Is S Corp Income Subject to Self-Employment Tax?

The net income that an S corporation passes through to its shareholders is not subject to self-employment tax. This tax advantage is a primary reason business owners elect S corp status. However, this benefit is entirely dependent on the corporation paying its owner-employees a reasonable salary for the work they perform. This salary is subject to standard payroll taxes.

The S Corp Pass-Through Tax Structure

Self-employment tax is a combination of Social Security and Medicare taxes levied on the net earnings of self-employed individuals, such as sole proprietors. An S corporation fundamentally changes this dynamic for its owners who work in the business. These individuals are considered employees, and the way they receive money is split into two distinct categories: a salary and profit distributions.

The salary paid to an owner-employee is considered wages and is subject to FICA taxes, which cover Social Security and Medicare. Functionally, FICA tax rates are the same as self-employment tax rates; the difference is how they are paid. The S corporation, as the employer, pays half of the FICA taxes, and the employee pays the other half through payroll withholding. This process mirrors that of any non-owner employee.

Any remaining net profit in the S corporation after all expenses, including the owner’s salary, are paid is passed through to the shareholders. These profit distributions are reported to the owner on a Schedule K-1 and are not subject to FICA or self-employment taxes. Shareholders are liable for income tax on these profits. The self-employment tax rate is 15.3%, which consists of a 12.4% Social Security tax that applies to earnings up to an annual limit, and a 2.9% Medicare tax that applies to all earnings.

Additionally, a 0.9% Additional Medicare Tax may apply to earnings over certain thresholds. These thresholds are $250,000 for married joint filers, $125,000 for married separate filers, and $200,000 for all others.

Determining Reasonable Compensation

The IRS requires that S corporation shareholders who provide services to the business must be paid a reasonable salary before any distributions are taken. This rule prevents business owners from avoiding payroll taxes by classifying all their compensation as a distribution. The IRS has the authority to recharacterize distributions as wages if it determines the salary paid is unreasonably low. This action would subject the reclassified amount to back payroll taxes, along with penalties and interest.

Determining what constitutes “reasonable” is not based on a simple formula but on the facts and circumstances of the business. The IRS considers several factors when evaluating salary levels. These include the owner’s specific duties and responsibilities, the amount of time and effort dedicated to the business, and the individual’s level of training and experience.

To establish a defensible salary, a business should look at what comparable businesses pay for similar services. This involves researching market data for positions with equivalent roles and responsibilities in the same geographic area. Documenting this research is a good practice. Other factors the IRS may review include the company’s overall financial condition and its history of paying salaries to owners.

The risk of an IRS challenge is highest for S corporations that pay no salary at all to an active owner-employee or pay a token amount that is not aligned with the value of their services. For example, if an owner is the primary generator of revenue and manages all operations but takes only a $10,000 salary while receiving $200,000 in distributions, the IRS would likely deem this unreasonable.

Tax Reporting for S Corp Owner-Employees

The two streams of income an owner-employee receives from an S corporation are reported on separate tax forms. The salary component is handled like any other employee’s wages. The corporation issues a Form W-2 to the owner-employee, detailing their gross wages and the amount of income and FICA taxes withheld. This W-2 income is then reported on the owner’s personal tax return, Form 1040.

The profit distribution component follows a different path. The S corporation first reports its total financial activity for the year on Form 1120-S, U.S. Income Tax Return for an S Corporation. From this return, the corporation prepares a Schedule K-1 for each shareholder.

The shareholder receives their copy of the Schedule K-1 and uses the information to complete their personal tax return. The income shown on the K-1 is reported on Schedule E (Supplemental Income and Loss) of the Form 1040. This income is then combined with other income on the 1040 to determine the owner’s total income tax liability.