Key Takeaways

  • S corporation income is passed directly to shareholders, who report it on their individual tax returns, avoiding corporate-level taxation.
  • This income can include profits from operations, capital gains from asset sales, dividends, and other revenue streams.
  • Shareholders must pay income tax on their allocated share of the S corp’s earnings, whether or not the income is distributed.
  • Dividing compensation between a “reasonable salary” and profit distributions can minimize self-employment tax, but misclassification risks IRS scrutiny.
  • Accurate recordkeeping, compliance with IRS rules, and timely filing of forms like Schedule K-1 are essential for proper S corporation income reporting.

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.

Sources of S Corporation Income

S corporation income isn’t limited to a company’s core business operations. It can come from several sources, all of which flow through to shareholders’ personal tax returns. Common types of S corporation income include:

  • Operating revenue: Profits from selling goods or providing services.
  • Investment income: Earnings from dividends, interest, or rental properties owned by the S corp.
  • Capital gains: Profits from selling company assets, such as real estate or equipment.
  • Other income: This may include royalties, partnership income, or debt forgiveness gains.

Each type of income retains its character when passed through to shareholders. For example, capital gains remain capital gains, and dividend income retains its dividend classification. This allows shareholders to potentially benefit from lower tax rates on certain income types.

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.

Allocation and Reporting of S Corporation Income

One of the defining features of S corporation income is how it’s allocated and reported. Income is divided among shareholders based on their ownership percentage — regardless of whether profits are distributed as cash. For instance, if you own 30% of an S corp and the company reports $300,000 in income, you must report $90,000 on your individual tax return even if no distribution is made.

Shareholders receive a Schedule K-1 (Form 1120-S) each year, detailing their share of income, deductions, and credits. This information must be included on their individual tax filings. Importantly:

  • Shareholders are taxed on their share of income even if undistributed, which can create cash flow challenges.
  • Income maintains its original tax character (e.g., capital gains, ordinary income).
  • Losses can also pass through but are subject to basis and at-risk limitations, restricting how much can be deducted in a given tax year.

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.

Reasonable Compensation and IRS Compliance

A key advantage of S corporations is the ability to classify income into two categories: salary (subject to payroll taxes) and distributions (not subject to self-employment tax). However, the IRS requires that shareholder-employees receive “reasonable compensation” before any distributions are made.

What qualifies as reasonable depends on several factors:

  • The industry standard for similar roles.
  • The shareholder’s experience and duties.
  • The corporation’s size, profitability, and revenue.

Underpaying yourself to avoid employment taxes can lead to penalties, back taxes, and heightened IRS scrutiny. On the other hand, setting a reasonable salary and taking the rest as distributions can significantly reduce overall tax liability.

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.

Tax Planning Strategies for S Corporation Income

Effective tax planning is essential to maximizing the benefits of S corporation income. Strategies often used by small business owners and their advisors include:

  • Balancing salary and distributions: Paying a competitive salary and distributing remaining profits reduces self-employment tax without raising IRS red flags.
  • Timing distributions: Scheduling payouts at year-end can help shareholders manage personal tax liabilities.
  • Using retained earnings strategically: Keeping profits within the company for future investments can defer individual taxation until distributions occur.
  • Tracking basis: Maintaining accurate records of your basis in the S corporation ensures proper reporting of losses and distributions and avoids tax errors.

With careful planning, S corporations can offer significant tax advantages while remaining compliant with IRS rules.

Frequently Asked Questions

  1. What is considered S corporation income?
    S corporation income includes profits from operations, investments, capital gains, and other revenue sources. It’s passed through to shareholders for taxation on their individual returns.
  2. Do I pay taxes on S corporation income even if I don’t receive distributions?
    Yes. Shareholders are taxed on their allocated share of income whether or not it is distributed, as reported on Schedule K-1.
  3. How can S corporation owners reduce self-employment taxes?
    By paying themselves a reasonable salary and taking the remainder of profits as distributions, which are not subject to self-employment tax.
  4. What happens if I don’t pay myself a reasonable salary?
    The IRS can reclassify distributions as wages, assess back taxes, impose penalties, and increase scrutiny of your business.
  5. Can S corporation income be reinvested into the business?
    Yes. Retained earnings can be reinvested for growth, expansion, or operational needs. However, shareholders will still owe taxes on their share of the undistributed income.

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