How to Calculate S Corp Taxes for Your Business

An S corporation is a business structure that offers certain tax advantages, particularly for small businesses. It allows a business to pass its income, losses, deductions, and credits directly to its shareholders. This structure is a popular choice for many entrepreneurs because it simplifies how their business earnings are taxed.

Understanding Pass-Through Taxation for S Corporations

S corporations operate under a “pass-through” taxation model. This means the business itself generally does not pay federal income tax; instead, profits and losses are passed directly to the owners’ personal income tax returns. This avoids the “double taxation” scenario faced by C corporations, where the corporation pays tax on its profits, and shareholders pay tax again on dividends received.

An S corporation is still required to file an informational return with the IRS. This return details the business’s financial performance, including its income, deductions, losses, and other tax items. The information from this return determines each owner’s share of these items.

Income and losses are allocated to shareholders in proportion to their ownership percentage. For instance, a 40% shareholder will be allocated 40% of the ordinary business income or loss and 40% of any separately stated items. Shareholders are responsible for paying tax on their share of the S corporation’s income, even if the money is not distributed.

Determining S Corporation Income and Deductions

S corporations generate various types of income. This includes gross receipts from sales of goods or services, interest income, dividends from other companies, and capital gains from asset sales.

The S corporation can deduct many ordinary and necessary business expenses to reduce its taxable income. Common deductible expenses include salaries, rent, utilities, supplies, depreciation on business assets, and advertising expenses are also generally deductible.

A distinction exists between “ordinary business income or loss” and “separately stated items.” Ordinary business income or loss represents the net profit or loss from the S corporation’s regular operations after deducting typical business expenses. Separately stated items, on the other hand, are specific types of income, deductions, or credits that retain their character when passed through to shareholders.

Examples of separately stated items include capital gains or losses, Section 179 depreciation deductions, and charitable contributions. These items are reported separately because they may be subject to different tax rules or limitations on a shareholder’s individual tax return. For example, capital gains are taxed at different rates than ordinary income, and charitable contributions are subject to individual deduction limits.

Calculating Shareholder Taxable Income

The specific impact on a shareholder’s taxable income depends on several factors, including their salary, distributions received, and their basis in the S corporation stock.

S corporation owner-employees must pay themselves a “reasonable salary.” The IRS requires shareholder-employees to receive compensation comparable to what other businesses would pay for similar services. This salary is subject to federal payroll taxes, including Social Security and Medicare taxes, known as FICA taxes.

The FICA tax rate is currently 15.3%, split between employee and employer portions. The S corporation withholds the employee’s share from the salary and pays both portions to the IRS. This salary is reported to the shareholder on a Form W-2, Wage and Tax Statement.

Any additional profits beyond the reasonable salary can be taken as distributions. These distributions are generally tax-free to the extent of the shareholder’s basis in their S corporation stock. If distributions exceed the shareholder’s stock basis, the excess is typically taxed as a capital gain.

Calculating and tracking shareholder basis is an ongoing and important process. Initial basis is generally the cash or adjusted property basis contributed to the S corporation, or the cost of stock purchased. This basis is adjusted annually, increasing with additional capital contributions and the shareholder’s share of S corporation income.

Conversely, shareholder basis decreases by the shareholder’s share of S corporation losses, non-deductible expenses, and distributions received. Maintaining an accurate record of shareholder basis is essential because it determines the taxability of distributions and the amount of S corporation losses a shareholder can deduct on their personal tax return. Losses exceeding basis cannot be deducted in the current year but can be carried forward.

Reporting S Corporation Taxes

The S corporation files Form 1120-S, U.S. Income Tax Return for an S Corporation, with the IRS. This form reports the corporation’s income, deductions, gains, and losses for the tax year.

From the information reported on Form 1120-S, the S corporation generates a Schedule K-1 (Form 1120-S), Shareholder’s Share of Income, Deductions, Credits, etc., for each shareholder. This Schedule K-1 is a crucial document that provides each shareholder with their specific pro rata share of the S corporation’s ordinary business income or loss, separately stated items, and distributions received. Shareholders use this form when preparing their personal tax returns.

Shareholders use the information from their Schedule K-1 to report their share of the S corporation’s income or loss on their personal income tax return, Form 1040. Specifically, the S corporation’s ordinary business income or loss and certain separately stated items are typically reported on Schedule E (Form 1040), Supplemental Income and Loss. This schedule aggregates income and losses from various pass-through entities, including S corporations.

The net income or loss from Schedule E flows to the shareholder’s Form 1040, impacting their overall taxable income. Shareholders may also need to make estimated tax payments throughout the year using Form 1040-ES if they expect to owe at least $1,000 in tax. These estimated payments help cover the tax liability from S corporation income, as it is not subject to traditional payroll withholding at the corporate level.