Do S corporations pay taxes? S Corporations do not pay federal corporate tax. However, If the S corporation has employees or shareholder employees, it must withhold and pay payroll taxes. Shareholders of S corporations pay income tax and inactive shareholders may qualify for Net Investment Income. At the state level, depending on laws of the state and the structure of the business, the S corporation may be required to pay state corporate tax, franchise tax, workers' compensation insurance and unemployment insurance.

Many small business owners decide to be taxed as an S Corporation primarily to avoid paying federal corporate tax. This tax, which chops about 21 percent off a corporation's profits, can eat big into the amount each shareholder will eventually take home as a dividend. However, the S corporation and its owners are still subject to a number of taxes as summarized below.

Federal Taxes on S Corporations

S corporations are seen as pass-through entities by the federal government and therefore do not pay corporate tax. However, they file information returns to the IRS using Form 1120S.

  • Income Tax
    The shareholders of an S corporation are subject to personal income tax on income obtained from their share of the corporation's earnings. They must file returns using Schedule K-1 on IRS Form 1040 by March 15. The top rate for federal personal income tax is 37 percent. The top marginal rates for dormant shareholders are likely to be higher than those of active ones.
  • Medicare and Social Security(FICA) Taxes
    Shareholders of S corporations don't pay self-employment tax. However, If the shareholders also work for the business, they are subject to Social Security and Medicare taxes and it is the responsibility of the S corporation to file these. Unlike corporations that must file payroll taxes every quarter, S corporations are only required to pay once a year.
    Both the S corporation and the employee contribute to Medicare and Social Security taxes. For the typical employee, the total amount for both taxes is the equivalent of 15.3 percent of the wages. Shareholders would naturally try to avoid these taxes by having their salaries paid as earnings, which don't qualify for payroll taxes. So the IRS requires all S corporation employee-shareholders to receive a salary that is similar to other such employees in the industry.
  • Net Investment Income Tax
    S corporation shareholders who are not employed by the business do not pay FICA taxes. But they might qualify for the Net Investment Income Tax established by the Affordable Care Act. Dormant shareholders whose income exceeds $200,000 if they file individually or $250,000 if they file jointly with a spouse must pay this tax.

State Taxes on S Corporations

States have different approaches when taxing S corporations. Some treat the corporation the same way the IRS does and only charge income tax. Some states, in addition to income tax on the shareholders, tax the S corporation itself. The taxes are normally charged on the income the corporation obtained from the state. States levy a number of taxes on corporations, including the following:

  • State Sales and Excise Taxes
    S corporations involved in selling goods or services are subject to state sales taxes. S corporations in the manufacturing industry might be required to pay excise taxes.
  • Franchise Tax
    A number of states require S corporations to pay annual franchise taxes or gross-receipts tax. Some states even levy corporate tax on S corporations.
  • Unemployment and Workers' Compensation Insurance
    These taxes are standard requirements in many states for all S corporations that have employees.
  • Personal Income Tax
    Most states levy income tax on the dividends of S corporation shareholders. Personal Income tax rates for S corporation shareholders vary by state and might even vary depending on the location of the business within the state. These taxes are as high as 13.3 percent in some states.

Although they do not pay federal corporate tax, S corporations pay most of the other taxes that C corporations pay.  S corporations must withhold and forward payroll taxes if they have employees. In many states, S corporations also pay an annual franchise tax. The shareholders of S corporations pay federal and state income taxes at rates that are similar to taxpayers in the other entities. 

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