How Are S Corp Profits Taxed for Shareholders?

An S corporation (S corp) is a business structure recognized under the Internal Revenue Code. It allows profits and losses to pass directly to owners’ personal income without corporate tax rates. This structure helps businesses avoid double taxation, a common characteristic of C corporations. C corporation profits are taxed at the corporate level, and again when distributed as dividends. An S corp eliminates this second layer of taxation on distributed profits.

The Pass-Through Tax Model

The core advantage of an S corporation lies in its pass-through tax model. Under this system, the corporation itself does not pay federal income taxes on its earnings. Instead, the company’s income, losses, deductions, and credits are “passed through” directly to its shareholders. Each shareholder then reports their share of the S corporation’s financial results on their personal income tax return, regardless of whether the cash was actually distributed to them.

This direct flow-through of income means that profits are taxed only once, at the individual shareholder’s tax rate. This contrasts with a C corporation, where corporate profits are taxed at the corporate level, and then again when distributed to shareholders as dividends. By avoiding this dual taxation, S corporations can offer significant tax efficiencies for business owners.

Reporting S Corporation Income to Shareholders

An S corporation is required to file its own informational tax return with the Internal Revenue Service (IRS) using Form 1120-S, U.S. Income Tax Return for an S Corporation. This form details the corporation’s income, gains, losses, deductions, and credits for the fiscal year.

The S corporation issues a Schedule K-1 (Form 1120-S) to each shareholder. This form reports their specific share of the corporation’s income, deductions, credits, and other relevant tax items. Shareholders then use this information to prepare their personal income tax returns, Form 1040. This ensures that each owner’s share of the S corporation’s taxable income or loss is accurately reported and taxed at their individual income tax rates.

Understanding S Corporation Distributions

Distributions from an S corporation refer to the cash or property paid out to shareholders. Generally, distributions are not taxed again when received by shareholders, provided they do not exceed the shareholder’s stock basis. Profits are taxed to shareholders when earned by the S corporation, whether or not they are distributed. The stock basis represents a shareholder’s investment in the company, which is adjusted annually by their share of the S corporation’s income, losses, and other items.

The Accumulated Adjustments Account (AAA) tracks cumulative taxable income already passed through and taxed to shareholders but not yet distributed. Distributions are generally tax-free to the extent they come from the AAA and do not exceed the shareholder’s stock basis. If distributions exceed a shareholder’s stock basis, the excess is treated as a capital gain.

Important Tax Rules for S Corporations

Shareholder-employees of an S corporation are required to pay themselves a reasonable salary for services rendered to the business. This salary is subject to federal payroll taxes, including Social Security and Medicare taxes. After the salary is paid, any remaining profits can be distributed to shareholders as pass-through income, which is not subject to these payroll taxes. The IRS scrutinizes S corporations to ensure shareholder-employees are not attempting to avoid payroll taxes by classifying too much compensation as distributions rather than salary.

Shareholder basis is important for S corporation owners. This basis, which includes stock basis and debt basis from direct loans, determines the tax treatment of distributions and the deductibility of losses. Losses passed through from an S corporation can only be deducted by a shareholder up to their total basis. Any losses exceeding this basis are suspended and carried forward until the shareholder’s basis is restored. Shareholders must accurately track their stock and debt basis annually.