How S corporations are taxed revolves around strict eligibility guidelines, such as having less than 100 shareholders, all of whom must be U.S. citizens and cannot be other businesses. In S corporations, income is "passed through" to the owners, who are responsible for paying taxes on that income. 

S Corporation Taxation

Corporations in the U.S. have the option to be taxed at the shareholder or corporate level. An S corporation still calculates its taxable income and files its own corporate tax return and the taxable income, deductions, and tax credits are distributed among the shareholders. 

Like other pass-through businesses, S corporations are subject to similar marginal tax rates as individual wage earners. Tax liabilities vary between owners based on how active they are in the business itself. Someone who participates in the day-to-day activities is considered an active shareholder while passive shareholders do not participate. 

Active shareholders are typically allotted two income types: profit distribution and wage income. Wage income is subject to the payroll tax and the profit distribution is not. Passive shareholders are not required to pay payroll taxes on income since they don't take a salary from the business. 

Characteristics of S Corporations

S corporations pass along the business' income, deductions, losses, and credits to their shareholders for tax purposes. The income and losses show up on shareholders' federal tax forms and they are assessed at individual income tax rates. This is how S corporations avoid double taxation

S corporations are also responsible for paying taxes at the entity level with a particular set of built-in gains and passive income. 

Taxation at the Corporate Level 

Although income and losses are passed through to shareholders, S corporations are required to pay a variety of taxes at the corporate level.

Two examples are:

  • Excessive net passive income tax: passive income taxed at a corporate level which includes income from sources like dividends, annuities, rent, and interest. If passive income exceeds more than 25% of the gross receipts, the S corporation will be required to pay the excess net passive income tax.
  • LIFO recapture tax: This tax applies if the corporation adopted the LIFO inventory method ("last in, first out") during its last tax year as a C corporation, or transferred LIFO inventory to the company in a non-recognition transaction where assets were transferred basis property.

LIFO recapture and excessive net passive income taxes only apply if an S corporation was once a taxable C corporation or if it underwent a tax-free reorganization with a C corporation. 

S corporations are only required to file and pay income taxes once a year versus C corporations that do it quarterly. However, you'll be subject to payroll taxes more often if you have employees. Also, shareholders may be required to pay quarterly estimated taxes if you don't receive a regular salary, or insufficient funds are being withheld from your check.

Businesses who opt for S corporation status can claim some income as a salary and the rest as a distribution. Although you're still liable for self-employment taxes for the salary portion, you only pay regular income taxes on the distribution. By converting to an S corporation, you may see good savings on self-employment taxes depending on how income is divided.

Self-Employment Taxes 

You're responsible for Medicare and Social Security taxes no matter whether you're self-employed or an employee. As an employee, you're only responsible for a portion of those taxes and your employer pays the remainder. Self-employed persons will pay both portions of the taxes. 

S corporation tax filing means shareholders don't pay self-employment taxes on their individual share of business profits. The only catch is that prior to declaring any profits, each individual owner is required to be paid a reasonable salary if they also work as an employee. The reasonable compensation portion is also subject to Medicare and Social Security taxes. 

Reasonable salary is not a specific figure and has been a regular topic of debate in court cases involving the IRS and business owners who are believed to be paying extremely small salaries to save on taxes. The IRS doesn't define specific guidelines, which adds to the confusion. 

If there are not enough funds to still show profits after paying out the "salaries," then there is no real benefit to S corporation status since the benefits don't kick in until there are profits. 

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