligible for
the 3% reduced tax rate under Code Section 12-6-545(A) through (F).
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The form design of the SC 1065 is different enough from the SC 1120S that it does not appear to have this Section 179
reporting issue.
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The 2021 Form SC 1120S, “S Corporation Income Tax Return” Lines 1 – 10 read:

(* The bold portion in Line 7 below has been added for purposes of this Information Letter)

1. Total of line 1 through 10, Schedule K of the federal 1120S ..................................................

2. 00

3. Total net income as reconciled (add line 1 and line 2) ............................................................

4. If multi-state corporation, enter amount from Schedule G, line 6; otherwise, enter amount
   from line 3. .........................................................................................................................
5. Active Trade or Business Income (from I-435, line 22) .........................................................
6. Active Trade or Business Tax (from I-435, line 25) ...............................................................
7. Income taxed to shareholders (*See Section 179 expense workaround described below) .

8. South Carolina net taxable income (subtract line 5 and line 7 from line 4) ............................

9. 00

10. 00
11. 00
12. 00
13. 00
14. 00

10.Total Income Tax (add line 6 and line 9) ................................................................................

10. 00

Advised Reporting Workaround for 2021 SC Form 1120S – Use of Line 7, “Income taxed
to shareholders.” In order for the electing entity to arrive at the correct South Carolina net
taxable income amount on Line 8, the Department’s Income Tax Services Section is instructing
tax return preparers and tax preparation software companies to enter the Section 179 deduction
amount on SC Form 1120S, Line 7, “Income taxed to shareholders.” This workaround will create
an amount on Line 7 that is not “income taxed to shareholder,” and should be disregarded as
such, but will create an amount on Line 7 that will prevent the electing entity from erroneously
reporting taxable income on Line 7 equal to the South Carolina Section 179 deduction amount.
Caution: The South Carolina Section 179 expense deducted by the entity should not also be
reported separately to the shareholder.
The Department acknowledges that as a result of this directed workaround on the 2021 SC
1120S, that page 1, line 7, of the SC 1120S will not correctly state the “Income taxed to
shareholders” and may not match the I-335 or SC 1040 of the shareholder. This line will be
disregarded by the Department for audit and compliance purposes in this context. A preparer
using this workaround is not required to make a disclosure statement with the return regarding
this “mislabeled” amount reported on Line 7 as a result of this workaround. Any applicable
penalty will not be imposed as a result of this workaround.
Note: Line 7 may be used to report any non-ATBI income items (e.g., dividends, portfolio
interest, capital gains, etc.). In the event the entity has non-ATBI income items taxed to the
shareholders (e.g., dividends) reflected on the SC 1120S K-1, the sum of the non-ATBI items
should equal SC 1120S, Line 7, after reducing Line 7 for the South Carolina Section 179
amount, if any, included on Line 7.
Issue 2: Clarification of Determination of ATBI or Passive Investment Income for Form I435, Column C, South Carolina ATBI amounts
Distributive share items reflected on the I-435, “Active Trade or Business Income for Electing
Partnerships and S Corporations,” contain elements of the federal Schedule K’s for Forms 1120S
and 1065. Portions of these federal Schedule K lines do not impact South Carolina ATBI and are
shaded on the I-435. However, several lines that are not shaded will often be passive investment
income as defined in IRC Section 1362(d) and will not meet the definition of South Carolina
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ATBI. For example, electing entities will generally not have a value on Form I-435, Column C,
line 2 rental real estate, line 5 interest, line 7 royalties, or line 10 Section 1231 gain, unless one
of the exceptions in IRC Section 1362(d) is met. See the guidance in SC Revenue Ruling #21-15,
Question 20, and SC Revenue Ruling #08-2, Question 9, particularly for when rental real estate
qualifies as ATBI under Code Section 12-6-545.
Issue 3: Active Trade or Business Losses From Other Non-electing Entities – Manual Tax
Calculation Issue on SC 1040 for Owners
Code Section 12-6-545(G)(4) provides that active trade or business losses of the qualified owner
from other pass-through entities that are reported directly by such owner may not reduce tax at a
rate higher than 3%.
It is the Department’s understanding that this computation may not currently be performed by tax
software. A manual override in the tax software may be required to correctly compute South
Carolina income tax on the 2021 SC Form 1040 for taxpayers with this situation.
See SC Revenue Ruling #21-15, Question 28, for a complete discussion of this issue and an
example that illustrates the tax impact to the owner of a qualified entity that makes the election
to pay income tax at the entity level and the owner also has active trade or business losses passed
through to him by other pass-through entities.
Issue 4: State Tax Credits – Proper SC K-1 Disclosure to Prevent Credit used by Entity
from also Being used by Owner
The use of South Carolina tax credits to reduce an electing entity’s tax depends, in part, on
whether the credit was earned by an S corporation or a partnership and whether it is related to
active trade or business income.
See SC Revenue Ruling #21-15, Question 24, for a complete discussion of the use of credits by
electing S corporations or partnerships and SC Revenue Ruling #21-15, Question 25, for
guidance on the application of a credit against the owner’s income tax liability to the extent a
qualifying entity passes through a South Carolina unused tax credit.
Caution: South Carolina’s tax credit forms and tax software may not be reflecting the pass
through credit amounts correctly. A South Carolina tax credit amount used by the qualifying
entity must be properly disclosed to the owner in order to prevent the owner from claiming a
credit amount already claimed by the electing pass-through entity.
Issue 5: SC State Tax Addback – Tax Reporting Issue on SC 1040 for Owners
If the electing entity taxes were deducted in computing federal taxable income that is reported on
the owner’s federal 1040, a shareholder or partner is required to make a federal to state
adjustment on his Form SC 1040 to “addback” his share of entity level taxes paid directly by a
partnership or S corporation making the election under Code Section 12-6-545. The electing
entity will report to each owner the South Carolina income tax that was deducted at the entity
level.
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Form SC 1040 does not, however, contain a specific line item addback for South Carolina ATBI
income taxes by the owner that are deducted by the the electing entity. This addback should be
reported as an “other addition” on page 2 of the SC 1040 and clearly labeled, for example, “SC
ATBI entity tax.” Note: This entity level state tax is not deductible by the partner or shareholder
on his federal Form 1040, Schedule A. See SC Revenue Ruling #21-15, Question 25, for more
information on owner compliance and reporting.
QUESTIONS AND TECHNICAL GUIDANCE
Forms questions regarding the ATBI calculation and reporting should be directed to the
Department’s Income Tax Services Section at [email protected].
The guidance published in SC Revenue Ruling #21-15 and in this Information Letter is
controlling over the tax form mechanics and instructions. While the applicable South Carolina
form mechanics may differ from the illustrations provided in the Revenue Ruling, the electing
entity and qualified owners should arrive at the result as illustrated in the examples in SC
Revenue Ruling #21-15.

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