As you may know, an S Corporation is treated legally as a corporation,
but is treated taxwise much more like a partnership.  An S Corporation
prepares a tax return (1120S) which it files without a payment.  The S
Corporation prepares for each of its shareholders a Schedule K-1,
which is basically that shareholder's prorated (based on percentage of
ownership) part of the corporation's return.

I am one of two owners of an S Corporation.  I handle the accounting
and tax returns for the company.  Assuming that the company posts a
profit, the shareholder owes more tax than they would without the
company's Schedule K-1 (likewise, if the company posts a loss, the
shareholder owes less tax - as long as the shareholder's basis does
not hit zero.)

* How do S Corporations typically handle the increased or decreased
tax amount in the shareholder's tax return?

Although I handle the accounting and tax returns for our company, we
do have a CPA that we consult with occasionally.  He was able to tell
us that the S Corporation typically writes the shareholder a check to
cover the difference in the tax return (or receives a check from the
shareholder if the S Corporation posted a loss assuming the
shareholder's basis does not hit zero.)  He was unable to tell us the
specifics of how this works.

* If this method is not typical, is this method of "reimbursement"
acceptable accountingwise and taxwise?

* I can handle the accounting entries.  What tax entries need to be
made?  I am certain a disbursement of funds like this would not be
counted as taxable income for the individual (stopping tax on already
taxed money is one of the points of an S Corporation.)

Assuming that it is acceptable for each shareholder to prepare a tax
return with and without the company (both shareholders use TurboTax,
neither minds), and settle with the company on the difference, which
of last tax year's returns should the shareholder use for any
carryover information?  (The last year return that was actually filed
with the Schedule K-1, or the prepared one for comparison purposes
only without the Schedule K-1?)

Hello and thank you for your question.

As you know, your company's sub-S election makes you and your
co-shareholder responsible for paying the income tax on essential all
of the company's profits, whether or not the company actually
distributes any of those profits to you during the year.

There are basically two approaches to handling the tax situation.  One
would be for the two of you to draw salaries and cash bonuses from the
company on an agreed basis between you, in an amount sufficient to
eliminate the company's income.  In other words, despite the sub-S
election, the company is allowed an income tax deduction for all of
its "ordinary and necessary" business expenses, including reasonable
compensation to the two of you for the services you render to the
company.  This is actually the method that the IRS favors, because it
gives the government the opportunity to collect FICA (Social Security)
tax on the compensation payments in addition to income tax.
Officer Compensation
http://www.withum.com/Articles/Officercompensation.shtml

Alternatively, and especially if you two are not also the key
employees of the company, you can draw smaller (but still reasonably
adequate) salaries, which will allow profits to accumulate in the
company.  Then, the mechanism that you need to provide the two of you
with funds to pay your income taxes on these profits, is to declare
and pay corporate dividends in an agreed amount.  Although dividends
do not reduce the company's taxable profits the way compensation does,
the sub-S basis rules are designed to allow this mechanism to work. 
"[A] shareholder's basis in S corporation stock is dynamic.  In
addition to capital contributions..., profits increase basis in the
shares.  Distributions and losses decrease basis."
Choice of Entity
http://www.staleylaw.com/images/Choice_for_EP_102503m.pdf

"A distribution made by a Subchapter S corporation, as defined in 26
U.S.C. 1361, to its owners, including a distribution intended to cover
a shareholder's personal tax liability for the shareholder's
proportionate share of the taxable income of the institution, is
considered to be a capital distribution under this rule."
http://www.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=1998_register&docid=:fr07ja98-32


Since the two of you are equal shareholders, each $1.00 of dividend
will be allocated 50 cents to each of you.  I do not think you need to
concern yourself with each other's tax brackets, NOL history and the
like.  Even if the two of you are in different tax brackets (because
one of you has more outside income, different personal tax deductions,
etc.) there is no reason the distributions should not be equal between
you.  Otherwise it would be as if in setting salaries for each of you,
you tried to take your respective income tax brackets into account. 
This is never done in any other business entity (C corporation,
partnership, LLC) nor is there any reason to do it here.

Anyway, chances are each of you are in approximately a 35% tax bracket
anyway (more or less depending on the state you live in, since you
will also incur state income tax, assuming that your state like most
follows the federal sub S rules), so a good rule of thumb will be to
distribute at least one-third of the profits, or any larger amount if
the cash needs of your business make such distributions practical.

You also asked about the proper treatment in years that the company
generates a tax loss.  Unless the company needs extra cash, I see no
reason why the two of you should feel obligated to contribute the tax
savings to the company (although you could if you wanted to, since the
contribution would increase your tax basis in the shares so a future
distribution in effect a return of that capital could be made tax-free
at a later date).  Again I suggest that you mainly consider the cash
needs of the company in deciding how much cash should be held in the
company accounts, rather than the factors alluded to in your question.

Search terms used:
sub-s compensation shareholder planning
compensation shareholder  "subchapter s " site:.gov

Thanks again for bringing us your question.  If you find any of my
answer unclear, please request clarification.  I would appreciate it
if you would hold off on rating my answer until I have a chance to
reply.

Sincerely,
Google Answers Researcher
Richard-ga

We wound up also hiring a CPA to get a second opinion, and he gave the
same type of answer that you did.  Thanks!

In your answer you stated: 
"there is no reason the distributions should not be equal between
you. "

In fact your distributions MUST be equal because your stock ownership
is equal.  In an S-Corporations distributions must be on a pro-rata
basis, based on stock ownership.  Making distributions
disproportionate to share ownership could jeopordize your S-election.

As the comment above indicates, company dividends must be
proportionate to stock ownership.
The 'distributions' I was referring to in that part of my answer were
addressing the question regarding the accountant's statement that a
sub-S company will
"typically write the shareholder a check to cover the difference in
the tax [brackets] of the shareholders ...."

This is the <distribution> I was referring to (maybe I could have used
a different word).  It would be a salary or bonus differential between
the employee/shareholders, and not a dividend.
So that's something the company could do but in my answer I advised
against it for other reasons.

-R