How Is an S Corp Taxed: Everything You Need to Know
How is an S corp taxed? S corporations can opt to be taxed at the shareholder level or the corporate level. The S corporation is one of the fastest growing types of pass-through businesses.3 min read
2. Tax Forms for S Corporations
3. Self Employment Taxes
4. Cost Basis in S Corporations
5. Other Taxes S Corporations Pay
How is an S corp taxed? S corporations can opt to be taxed at the shareholder level or the corporate level. The S corporation is one of the fastest growing types of pass-through businesses. Shareholders must be U.S. citizens or resident aliens, shares cannot be owned by other businesses, and there is a cap of 100 shareholders.
Corporation Taxation Characteristics
If they are taxed at the corporate level, the corporation files corporate tax returns and is responsible for calculating taxable income. This is referred to as a C corporation treatment. When C corporations distribute dividends to their shareholders, the shareholders are responsible for the taxes.
The other option is to pay taxes at the shareholder level where the corporation is still responsible for measuring its taxable income and filing its own tax return. This is referred to as S corporation treatment. Shareholders will divide taxable income in addition to tax credits and deductions. Every shareholder will include their portions of the corporate income, credits, and deductions on their personal tax returns. All income items are taxed at personal tax rates, and there is no taxation at the corporate level.
In S corporations, the S comes from Subchapter S of Chapter 1 in the Internal Revenue Code. Active shareholders have two income types from S corporations: profit distributions and wage income. The term "pass-through" refers to "passing" income, tax credits, and deductions "through" to the shareholders. The income and other tax items will pass-through from the corporation's tax return to the shareholders' personal returns.
Tax Forms for S Corporations
S corporations should use IRS Form 1120S for the annual tax return. Schedule K and K-1 are used to show how the S corporation's different income and deductions are divided among owners. The shareholder will report the K-1 information on Line 17 of his or her 1040 form.
Self Employment Taxes
You have to pay Medicare and Social Security taxes whether you're an employee or self-employed. If you are an employee, you're only responsible for the employee portion, and the employer will pay the balance. If you're self-employed, you have to cover both portions.
The S corporation shareholders don't pay self-employment taxes on their shares of the business' profits. The one caveat is each owner who works as an employee must receive a "reasonable" salary before there can be any profits and you must pay Medicare and Social Security taxes on the salary. There is no savings benefit and no self-employment tax on the profits until the S corporation is earning enough for profits to be paid out after reasonable compensation, aka salaries, are paid.
The question of reasonable salary is a common debate in cases between business owners and the IRS where there is concern that business owners are paying a very small salary to save on self-employment taxes. The tax code doesn't provide guidelines on what is reasonable.
When courts are required to rule on the issue, they look at a variety of factors:
- Share-holder employee duties and responsibilities .
- How much time is devoted to the business.
- Wages paid to the business' non-shareholder employees.
- What comparable companies would pay for similar services.
Cost Basis in S Corporations
Shareholders are taxed on allocated shares of the S corporation's profits, even if the profits were not actually distributed to them. On the flip side, they are not taxed on distributions as long as they don't exceed the cost basis of the S corporation. Shareholder's cost basis increases by the allocated business income share and by any contributions he or she makes to the company. It is then decreased by his or her share of the losses and distributions received from the business.
Other Taxes S Corporations Pay
S corporations pay other taxes as well. They may pay employment tax, which includes everything from FICA to unemployment taxes. If the S corp owns any real estate, they will be required to pay property tax. They are also responsible for state sales taxes and excise taxes, like other business organization types. Depending on what state the S corp is located in, they may have to pay franchise taxes, state income taxes, and gross receipt taxes. Check with your respective state for clarification.
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