Are S Corps Double Taxed and How Do They Avoid It?
Understand S corporation taxation and how this business structure effectively prevents double taxation.
Business owners often inquire about the tax implications of different entity structures, especially regarding double taxation. This article clarifies how S corporations are treated under federal tax law, addressing whether they are subject to double taxation and how they avoid it.
Understanding Corporate Taxation
Understanding how traditional C corporations are taxed helps clarify the tax advantages of an S corporation. A C corporation is a distinct legal and taxable entity separate from its owners. This separation results in “double taxation.”
The first layer of taxation occurs at the corporate level. The C corporation pays federal income tax on its net profits before any distributions to shareholders. After corporate taxes, remaining profits can be distributed as dividends.
The second layer of taxation arises when shareholders receive these dividends. They must report them as personal income on their individual tax returns, where they are subject to individual income tax rates. For instance, if a C corporation earns $100 in profit, it first pays corporate income tax. If the remaining amount is then distributed as a dividend, the shareholder pays individual income tax on that same income, effectively taxing the original $100 twice.
How S Corporations Are Taxed
S corporations operate under a different federal tax framework designed to avoid the double taxation inherent in C corporations. These entities are characterized as “pass-through” organizations for federal income tax purposes. This means the S corporation itself generally does not pay federal income tax on its profits, though some states may impose a modest corporate-level tax. Instead, the company’s income, losses, deductions, and credits are passed directly through to its shareholders.
Shareholders then report their proportional share of these items on their individual federal income tax returns, using information provided on a Schedule K-1. For example, if an S corporation earns $100 in profit, that entire $100 is allocated to the shareholders based on their ownership percentage. The shareholders then pay individual income tax on that $100, eliminating the corporate-level tax. This mechanism effectively taxes the business income only once, at the individual shareholder level.
S corporation shareholder-employees must pay themselves a “reasonable salary” for services performed. This salary is subject to payroll taxes, including Social Security and Medicare taxes, similar to wages paid to any employee. After paying the reasonable salary, any remaining profits distributed to shareholders are generally considered distributions of profit, not subject to additional payroll taxes, which can provide a tax advantage compared to self-employment income.
Requirements for S Corporation Election
To benefit from the pass-through taxation structure of an S corporation, a business must meet specific eligibility criteria established by the Internal Revenue Service. First, the entity must be a domestic corporation, or an eligible limited liability company (LLC) that has elected to be taxed as a corporation. This foundational requirement ensures the business operates within the U.S. legal and tax framework.
Furthermore, an S corporation is subject to strict limitations on its stock and shareholders. It can only have one class of stock, meaning all shares must carry identical rights to distribution and liquidation proceeds, even if voting rights differ. The number of shareholders is also limited, typically to no more than 100. These shareholders must generally be U.S. citizens or residents, or certain types of trusts or estates; partnerships and corporations are generally not permitted to be S corporation shareholders. Certain financial institutions and insurance companies are also typically ineligible to elect S corporation status.
For a qualifying business to elect S corporation status, it must file Form 2553, Election by a Small Business Corporation, with the IRS. This form must be submitted by a specific deadline, generally by the 15th day of the third month of the tax year the election is to take effect, or at any time during the preceding tax year. It is crucial for the business to continuously meet all these eligibility requirements to maintain its S corporation status; failure to do so can result in the termination of the S election and a reversion to C corporation taxation.