How Much Do S Corporations Pay in Taxes?

An S Corporation is a business structure that has elected a special tax status with the Internal Revenue Service (IRS). This election allows the entity to avoid federal income taxes at the corporate level. Businesses often choose this classification to combine the legal benefits of incorporation, such as limited liability protection for owners, with specific tax advantages. This structure simplifies the tax burden compared to a traditional C Corporation, which faces corporate income tax on its profits before distributing earnings to shareholders. S Corporations are a common choice for smaller businesses and closely held companies across the United States.

The Pass-Through Taxation Model

A defining characteristic of an S Corporation is its pass-through taxation model. An S Corporation generally does not pay federal income tax at the entity level. Instead, the corporation’s income, losses, deductions, and credits are passed through directly to its shareholders. These amounts are then reported on the shareholders’ individual income tax returns.

This structure eliminates “double taxation,” where corporate profits are taxed once at the corporate level and again when distributed to shareholders as dividends. Shareholders report their share of the S Corporation’s financial results regardless of whether the income is distributed to them. The flow of income and losses from the S Corporation to its shareholders is proportional to their ownership percentage in the company. For example, if an S Corporation has $100,000 in net income and a shareholder owns 30% of the company, that shareholder will report $30,000 of income on their personal tax return. This pass-through mechanism applies to both profits and losses, allowing shareholders to potentially deduct their share of the company’s losses on their individual returns, subject to certain limitations.

Taxation of S Corporation Shareholder Income

Shareholders of an S Corporation report their share of the company’s income or loss on their personal federal income tax return, Form 1040. The S Corporation provides each shareholder with a Schedule K-1, detailing their proportionate share of the company’s income and other items. This information is used by the shareholder to complete their individual tax filings.

The income passed through from an S Corporation increases a shareholder’s adjusted gross income (AGI) and is taxed at their individual income tax rates. Shareholders track their basis in the S Corporation stock, which is their initial investment plus contributions and their share of corporate income, minus distributions and losses. A shareholder’s ability to deduct losses passed through from the S Corporation is limited to their stock basis and any direct loans made to the corporation.

Distributions received from the S Corporation reduce a shareholder’s basis. These distributions are generally tax-free to the extent of a shareholder’s stock basis. Amounts distributed in excess of basis are treated as capital gains. Some S Corporation income may also qualify for the Qualified Business Income (QBI) deduction under Internal Revenue Code Section 199A. This deduction allows eligible taxpayers to deduct up to 20% of their qualified business income, subject to limitations.

Shareholder Compensation and Distributions

S Corporation taxation involves the distinction between shareholder compensation (salary) and distributions of profits. This is important for shareholder-employees, individuals who both own shares and work for the S Corporation. The IRS requires that shareholder-employees receive “reasonable compensation” for services rendered. This compensation is treated as wages and is subject to federal income tax withholding and payroll taxes, including Social Security and Medicare taxes.

Remaining profits, after paying reasonable compensation and other expenses, can be distributed to shareholders as dividends. These distributions are generally not subject to self-employment taxes (Social Security and Medicare taxes) because the shareholder’s compensation has already been taxed. The IRS closely scrutinizes the reasonableness of compensation paid to shareholder-employees.

If the IRS determines that compensation is unreasonably low, they can reclassify a portion of distributions as wages, subjecting those amounts to payroll taxes, including penalties and interest.

Other Taxes Applicable to S Corporations

While S Corporations generally avoid federal income tax at the entity level, they are responsible for various other taxes. Payroll taxes are a significant obligation. The S Corporation must withhold and pay FICA taxes, which include Social Security and Medicare, on all employee wages, including the reasonable salary paid to shareholder-employees. The corporation is responsible for both the employer’s and employee’s share of these taxes, remitting them to the IRS. Unemployment taxes, such as the Federal Unemployment Tax Act (FUTA) tax, are also levied on employee wages and must be paid by the S Corporation.

State income taxes represent another layer of taxation for S Corporations. Many states largely conform to the federal pass-through treatment, but some states may impose an entity-level income tax or a franchise tax on S Corporations. These state-specific taxes vary widely, with some states assessing a flat fee, others a percentage of income, and some a tax based on factors like net worth or capital.

In specific circumstances, an S Corporation may also be subject to federal income taxes at the corporate level. The Built-in Gains Tax, under Section 1374, applies if a C Corporation converts to an S Corporation and then sells appreciated assets within a recognition period. The Passive Investment Income Tax, under Section 1375, may apply if an S Corporation has accumulated earnings and profits from prior C Corporation years and its passive investment income exceeds 25% of its gross receipts. S Corporations are also subject to common business taxes like sales tax and property taxes.

S Corporation Tax Reporting

The primary tax document for an S Corporation is Form 1120-S, U.S. Income Tax Return for an S Corporation. This form is an informational return that details the corporation’s income, deductions, gains, and losses for the tax year. It is not used to calculate a corporate income tax liability, but rather to report the financial activities that will pass through to the shareholders. The S Corporation must file Form 1120-S by March 15 following the close of the calendar tax year.

The S Corporation then issues a Schedule K-1 to each shareholder. This document reports each shareholder’s share of the S Corporation’s income, losses, deductions, and credits. Shareholders use this information to prepare their individual federal income tax returns, Form 1040.

Shareholders of an S Corporation are generally responsible for making estimated tax payments throughout the year to cover their individual tax liability on the pass-through income. This is because income is passed through to them as it is earned by the corporation, and there is no corporate-level tax withholding on this income. These estimated payments help shareholders avoid underpayment penalties at year-end. The corporation also has obligations for payroll tax reporting, including filing Form 941, Employer’s Quarterly Federal Tax Return, and Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return.