Key Takeaways

  • S corporations are pass-through entities, meaning profits and losses are reported on shareholders’ personal tax returns.
  • The main advantage is avoiding double taxation faced by C corporations.
  • Shareholders pay taxes at their individual income tax rates instead of corporate rates.
  • S corps must pay attention to IRS requirements to maintain their status and avoid termination traps.
  • Certain built-in gains and passive income may still trigger corporate-level taxes.
  • Reasonable compensation rules affect how much income is subject to self-employment tax.
  • S corps must file Form 1120-S annually and provide Schedule K-1 to shareholders for income reporting.

Knowing how S corporations are taxed can help you decide if it's beneficial for you to choose this tax designation for your business. One of the advantages of S corps is pass-through taxation, as well as the possibility of paying less in self-employment taxes.

About S Corporations

S corps are corporations that choose to pass the following through to company shareholders for tax purposes: 

  • Corporate income 
  • Deductions 
  • Credits 
  • Losses

An S corp's shareholders report income and losses on their personal tax returns. Their taxes are assessed at individual rates. This pass-through taxation means that shareholders aren't taxed twice, or what's commonly known as double taxation. They don't have to pay individual and corporate taxes.

These business types pay taxes on certain passive income and built-in gains. If an S corp donates to charity, this charitable contribution is reported on the Schedule K-1. Plus, the shareholder reports his or her portion as an itemized deduction.

One of the advantages for S corp shareholders is not having to pay self-employment tax on their portion of the profits.

How Are S Corporations Taxed?

Business owners may elect for S corp designation for these two important benefits: 

  • The elimination of double taxation 
  • Simplified tax filing

Understanding Pass-Through Taxation and Filing Obligations

S corporations are classified as pass-through entities, meaning the company itself does not pay federal income tax. Instead, all income, losses, deductions, and credits flow through to shareholders, who report these amounts on their personal tax returns. Each shareholder’s portion of the company’s earnings is shown on Schedule K-1 and included on their individual Form 1040.

While S corps avoid corporate income tax, they are still required to file Form 1120-S, which summarizes income, deductions, and distributions for the year. States may impose additional filing obligations; for example, some states charge franchise or excise taxes even if the business is federally exempt.

Unlike C corporations that pay tax at the corporate level and again on dividends, S corp profits are taxed only once—at the shareholder level. However, certain situations, such as built-in gains tax or excess passive income, can trigger a corporate-level tax if the S corp was formerly a C corporation or holds appreciated assets.

Avoiding Double Taxation

In a C corp, proceeds are basically taxed twice. Individual shareholders are taxed on capital gains and dividends, and the company is taxed on the corporate level. If a shareholder is also a corporation's primary owner, he or she is taxed twice.

In S corps, however, the net income of the company goes straight to the shareholders and owners. They in turn pay taxes on it via their individual tax returns. Corporate tax rates are usually higher than personal tax rates, so an S corp owner will probably pay less taxes. The tax difference between C corps and S corps doesn't lie in how much income is taxed, but where and when it's taxed.

Built-In Gains and Passive Income Taxes

Even though S corporations generally escape double taxation, two main exceptions can trigger corporate-level taxes:

  1. Built-In Gains Tax (BIG):
    If an S corporation was previously a C corporation and owns appreciated assets, it may owe a built-in gains tax when selling those assets within five years of converting. This tax ensures the IRS still collects revenue on appreciation that accrued while the company was taxed as a C corp.
  2. Excess Net Passive Income Tax:
    If an S corporation has accumulated earnings and profits from its C corp years and receives more than 25% of its gross income from passive sources like rents, royalties, or interest, it may face a tax on that passive income. Continuous violations can even terminate S corporation status.

Careful tax planning—such as monitoring passive income levels and the timing of asset sales—can help S corporations avoid these pitfalls.

Simplified Tax Filing

The way S corps file taxes is simpler than how C corps file them. There's no need for a separate corporate tax return, for one thing. You'll probably have to file some additional forms, and you will have to report proceeds separately. For instance, S corp proceeds aren't the same as C corp dividends. However, these added steps should take much less time than having to prepare a separate corporate tax return.

In addition, while you might have to pay payroll taxes more frequently if you employ people, in an S corp, you only have to file taxes once a year. C corps must file every quarter.

If you don't earn a regular paycheck or you don't have sufficient funds withheld from your pay, you'll likely be required to pay estimated taxes every quarter. This is still simpler than filing a full corporate tax return every quarter.

