Are Shareholders Considered Self-Employed in an S Corporation?
Understand how S corporation shareholders are classified for tax purposes, including their earnings, tax obligations, and the impact on self-employment status.
Owning shares in an S Corporation comes with unique tax and income considerations, particularly regarding employment status. Many shareholders actively participate in the business, but does that make them self-employed? The answer depends on how they receive compensation and their role within the company.
Business Structure Impacts
An S Corporation is a separate legal entity, meaning shareholders are not automatically considered self-employed. This differs from sole proprietorships and partnerships, where owners are directly taxed on business income and must pay self-employment taxes.
S Corporations are pass-through entities, meaning they do not pay federal income tax at the corporate level. Instead, profits and losses flow through to shareholders, who report them on their personal tax returns. This avoids the double taxation seen in C Corporations, where both the company and shareholders pay taxes on earnings. The classification of income—whether wages, dividends, or distributions—determines tax treatment and whether self-employment taxes apply.
Shareholder Activities
A shareholder’s role in the company affects how their income is taxed. Passive shareholders, who do not participate in operations, typically receive distributions, which are not subject to self-employment taxes. In contrast, shareholders who actively manage the business must receive reasonable compensation in the form of wages before taking distributions.
The IRS requires shareholder-employees to be paid a salary that reflects their role, industry standards, and company profitability. This prevents business owners from avoiding payroll taxes by classifying all earnings as distributions. If the IRS determines that wages are too low, it can reclassify distributions as taxable wages, leading to audits, penalties, and back taxes.
W-2 Wages vs. Shareholder Distributions
The way an S Corporation compensates its shareholders affects tax liability and compliance. Shareholders who work for the business must receive W-2 wages, which are subject to payroll taxes, including Social Security and Medicare. These wages are reported on Form W-2, and the corporation must withhold federal income tax and remit employer payroll taxes.
Distributions represent a shareholder’s share of company earnings and are not considered wages. Since they are not subject to payroll taxes, they provide a tax-efficient way for S Corporation owners to receive income. However, distributions must be proportionate to ownership percentages, and excessive reliance on them without reasonable W-2 compensation can trigger IRS scrutiny. If the IRS reclassifies distributions as wages, the shareholder may owe back taxes, penalties, and interest.
Determining the right balance between wages and distributions requires careful planning. The IRS does not provide a fixed formula for reasonable compensation, but factors such as industry norms, the shareholder’s role, and business revenue help establish an appropriate salary. Business owners often use Bureau of Labor Statistics wage data or salary surveys to justify their compensation levels. Courts have upheld IRS reclassifications in cases where shareholder-employees paid themselves disproportionately low wages while taking large distributions, reinforcing the need for a defensible pay structure.
Self-Employment Taxable Earnings
Unlike sole proprietors and partners, S Corporation shareholders who work for their business are not automatically liable for self-employment tax on all earnings. Instead, tax liability depends on how income is classified. Retained earnings—profits that remain in the business rather than being distributed—are reported on shareholders’ personal tax returns but do not trigger self-employment taxes.
Fringe benefits also impact tax liability. Health insurance premiums paid for shareholders who own more than 2% of the company must be reported as taxable wages but are exempt from self-employment tax. Retirement plan contributions, such as those made to an S Corporation-sponsored 401(k), allow for tax deferral without increasing self-employment tax obligations.
Payment and Reporting Obligations
S Corporation shareholders who receive compensation or distributions must follow specific tax payment and reporting requirements. The IRS closely monitors how shareholder-employees structure their income to ensure compliance with payroll tax laws and proper tax withholding.
Payroll Tax Withholding and Filings
Shareholders who receive W-2 wages are treated like any other employee for payroll tax purposes. The corporation must withhold federal income tax, Social Security, and Medicare taxes from their paychecks and remit these amounts to the IRS. The company is also responsible for paying the employer portion of payroll taxes, which includes a 6.2% Social Security tax (on wages up to the annual limit) and a 1.45% Medicare tax. If wages exceed $200,000 for an individual, an additional 0.9% Medicare surtax applies.
Employers must file Form 941 quarterly to report payroll taxes and submit Form W-2 to both the IRS and employees by January 31 each year. State payroll tax obligations vary, requiring businesses to comply with state-specific filing and payment deadlines. Failure to properly withhold or remit payroll taxes can result in fines, interest on unpaid amounts, and trust fund recovery penalties for responsible parties.
Estimated Tax Payments and Shareholder Reporting
Unlike wages, S Corporation distributions are not subject to withholding, meaning shareholders must make estimated tax payments if they expect to owe at least $1,000 in federal taxes for the year. These payments are due quarterly—April 15, June 15, September 15, and January 15 of the following year—and are reported on Form 1040-ES. Shareholders who fail to make sufficient estimated payments may face underpayment penalties.
Each shareholder receives a Schedule K-1 (Form 1120S) annually, detailing their share of the corporation’s income, deductions, and credits. This form is necessary for completing personal tax returns. If the corporation operates in multiple states, shareholders may need to file state tax returns based on their allocated income from each jurisdiction. Some states impose additional taxes on S Corporations, such as California’s 1.5% franchise tax on net income, which must be factored into tax planning.