S Corp Tax Rate: Everything You Need to Know
The S corp tax rate applies to domestic corporations from which all corporate income is sent directly to the owners, who in turn pay taxes on the income.6 min read
2. 9 Things S Corporation Owners Need to Know About Income and Tax Rates
3. S Corporation Tax Forms
4. Self-Employment Tax vs. S Corporations
5. Determining a Reasonable Salary for S Corporation Shareholders
6. General Rules for Cost Basis in an S Corporation
7. S Corporations and State Taxes
8. Risks Associated With S Corporations
9. S Corporations' Additional Costs
10. Corporate-Level Taxes
11. Accumulated Earnings Tax
Updated October 28, 2020:
The S corp tax rate applies to domestic corporations from which all corporate income is sent directly to the owners, who in turn pay taxes on the income.
What Are S Corporations?
A corporation uses corporate tax rates to calculate its taxes, track taxable income, and file a corporate tax return when it decides to be taxed at a corporate level. A C corporation provides shareholders with dividends as a form of profit. The dividends that each shareholder receives are considered taxable income. However, an S corporation does not operate the same way a C corporation does.
S corporations are considered pass-through entities. All of the profits that the company receives are passed directly to its shareholders. This also passes the tax liability to the shareholders, and the corporation does not pay taxes at a corporate level. S corporations may only have 100 or fewer shareholders, and all of the shareholders must be U.S. citizens. S corporations cannot operate underneath other businesses; they are a separate entity.
9 Things S Corporation Owners Need to Know About Income and Tax Rates
- Owners of S corporations are subject to marginal tax rates just as wage earners are.
- How much involvement an owner has in the S corporation will determine how much that owner will pay in taxes.
- S corporation owners are required to pay federal income taxes, state taxes, and local income tax.
- There is an extra 1.18 percent marginal tax rate caused by Pease limitations on all itemized deductions.
- The ACA Net Investment Income Tax and payroll tax affect S corporations differently, and therefore how S-corporation owners are taxed will vary.
- An S corporation has two types of shareholders: active and passive.
- An active shareholder is involved in the daily business operations of the corporation and usually garners income through both profit distribution and wages. Their wages are taxed three ways: 15.3 percent on the first $117,000, 2.9 percent on the next $83,000 after $117,000, and 3.8 percent on income over $200,000.
- Although wages are taxed, profit distribution is not. Because of this, S corporations often try to pay very little in wage income and instead distribute a significant amount of profit instead. However, there are specific guidelines set forth by the IRS on how profits can be distributed.
- Passive shareholders do not earn any wages from an S corporation, and therefore their income is not subject to payroll tax. In place of a payroll tax, passive shareholders are subject to the ACA's Net Investment Income Tax. This only affects anyone who makes an annual income of $200,000 or more — or at least $250,000 for anyone who is married and filing jointly. Passive shareholders are often hit with a higher marginal tax than their active shareholder counterparts.
S Corporation Tax Forms
The form that you need for your S corporation annual tax return is Form 1120S. With a partnership, Schedule K and K-1 must be filled out to show what deductions each owner receives and what the income of each owner is.
Self-Employment Tax vs. S Corporations
Every business owner is subject to self-employment taxes, which are used to pay Medicare and Social Security. When you incorporate your business entity as an S corporation, you can reduce some of your taxes. One of the primary advantages of incorporating your business as an S corporation is that the shareholders of an S corporation are not required to pay self-employment tax on business profits.
Determining a Reasonable Salary for S Corporation Shareholders
There are no set guidelines in the tax code that show a business owner how to determine shareholder's salaries. However, here are some things you can consider in order to make the decision process easier:
- What responsibilities each shareholder has.
- How experienced each shareholder is.
- How committed each shareholder is to the corporation.
- What dividends each shareholder receives.
- The wage income of employees who are not shareholders.
- The salaries set forth by businesses that are similar to your business.
General Rules for Cost Basis in an S Corporation
Every S corporation shareholder has their share of profits taxed even if they didn't receive those profits.
However, if distributions aren't higher than the shareholder's cost basis, that shareholder is not taxed on distributions.
A shareholder's cost basis can be increased according to how much he contributes to the corporation and by his share of the corporate income. It can be decreased by distributions and losses in the business.
S Corporations and State Taxes
Along with federal income tax, shareholders of S corporations may be required to pay state taxes as well. This varies by state. In some states, the tax liability goes directly to the S corporation.
Risks Associated With S Corporations
Because of the way S corporations handle the distribution of profits and their associated tax liabilities, there is a temptation for S corporation shareholders to abuse the tax system. Therefore, as you may imagine, these corporations are monitored closely by the IRS.
Nobody wants an IRS audit, whether they are a shareholder or a corporate officer. Therefore, S corporations must be careful about the way they categorize business wages and distributions. If this is not done correctly and the calculation of a “reasonable salary” is suspicious, the IRS may assess the corporation's accounting methods. If they decide that taxes have been declared incorrectly, the company may face legal penalties and will be required to pay interest on any taxes that are owed.
S Corporations' Additional Costs
Although forming an S corporation allows a company to save money in many respects, such as the avoidance of self-employment taxes, there are additional costs to consider. Compared to a sole proprietorship or partnership, an S corporation has to pay extra legal fees and accounting costs, especially during the first year it is in operation. Therefore, S corporations are not always an economical choice.
Shareholders of S corporations do, however, avoid the double taxation that applies to most C corporations. In fact, this is one of the most common reasons for converting a C corporation to an S corporation. C corporation shareholders are taxed on the dividends they receive as a distribution of profit, while the company also pays taxes at a corporate level on the same profit. Because S corporations are not taxed at the corporate level, their profits are only taxed once.
Although S corporations allow for the tax liability on profits to pass through to the shareholders, there are still corporate-level taxes that must be paid by S corporations. These include:
- Excess Net Passive Income
- LIFO Recapture Tax
- Built-in Gains Tax
The Excess Net Passive Income tax applies to S corporations that were previously C corporations or have been restructured as a tax-free company from their status as a C corporation. It is a tax on the company's passive income, which includes interest income, annuities, rents, royalties, and dividends. An S corporation must pay this type of tax if the passive income exceeds 25 percent of the total revenue it receives from its usual services and business operation.
The LIFO Recapture Tax also applies to S corporations that have converted from status as a C corporation. If they used the Last In First Out (LIFO) method for inventory pricing during the last year they operated as C corporations, this tax requires a calculation of the asset value that should be taxed at a corporate level.
The Built-In Gains Tax is applicable to S corporations that acquired their business assets when they were a C corporation. If these assets are sold within five years of this conversion in status, the business must pay this tax.
Accumulated Earnings Tax
A C corporation may choose not to distribute dividends to its shareholders in an effort to avoid the shareholders' tax liability. However, this may result in an additional tax that the IRS imposes, called the Accumulated Earnings Tax.
Accumulated earnings taxes of 20 percent are applied to corporations that do not distribute dividends to their shareholders; this is on top of the regular corporate taxes that these corporations must pay.
This tax does not apply to certain types of corporations, which include nonprofits, passive foreign investment companies, and personal holding companies.
The IRS uses the Accumulated Earnings Tax to keep corporations from accumulating profits in their accounts instead of distributing them to shareholders as dividends, as they should be doing. Paying taxes on this money cannot be avoided.
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