How S Corporations Are Taxed: A Breakdown for Shareholders

An S corporation is a tax election for eligible businesses, allowing a distinct tax treatment compared to traditional corporations. This election signifies the business entity will not be subject to federal income tax at the corporate level. Instead, the company’s income, losses, deductions, and credits are passed through directly to its owners. This approach avoids the “double taxation” of a C corporation, where profits are taxed at the corporate level and again when distributed to shareholders as dividends.

Understanding an S corporation’s tax structure reveals how it impacts shareholder financial responsibilities. Its pass-through nature means that while the entity files a tax return, the tax burden or benefit rests with individual owners. This article details how S corporations are taxed, covering pass-through taxation, shareholder reporting, and compliance obligations.

Understanding S Corporation Pass-Through Taxation

S corporations operate under “pass-through taxation,” meaning the company’s financial results flow directly to its owners. The business itself generally does not pay federal income tax on its profits. Instead, income, losses, deductions, and credits are passed through to the shareholders.

Shareholders then report these items on their personal tax returns, where they are taxed at their individual income tax rates. An S corporation acts primarily as an informational reporting entity, providing details of its financial performance to the IRS and its shareholders.

While the S corporation files its own tax return, Form 1120-S, this form reports the business’s financial activities and allocates those figures among its shareholders, rather than calculating a corporate tax liability. This ensures business income is taxed only once, at the shareholder level, aligning the tax treatment more closely with that of a partnership or sole proprietorship. The individual shareholder’s tax rate determines the tax paid on their share of the S corporation’s income.

Shareholder Tax Reporting

Individual shareholders of an S corporation report their share of the company’s income, losses, deductions, and credits on their personal tax returns. This process uses Schedule K-1 (Form 1120-S), provided by the S corporation to each shareholder. Schedule K-1 details the shareholder’s portion of the S corporation’s financial items, including ordinary business income, rental income, interest, dividends, and capital gains. Shareholders use Schedule K-1 information to complete their individual Form 1040. Income passed through from an S corporation is generally not considered self-employment income, so it is not subject to self-employment taxes for the shareholder.

Shareholder basis represents a shareholder’s investment in the S corporation and is adjusted annually based on operations and distributions. Basis increases with income items and capital contributions, and decreases with distributions, non-deductible expenses, and loss items. Shareholder basis limits the amount of S corporation losses a shareholder can deduct on their personal tax return. Losses can only be deducted up to the shareholder’s basis in their stock and any direct loans to the corporation. Any losses exceeding this basis are suspended and carried forward to future tax years, deductible when sufficient basis is re-established.

Distributions from an S corporation to its shareholders are typically tax-free to the extent of the shareholder’s basis and the company’s Accumulated Adjustments Account (AAA). The AAA tracks the corporation’s undistributed earnings already taxed at the shareholder level. Distributions exceeding the AAA, particularly if the S corporation has accumulated earnings and profits from a prior C corporation history, may be treated as taxable dividends or capital gains.

S Corporation Filing and Compliance

While S corporations avoid federal income tax at the entity level, they are still subject to filing and compliance requirements. The S corporation must file an annual informational tax return, Form 1120-S, U.S. Income Tax Return for an S Corporation, with the IRS. This form reports the company’s income, gains, losses, deductions, and credits for the tax year and is due by the 15th day of the third month following the close of its tax year, typically March 15 for calendar-year filers.

A compliance requirement for S corporations with shareholder-employees is the payment of “reasonable compensation.” If a shareholder performs services for the corporation, they must receive a salary comparable to what an unrelated party would be paid for similar services. This salary is subject to federal payroll taxes, including Social Security and Medicare taxes (FICA), split between the employer and employee. The IRS scrutinizes reasonable compensation to prevent shareholder-employees from reclassifying salary as tax-free distributions to avoid payroll taxes. Failure to pay reasonable compensation can lead to the IRS recharacterizing distributions as wages, resulting in penalties and interest.

Beyond federal obligations, S corporations must also navigate state tax requirements. Many states recognize the S corporation election and follow the federal pass-through taxation model, but some states may impose entity-level taxes. These can include state income taxes, franchise taxes, or other fees. Franchise taxes are often levied for the privilege of doing business in a particular state and may be based on factors like net worth, asset value, or gross receipts.

Maintaining accurate accounting records is a compliance step for S corporations. Proper record-keeping is essential for accurately preparing Form 1120-S and generating Schedule K-1s for each shareholder. These records substantiate the financial figures reported and ensure the S corporation adheres to tax regulations.