Does An S Corp Pay Taxes: Everything You Need to Know
Does an S Corp pay taxes is a common question for business owners who want to incorporate their business and further elect to be taxed as an S Corp. 3 min read
Does an S Corp Pay Taxes
Does an S Corp pay taxes is a common question for business owners who want to incorporate their business and further elect to be taxed as an S Corp. An S Corp is taxed differently from C Corporations, as the S Corp avoids double-taxation. The S Corp doesn’t pay corporate income tax. Instead, the business passes through its profits to the shareholders who must report a portion of the profits on their personal tax return (Form 1040). Keep in mind that the S Corp can have only 100 shareholders at most, all of who must be U.S. citizens; the shareholders cannot be businesses.
How the S Corp Pays Taxes
As previously mentioned, the S Corp passes its profits, losses, credits, and deductions to its shareholders who report it on their personal tax returns. Therefore, the S Corp doesn’t pay federal income taxes. However, this is really the only difference between the S and C Corp.
While the S Corp doesn’t pay corporate tax, it still must file IRS Form 1120S, which will include the share of profits and losses for each shareholder. Thereafter, the information will be identified on Schedule K-1 for each shareholder. This form will then be given to the shareholder so that he or she knows what to report on their tax return (Form 1040- Line 17).
How Owners Are Taxed
The owners of the S Corp will be taxed based on their percentage of ownership in shares. For example, if the S Corp has profits of $500,000 and there are 4 shareholders, then each shareholder will pay $100,000 in profits. Generally, all shareholders must pay two types of income – wage income and a profit distribution.
The wage income is subject to payroll tax. Any shareholder/employee of the S Corp must be paid a reasonable compensation, which is determined by considering several factors that most courts look at when deciding if the salary is sufficient.
The profit distribution is not taxed. This means that the dividends are paid out tax-free. Because of this, shareholder/employees would rather be paid in dividends and not wages, so to reduce their tax liability.
Since there is a large incentive to pay higher dividends and less compensation, the IRS closely monitors how much compensation each shareholder/employee pays him or herself. Also, keep in mind that the IRS could subsequently determine that you are not paying yourself a reasonable salary and therefore, re-allocate your dividends into wages making you pay taxes on it.
You will have to pay Social Security and Medicare taxes on the compensation you earn from the S Corp. However, a benefit of the S Corp is the fact that you don’t have to pay self-employment taxes on the wages you earn from the business or the dividends paid out.
Determining Reasonable Compensation
In order to determine what constitutes a reasonable salary, there are several factors that should be taken into account, including the following:
• The type of work conducted by the shareholder/employee
• The level of education
• Number of years of professional experience
• Amount of time dedicated to working for the S Corp
• Amount of dividends that the shareholder/employee receives from the business
• What other non-shareholder employees make for similar services
• What other professionals make for other businesses in the same industry
The S Corp will likely pay other types of taxes, including withholding taxes, employment taxes on wages paid to employees, paying FICA taxes for the Social Security and Medicare taxes that will be jointly paid by you and the employee, workers compensation taxes, and unemployment taxes. If the S Corp owns property, then the company will need to pay property taxes.
Furthermore, the S Corp might also need to pay state sales tax and excise tax. Some states charge state income taxes, franchise taxes, gross receipt taxes, and other state-related fees depending on the industry in which you operate. Be sure to visit your State’s Secretary of State website to determine what state and local fees are due for your business.
If you need help learning more about S Corporation taxes, or if you need assistance filing state or federal taxes for your S Corp, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5-percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law, and average 14 years of legal experience, including work with, or on behalf of companies like Google, Menlo Ventures, and Airbnb.