Key Takeaways

  • S corporations do not pay federal income taxes at the entity level; instead, shareholders report income on their personal tax returns.
  • Shareholders are taxed based on activity level—active shareholders may receive wages and distributions, while passive shareholders typically receive only distributions.
  • Reasonable compensation is required for active shareholders to avoid IRS scrutiny.
  • Form 1120S, Schedule K-1, and state forms are used for S corp tax filings.
  • S corps avoid self-employment tax on distributions but must still comply with payroll tax obligations.
  • Corporate-level taxes such as Built-in Gains Tax and LIFO Recapture Tax may still apply under specific conditions.
  • State tax obligations vary—some states tax S corporations directly, others do not.
  • S corps must maintain careful documentation to avoid audits and penalties.

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.

S Corp Eligibility and Election Requirements

To qualify for S corporation status, a business must first be a domestic corporation or LLC eligible to file Form 2553 with the IRS. The company must:

  • Have only allowable shareholders—individuals, certain trusts, and estates (no partnerships or corporations).
  • Have no more than 100 shareholders.
  • Have only one class of stock.
  • Not be an ineligible corporation, such as certain financial institutions, insurance companies, or domestic international sales corporations.

The election must be made within two months and 15 days of the beginning of the tax year in which the election is to take effect, or at any time in the preceding tax year. Late elections may be allowed with reasonable cause.

9 Things S Corporation Owners Need to Know About Income and Tax Rates

  1. Owners of S corporations are subject to marginal tax rates just as wage earners are.
  2. How much involvement an owner has in the S corporation will determine how much that owner will pay in taxes.
  3. S corporation owners are required to pay federal income taxes, state taxes, and local income tax.
  4. There is an extra 1.18 percent marginal tax rate caused by Pease limitations on all itemized deductions.
  5. The ACA Net Investment Income Tax and payroll tax affect S corporations differently, and therefore how S-corporation owners are taxed will vary.
  6. An S corporation has two types of shareholders: active and passive.
  7. 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.
  8. 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.
  9. 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.

How S Corporation Taxes Compare to Other Business Types

Unlike sole proprietorships and partnerships, S corps provide more flexibility in reducing self-employment tax by allowing profit distribution separate from wages. Compared to C corporations, S corporations avoid double taxation—C corps pay taxes at both the corporate and shareholder levels. However, S corps require more administrative oversight and stricter compliance, especially with IRS scrutiny of shareholder compensation.

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.

Estimated Payments and Quarterly Tax Obligations

Although the S corporation itself typically does not pay federal income taxes, shareholders may need to make quarterly estimated tax payments to cover their personal tax liabilities from their share of the S corp’s income. These payments are due in April, June, September, and January of the following year. S corporations themselves may also need to make estimated payments for state-level franchise or excise taxes, depending on the jurisdiction.

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.

Examples of State-Level S Corporation Tax Treatment

  • California: S corporations must pay a 1.5% franchise tax on net income (minimum $800), and shareholders pay personal income tax on their share of earnings.
  • New York: S corps are subject to both state and city taxes unless exempt. New York City does not recognize S corp status, so businesses may face corporate-level taxes at the city level.
  • Texas: Although there’s no personal income tax, S corporations must file and pay the Texas franchise tax if revenue exceeds a certain threshold.

State laws vary widely, so it is crucial to understand local requirements for both the corporation and its shareholders.

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.

Corporate-Level Taxes

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.

Late Filing Penalties for Form 1120S

Failing to file Form 1120S on time can result in significant IRS penalties. The penalty is $235 per shareholder per month for up to 12 months (for tax years beginning in 2023). For example, if an S corp with three shareholders files three months late, the penalty would be $2,115. These penalties apply even if the business owes no tax, emphasizing the importance of timely filing.

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.

Frequently Asked Questions

  1. What is the S corp tax rate?
    S corporations do not pay federal income tax at the corporate level. Instead, income "passes through" to shareholders, who are taxed at individual income tax rates.
  2. Do S corp shareholders pay self-employment tax?
    Not on distributions. Active shareholders must receive a reasonable salary subject to employment taxes, but distributions are not subject to self-employment tax.
  3. What tax form do S corporations file?
    Form 1120S is used for the corporate return, and Schedule K-1 reports each shareholder’s share of income.
  4. Can an S corp reduce taxes through profit distributions?
    Yes, by classifying a portion of the shareholder’s compensation as distributions instead of wages—provided the wage is reasonable per IRS guidelines.
  5. Do S corporations pay state income tax?
    It depends on the state. Some states tax S corporations directly, while others tax only the shareholders on their income.

Need additional information related to S corporation tax rates? Don't hesitate to 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.