1. What Is an S Corporation?
2. Pass-Through Taxation in an S Corporation
3. Distributions in an S Corporation
4. Risks of an S Corporation
5. Additional Costs for an S Corporation
6. Self-Employment Taxes in an S Corporation

S corporation income refers to the income an S corporation makes from the sale of its goods, services, or assets. An S corporation (S corp) is an alternative form of corporation that allows its income, loss, deductions, and tax credits to pass through to its shareholders' individual tax returns. This makes it an appealing option for business owners who wish to avoid double taxation, a situation that affects a regular corporation, or a C corporation. However, electing S corp status exposes a business to certain additional costs and risks.

What Is an S Corporation?

A corporation can opt to pay taxes on its income at the shareholder level by converting to an S corporation. The letter "S" stands for the Subchapter S of the Internal Revenue Code.

An S corporation files its corporate tax return and calculates its taxable income. The taxable income, along with deductions and credits, is then divided among its shareholders. Every shareholder will report on the personal tax returns his or her portions of the:

  • Corporate income
  • Tax credits
  • Deductions.

The corporation's income items will not be taxed at the corporate level. Instead, they will be taxed at the shareholder level at personal income tax rates.

Pass-Through Taxation in an S Corporation

Pass-through taxation refers to the process where income and other taxable items flow from a corporate tax return to the shareholders' individual tax returns. If an S corporation sells a certain asset that is regarded as a long-term capital gain, income from the sale will be reported as a long-term gain on Schedule K-1. The corporation will provide a Schedule K-1 for each shareholder, who will in turn report the income on his or her Schedule D forms as a long-term gain.

Likewise, if an S corp makes a monetary donation to a charity, the donation will be reported on Schedule K-1 as a charitable contribution. The shareholders will then report their portions of the donation as an itemized charitable donation. In pass-through taxation, all income items, deductions, and credits have to be handled appropriately when they are reported on the individual tax returns of shareholders.

Distributions in an S Corporation

If you elect S corp status, you can classify a portion of your income as salary and the remainder as a distribution. The salary portion of the income is subject to self-employment taxes. However, the distribution portion will be taxed at the normal income tax rate. Depending on how your income is divided, you can potentially reduce your self-employment taxes substantially by becoming an S corporation.

Risks of an S Corporation

Since there is a big potential for tax abuse, the IRS has a tendency to look at the tax returns of an S corporation with greater scrutiny. For instance, if you earn an income of $500,000 in a year, but you only allocate $20,000 as salary income, you may trigger an inquiry from the IRS, because you are avoiding too much self-employment tax.

The rule of thumb is to allocate a "reasonable" amount of the income you receive from your corporation as salary. What constitutes a "reasonable" amount is often unclear. But pushing the limits too far can increase your chances of getting an IRS audit, as well as penalties and interests on back taxes.

Additional Costs for an S Corporation

While organizing your business as an S corporation enables you to save on self-employment taxes, it comes with certain additional costs that may not make it worthwhile to make the switch. These costs include:

  • Startup costs
  • Ongoing legal expenses
  • Accounting costs
  • Ongoing taxes and fees in some states.

Self-Employment Taxes in an S Corporation

A major benefit of electing S corp status is that you are not required to pay self-employment tax on your share of the corporation's profits. Your salary, however, will be subject to self-employment taxes, which will be paid half by the corporation and half by you. You will only see savings from not having to pay self-employment tax on corporate profits when the corporation is making enough income to have some profits to distribute to its shareholders after paying the required "reasonable" compensation.

If you need help with allocating your S corporation income, 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.