The Fundamentals of S Corp Taxation

An S corporation is a federal tax election available to eligible business entities. It is not a distinct legal structure but a designation under Subchapter S of the Internal Revenue Code. This election alters how a business is taxed, allowing its profits and losses to be “passed through” directly to the owners’ personal tax returns. This approach avoids income tax at the corporate level, making it an appealing choice for many small businesses.

The S corp status is available to both traditional corporations and limited liability companies (LLCs) that meet the specific criteria set by the IRS. For an LLC, this involves electing to be treated as a corporation for tax purposes, a choice that can be made along with the S corp election itself.

Core Principles of S Corp Taxation

Unlike traditional C corporations, an S corp itself generally does not pay federal income tax. Instead, the financial results of the business—including all income, deductions, and credits—flow directly to the shareholders. The business calculates its net income or loss for the year and reports this information to the IRS on Form 1120-S, the U.S. Income Tax Return for an S Corporation.

From this return, the total financial activity is divided among the shareholders based on their percentage of ownership. Each shareholder then receives a Schedule K-1, which details their specific share of the income, losses, and other tax items.

Shareholders use the information from their Schedule K-1 to report the business’s financial results on their personal tax returns, typically on Schedule E of Form 1040. The income is then taxed at their individual income tax rates. This single layer of taxation stands in contrast to the “double taxation” of C corporations, where profits are taxed first at the corporate level and then again at the individual level when distributed as dividends. In certain circumstances, such as when a former C corporation holds appreciated assets or has excessive passive income, an S corp may be subject to specific corporate-level taxes.

S Corporation Eligibility Requirements

To qualify for S corporation tax status, a business must satisfy a set of requirements established by the IRS. The entity must be a domestic corporation, meaning it is created or organized in the United States.

An S corp can have no more than 100 shareholders. Allowable shareholders include individuals, certain trusts, and estates. Partnerships, corporations, and non-resident alien shareholders are explicitly prohibited from owning stock in an S corporation.

An S corporation may only have one class of stock. This means that all shares of stock must have identical rights to distribution and liquidation proceeds. While differences in voting rights are permitted, the economic rights of all shareholders must be the same.

Making the S Corporation Election

The process of becoming an S corporation involves a formal election with the IRS using Form 2553, Election by a Small Business Corporation. Before completing the form, the business must have its Employer Identification Number (EIN), the date of its incorporation, and the names and addresses of all shareholders. The form also requires the business to select its tax year, which must be a calendar year unless a specific business purpose for a fiscal year can be established.

Part I of the form requires the consent of all shareholders, meaning every person who owns stock on the day of the election must sign and date the form, indicating their number of shares and the date they were acquired.

To be effective for the current tax year, Form 2553 must be filed no more than two months and 15 days after the beginning of that tax year. For a new corporation using a calendar year, this deadline is March 15. Alternatively, the election can be made at any time during the preceding tax year. Should a business miss this deadline, the IRS provides procedures for late election relief, which may grant S corp status if the business can show reasonable cause for the late filing.

Shareholder Compensation and Distributions

Operating as an S corporation involves distinguishing between paying shareholder-employees a salary and distributing company profits. The IRS requires that any shareholder who provides more than minor services to the corporation must be paid a reasonable salary. Reasonable compensation is defined as the amount that a similar business would pay for the same or similar services.

This salary is treated as wages and is reported on a Form W-2. As such, it is subject to federal income tax withholding as well as FICA taxes, which cover Social Security and Medicare. The corporation is responsible for paying the employer’s share of these payroll taxes, and the employee-shareholder pays their portion.

In contrast to salaries, distributions are withdrawals of the corporation’s accumulated profits. These payments are allocated to shareholders based on their percentage of ownership. A tax advantage of the S corp structure is that these distributions are not subject to FICA taxes. This separation of salary and distributions allows for potential tax savings on the portion of earnings taken as profit distributions rather than wages.

Calculating Shareholder Basis

A shareholder’s basis is their financial investment in the S corporation for tax purposes. This figure is crucial for determining the tax consequences of distributions and the deductibility of losses. The initial basis is established when the shareholder first acquires stock, typically equal to the amount of cash contributed or the adjusted basis of any property transferred to the corporation in exchange for the stock.

This basis is not static; it must be adjusted annually. A shareholder’s basis increases by their pro-rata share of the corporation’s income and gains, as reported on their Schedule K-1. It also increases for any additional capital contributions made during the year. Conversely, the basis is decreased by the amount of any distributions received from the corporation and by the shareholder’s pro-rata share of any corporate losses or deductions.

Tracking basis is important for two primary reasons. First, it determines whether distributions are received tax-free. Distributions are generally not taxed as long as they do not exceed the shareholder’s adjusted basis. Second, it limits the amount of S corporation losses a shareholder can deduct. Losses can only be deducted up to the shareholder’s basis in their stock and any loans they have made to the corporation. Once a shareholder’s stock basis is reduced to zero, their debt basis can absorb additional losses before any remaining losses are suspended and carried forward to future years.