What Is the Tax Rate for an S Corp?

An S corporation is a business structure that elects a special tax status with the Internal Revenue Service (IRS). This election allows the entity to pass its income, losses, deductions, and credits directly to its owners, known as shareholders, for federal tax purposes. The primary purpose of this structure is to avoid the “double taxation” that can occur with traditional C corporations.

Understanding S Corporation Tax Status

For federal income tax purposes, the S corporation itself generally does not pay corporate income tax. Instead, the profits and losses of the business are “passed through” directly to the personal income tax returns of its shareholders. This means income is taxed only once, at the individual shareholder level, thereby avoiding the double taxation seen in C corporations.

To facilitate this pass-through taxation, an S corporation is required to file an informational return with the IRS, specifically Form 1120-S, by the 15th day of the third month following the end of its tax year. This form reports the corporation’s income, deductions, and other financial details, but it typically does not result in a tax payment from the entity itself for federal income tax. Instead, it allocates each shareholder’s portion of the business’s performance.

How Shareholders are Taxed

S corporation income and losses are allocated to shareholders based on their ownership percentage. Shareholders then report this allocated income or loss on their personal tax returns, specifically on Schedule K-1. The income is taxed at the shareholder’s individual income tax rates, which can vary based on their total taxable income.

A significant benefit for S corporation shareholders is the Qualified Business Income (QBI) deduction. This deduction allows eligible taxpayers to deduct up to 20% of their qualified business income from a domestic business operated through an S corporation. It is important to note that distributions (dividends) received from an S corporation are generally tax-free to the extent of the shareholder’s basis in the stock, because the income has already been taxed at the individual level. If distributions exceed a shareholder’s stock basis, the excess is typically taxed as capital gains.

Owner Compensation and Payroll

A specific requirement for S corporation owner-employees is that they must pay themselves a “reasonable salary” for services performed for the corporation. This salary is treated as wages and is subject to federal employment taxes, including FICA (Federal Insurance Contributions Act) taxes, which cover Social Security and Medicare. Both the employee and employer portions of FICA taxes apply to this salary.

The requirement for a reasonable salary is important because it prevents owners from reclassifying all their earnings as distributions, which are generally not subject to FICA taxes. The IRS scrutinizes S corporation salaries to ensure they are not artificially low to minimize payroll tax obligations. Any remaining profits after paying the reasonable salary can be distributed to shareholders, and these distributions are typically not subject to FICA taxes, providing a potential tax advantage for owner-employees.

State Tax Considerations

While S corporations generally avoid federal corporate income tax, their tax treatment at the state level can differ significantly. Many states recognize the federal S corporation election and follow the pass-through taxation model, meaning the corporation itself does not pay state corporate income tax, and income flows through to shareholders.

However, some states may impose a state-level corporate income tax on S corporations, or a franchise tax, which is a tax for the privilege of doing business in that state. For instance, some states might levy a tax on the S corporation’s net income, or a minimum annual tax regardless of income. Therefore, it is important for S corporation owners to research and understand the specific tax laws in each state where their business operates.