Federal and State Tax Compliance for S Corporations

While federal taxation for S corporations is relatively straightforward, compliance requires ongoing attention. S corps must:

  • File Form 1120-S annually with the IRS.
  • Issue Schedule K-1 forms to shareholders by March 15 (or the 15th day of the third month after the end of the fiscal year).
  • Remit payroll taxes on employee wages, including reasonable compensation paid to shareholder-employees.

At the state level, some states (like California and New York) impose their own minimum franchise taxes or fees. California, for instance, charges a 1.5% tax on net income, while others may require annual filing fees based on income or number of shareholders.

Shareholders may also need to file estimated quarterly taxes to cover their personal liability for S corp income. Staying compliant at both levels ensures the S corporation maintains its favorable tax treatment.

Can an S Corp Reduce Self-Employment Taxes?

Anyone who's an active shareholder in an S corp receives two types of income: wages and profit distribution.

Because many businesses would naturally want to distribute as much profit as possible while keeping wages low, the IRS puts guidelines in place so that businesses pay a reasonable salary to their active owners.

Everyone — employee of a company or self-employed individual — must pay various taxes to the government, including Medicare and Social Security taxes. If you're employed by someone else, you only pick up a portion of these taxes and your employer pays the rest. Self-employed individuals are responsible for both portions of these taxes.

If you elect to operate as an S corporation, you'll be able to classify your income differently. Some of it will be your salary and some will be distribution. You'll have to pay self-employment tax on the salary portion, but for the distribution portion, you'll only pay regular income tax. You might be able to save a substantial amount of money on self-employment tax, depending on how you classify your income, just by electing the S corp tax designation.

On the surface, S corps seem to have many benefits, especially in terms of taxation. However, that's not the only reason to elect for S corp designation. Being familiar with all the specific details of this business type is the best way to make the right decision for your company.

Common S Corporation Tax Pitfalls to Avoid

S corporations enjoy tax advantages, but they must comply with specific IRS rules to maintain their election. Common traps include:

  • Ineligible Shareholders: Only U.S. citizens, resident individuals, and certain trusts or estates can own shares. Ownership by a partnership, corporation, or nonresident alien will automatically terminate S corp status.
  • Multiple Classes of Stock: S corps may issue only one class of stock. Any arrangement giving different distribution or voting rights could invalidate the S election.
  • Failure to File or Late Elections: Missing the S corp election deadline or failing to file annual tax forms may result in loss of S status.
  • Improper Income Allocation: Distributions must match ownership percentages; unequal allocations can trigger IRS adjustments or termination.

Regular legal and accounting review helps prevent inadvertent termination and keeps the business in compliance.

Reasonable Compensation and IRS Scrutiny

A major advantage of S corporations is the ability to reduce self-employment taxes through a mix of salary and distributions. However, the IRS requires that shareholder-employees receive reasonable compensation for their services before taking distributions.

If an S corporation underpays salaries to avoid payroll taxes, the IRS may reclassify distributions as wages, resulting in penalties and back taxes.

Reasonable compensation varies depending on the nature of the work, market conditions, and comparable industry pay.

To minimize audit risk:

  • Document how salaries are determined (e.g., using industry benchmarks).
  • Separate payroll records and shareholder distributions.
  • Consult a tax professional to set defensible wage levels.

Following these practices keeps your S corp compliant and maximizes legitimate tax savings.

Comparing S Corporation Taxes to Other Structures

When evaluating how S corporations are taxed, it’s helpful to compare them to other structures:

  • C Corporations: Subject to double taxation—once at the corporate level and again when dividends are distributed.
  • LLCs (default partnership status): Members pay self-employment tax on all business income, but have more flexibility in allocations and ownership.
  • S Corporations: Avoid double taxation and allow for potential self-employment tax savings, but come with ownership and compliance restrictions.

For many small businesses, the S corp designation strikes a balance between favorable tax treatment and limited liability protection.

Frequently Asked Questions

  1. Do S corporations pay federal income tax?
    Generally, no. S corporations are pass-through entities, meaning profits and losses flow through to shareholders’ personal tax returns.
  2. What tax forms do S corporations file?
    They file Form 1120-S annually and issue Schedule K-1 to shareholders, detailing their share of income, deductions, and credits.
  3. Can an S corporation lose its tax status?
    Yes. Violating eligibility requirements—such as having more than 100 shareholders, issuing multiple stock classes, or accepting ineligible shareholders—can terminate S corp status.
  4. Are S corporation distributions taxable?
    Distributions are typically tax-free up to the shareholder’s basis in the corporation. Amounts exceeding basis are taxed as capital gains.
  5. How can S corporations avoid IRS penalties?
    Ensure reasonable shareholder salaries, maintain accurate records, file forms on time, and stay compliant with both federal and state tax laws.

If you need help understanding taxes for S corps or other businesses, 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.