How does an S corp pay taxes? The income and losses are “passed through” to the shareholders, who are responsible for reporting them on their personal income taxes.

What is an S Corporation?

S corps, or S corporations, are special business entities that are taxed like a partnership but operate as a corporation. They are unique in that they cannot be owned by other businesses, their shareholders must be U.S. citizens or resident aliens, and they can only have a maximum of 100 shareholders.

Is there Double Taxation?

Regular corporations are independent entities that pay taxes on their profits or net income. They are taxed on net income at the corporate rate and file an annual income tax return with the IRS. Corporations distribute extra profits to shareholders in the form of dividends after they pay taxes on the amount. They are taxed again on the shareholder's personal tax returns. This is known as double taxation and is a downside of doing business as a corporation. Small corporations with fewer than 100 shareholders can avoid double taxation when they opt to be treated as an S corporation for tax purposes since S corps are only taxed at the individual level.

 S corporation owners have similar marginal tax rates as individual wage earners. The amount owners have to pay in taxes will differ based on how involved they are in the business. Active shareholders participate in everyday business activities whereas passive shareholders don't.

Shareholders typically see two types of income: profit distribution and wage income. The IRS set forth guidelines to keep businesses from distributing too much profit while paying as low of a wage as possible. Passive shareholders don't pay payroll taxes since they don't receive a salary from the company. 

Distributive Shares

Shareholders receive income and loss allocations based on their ownership interests, which are referred to as the shareholder's distributive share. You still pay the taxes whether or not you pull your share out of the corporation. All profits and losses need to be divided among shareholders even if the corporation keeps some profits in the bank to pay future expenditures versus distributing to shareholders.

S Corporation Tax Forms

An S corporation uses IRS Form 1120S for its annual tax return. Schedules K and K-1 show how income and deductions are divided among owners. S corporations are required to file and pay income taxes only once a year, rather than every quarter like C corporations. Don't forget, you are still responsible for quarterly estimations on individual returns if you don't have sufficient funds withheld from the disbursement or you don't receive a regular paycheck.

Self-Employment Taxes

You are responsible for Medicare and Social Security taxes, no matter whether you're self-employed or an employee. As an employee, you are only responsible for a portion of the taxes and your employer picks up the balance. Self-employed people are required to pay both portions.

The advantage here is that shareholders of S corporations don't pay self-employment taxes on their share of business profits. Be aware though, each owner who works as an employee must receive "reasonable compensation." This salary is subject to Medicare and Social Security taxes, half of which is paid by the employee, and half by the business. The benefits of tax saving on the profits only start once the S corporation is making enough money to still have profits paid after the mandatory "reasonable compensation".

Courts sometimes struggle to determine what is the right amount for a reasonable salary. They often look at S corporations when they suspect owners are paying ridiculously low salaries to save on self-employment taxes. Reasonable is a fuzzy area since the tax code sets forth no guidelines, but be cautious testing the waters so you aren't audited.

S Corporation Distributions

When organizing as an S corporation, you have the option to classify some income as salary and the remainder as a distribution. You will pay self-employment tax on the salary amount, but only pay basic income tax on the distribution amount. Depending on how you divide your income, converting to an S corporation can result in a large tax saving.

Other Taxes 

Other taxes that S corporations pay include:

  • FICA 
  • Worker's compensation
  • Unemployment
  • Property taxes
  • Sales and excise taxes in the state they do business
  • And in some states, franchise and state income taxes

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