How Does an S Corporation Save Taxes?

An S corporation, often referred to as an S corp, is a business structure offering a distinct approach to federal income taxation. It allows a business to operate with the advantages of incorporation, such as limited liability protection for its owners, while potentially reducing the overall tax burden. The primary appeal of electing S corporation status lies in its ability to bypass certain federal corporate-level income taxes, providing significant tax savings for eligible small businesses.

Eligibility Requirements for S Corporation Status

To qualify for S corporation status, a business must meet specific criteria established by the Internal Revenue Service (IRS). The entity must be a domestic corporation and have no more than 100 shareholders. Shareholders must be individuals, certain trusts, or estates; partnerships, corporations, and non-resident aliens are not permitted to be shareholders. An S corporation can only have one class of stock, although differences in voting rights are allowed. Once these requirements are met, a corporation elects S corporation status by filing Form 2553, Election by a Small Business Corporation, with the IRS.

Understanding Pass-Through Taxation

A defining characteristic of an S corporation is its pass-through taxation; the business itself typically does not pay federal income tax. Instead, the corporation’s income, losses, deductions, and credits are passed through directly to the owners’ personal income tax returns, where shareholders report their share of these items and are assessed tax at their individual income tax rates.

This structure avoids the double taxation that applies to C corporations, where profits are taxed at the corporate level and again when distributed to shareholders as dividends. Even if profits are not distributed, owners are still liable for income tax on their share of the S corporation’s earnings. The S corporation provides an informational return, Form 1120-S, to report its financial activities and the allocated shares to each owner.

Owner Compensation and Distributions

A key tax advantage for S corporation owners arises from the distinction between owner compensation and distributions. Owners who actively provide services to the S corporation must pay themselves a “reasonable salary” for those services. This salary is subject to all applicable payroll taxes, including Social Security and Medicare taxes.

After paying a reasonable salary, any remaining profits can be distributed to the owner as a shareholder distribution. These distributions are not subject to self-employment taxes (Social Security and Medicare), which can lead to substantial tax savings compared to a sole proprietorship or partnership where all net income is subject to self-employment tax.

The IRS scrutinizes the “reasonable salary” rule to prevent owners from minimizing their salary to avoid payroll taxes, potentially reclassifying distributions as wages if the salary is deemed too low. Factors considered when determining a reasonable salary include the owner’s training, experience, duties, responsibilities, time devoted to the business, and what comparable businesses pay for similar services.

Key Tax Reporting Requirements

S corporations and their shareholders have specific tax reporting obligations. The S corporation must file Form 1120-S, U.S. Income Tax Return for an S Corporation, annually. This form serves as an informational return, detailing the corporation’s income, losses, deductions, and credits, which are then passed through to the shareholders.

Attached to Form 1120-S is Schedule K-1 (Form 1120-S). The S corporation prepares a Schedule K-1 for each shareholder, reporting their specific share of the corporation’s income, deductions, credits, and other financial items. Shareholders use the information from their Schedule K-1 to report their portion of the S corporation’s income or loss on their personal income tax return, Form 1040, typically on Schedule E (Supplemental Income and Loss). The owner’s reasonable salary is reported separately on a Form W-2.