How Exactly Is an S Corporation Taxed?

An S corporation is a tax election for certain small businesses, combining the legal benefits of a corporation, like limited liability, with a distinct taxation method. Its primary characteristic is “pass-through” taxation. For federal income tax purposes, the business itself generally avoids paying income tax directly. Instead, profits and losses pass through to the owners’ personal tax returns, simplifying the tax process compared to other corporate structures.

The Pass-Through Taxation Model

The pass-through taxation model defines S corporations, distinguishing them from traditional C corporations. An S corporation generally does not pay federal income taxes at the corporate level. Instead, its income, losses, deductions, and credits pass directly to the shareholders. Each shareholder reports their proportionate share of these items on their individual income tax return, Form 1040.

This structure helps S corporations avoid the “double taxation” C corporations face. A C corporation pays tax on its profits, and then shareholders pay a second tax on dividends. For an S corporation, profits are taxed only once, at the shareholder level, whether distributed as cash or retained by the business.

Profits and losses are allocated to shareholders based on their ownership percentage. For instance, a 30% owner receives 30% of the net income or loss. Shareholders pay taxes on their share of the S corporation’s income, even without a cash distribution. This income is generally not considered self-employment income, so it is not subject to self-employment tax.

Shareholder-employees of S corporations must receive a “reasonable salary.” The Internal Revenue Service (IRS) requires this salary for services performed, and it is subject to payroll taxes. This prevents shareholders from recharacterizing salary as tax-free distributions to avoid employment taxes. Remaining profits, after salary and expenses, can be distributed as non-wage distributions, which are not subject to employment taxes.

Understanding S Corporation Income and Deductions

S corporations report financial activities by distinguishing between ordinary business income or loss and separately stated items. Ordinary business income or loss represents the net profit or deficit from the S corporation’s primary operations, calculated after deducting regular business expenses such as salaries, rent, and utilities. This net figure then passes through to shareholders and is reported on their personal tax returns.

Certain items, however, are not included in ordinary business income or loss and must be reported separately to shareholders. These “separately stated items” retain their character as they pass through, allowing shareholders to apply specific tax rules or limitations at their individual level. This separate reporting is necessary because these items may be subject to different tax treatments or limitations on a shareholder’s personal tax return.

Common separately stated items include:
Capital gains and losses
Section 1231 gains and losses
Charitable contributions
Interest income
Dividend income
Passive activity income or losses
Foreign taxes
Section 179 expense deductions
Qualified Business Income (QBI) deduction components

This distinction ensures shareholders can correctly apply their individual tax situations to these specific types of income or deductions.

Shareholder Basis in S Corporations

Shareholder basis in an S corporation represents an owner’s investment in the company for tax purposes. This basis is initially established through cash contributions, property contributions, or the cost of purchasing the stock. It serves as an important figure for several tax calculations, including the deductibility of losses and the taxability of distributions received from the S corporation.

The basis is not static; it undergoes annual adjustments based on the S corporation’s activities and the shareholder’s transactions with the entity. The basis increases from the shareholder’s share of S corporation income, including both ordinary business income and separately stated income items, as well as any additional capital contributions made to the corporation. Conversely, the basis decreases due to the shareholder’s share of S corporation losses and deductions, non-taxable distributions received, and non-deductible expenses paid by the corporation.

The importance of tracking shareholder basis lies in its role as a limitation on deducting losses and determining the tax treatment of distributions. Shareholders can only deduct their share of the S corporation’s losses up to their basis in stock and any direct loans they have made to the corporation (debt basis). Any losses exceeding this basis are suspended and carried forward indefinitely until the shareholder has sufficient basis to utilize them in a future tax year.

Furthermore, distributions from an S corporation are generally treated as tax-free to the extent of a shareholder’s basis. If distributions exceed a shareholder’s basis, the excess amount is typically treated as a capital gain, which is a taxable event. This mechanism prevents the tax-free withdrawal of capital that has not yet been taxed or invested. The concept of “debt basis” is also relevant; if a shareholder personally loans money to the S corporation, this loan increases their basis for purposes of deducting losses, similar to stock basis.

S Corporation Tax Filings

The administrative implementation of S corporation taxation involves specific tax forms and reporting requirements for both the corporation and its shareholders. The S corporation itself files Form 1120-S, “U.S. Income Tax Return for an S Corporation,” with the IRS. This form serves as an information return, reporting the corporation’s income, deductions, gains, and losses for the tax year. Although it details the company’s financial performance, the S corporation generally does not pay federal income tax with this filing.

A central component of the S corporation’s tax filing is the Schedule K-1 (Form 1120-S), “Shareholder’s Share of Income, Deductions, Credits, etc.” The S corporation prepares and issues a Schedule K-1 to each shareholder, and also files a copy with the IRS. This document is essential as it reports each shareholder’s precise share of the S corporation’s ordinary business income or loss, along with all separately stated items.

Shareholders then use the information provided on their Schedule K-1 to complete their individual income tax returns, Form 1040. The amounts reported on the Schedule K-1 are entered on the shareholder’s personal tax return, where they are subject to the individual’s applicable tax rates and limitations. For calendar-year S corporations, Form 1120-S and the accompanying Schedule K-1s are typically due by March 15th for the preceding tax year. Corporations can request a six-month extension for filing Form 1120-S by submitting Form 7004.