Key Takeaways

  • An S corporation (S corp) is a tax designation, not a business structure, and can be adopted by eligible LLCs or corporations.
  • S corps avoid double taxation by passing income through to shareholders, who report it on personal returns.
  • S corps must meet strict IRS requirements, including limits on shareholder types and total number.
  • S corps must file IRS Form 1120S and issue Schedule K-1s to shareholders annually.
  • Shareholders must be paid a reasonable salary, and distributions are not subject to self-employment taxes.
  • S corps may be subject to built-in gains tax if assets appreciated during prior C corp status.
  • Tax filing deadlines and late penalties are key considerations for S corps.

Most people need s corp taxes for dummies as S corporations are one of the most misunderstood business organization types. It's likely because it's more of a tax designation rather than its own form of entity. 

What is an S Corporation?

Both LLCs and corporations can opt to become S corporations; however, no state offers entrepreneurs the opportunity to become an S corporation. S corporations have the ability to avoid double taxation since an S corporation is a pass-through entity. Profits are passed on to shareholders, who report them as personal income versus the corporation paying taxes on them. 

To be eligible for S corporation status, you must meet certain criteria:   

  • They must be domestic companies    
  • Shareholders can only be individual people, estates, and certain trusts only   
  • Shareholders cannot be non-US residents, partnerships, or corporations  
  • S corps must have less than 100 shareholders or LLC members   
  • Certain types of corporations don't qualify, including some financial institutions, domestic international sales corporations, and insurance companies

Becoming an S Corporation

S corporations can only be formed when regular corporations file a special small-business tax status with the IRS, which is done by filing IRS Form 2553 within a few months of forming the corporation. 

The primary difference between corporation types is that with S corporations, owners and shareholders can be employed and receive a salary that has payroll taxes deducted. 

When deciding on what type of corporation to form, companies should ask themselves what is the best method to reduce the tax burden on the business.  Should you become an S corporation, provided you qualify and pass the taxable income along to the shareholders? Or, keep the business as a traditional corporation and have shareholders pay tax on the dividends in addition to the taxes the business already paid? 

Corporations and Taxation

To understand the benefits of S corporation status, it's best to start by understanding how a traditional C corporation is taxed. By default, a corporation is taxed as a C corporation. Net profits are taxed at the corporate level and whatever is left can be distributed to shareholders as dividends. Shareholders pay personal income taxes on dividends. 

This means the net profits are essentially taxed twice, once as a corporation and one at the personal shareholder level. The S corporation gets rid of that double taxation. 

S corporations must annually file Form 1120S versus Form 1120, which normal corporations are required to file. You still must issue K-1s to shareholders just like with a partnership.

Three things to note with paying taxes based on dividends from an S corporation:  

  • Income or loss from the company gets reported on your 1040 tax form.
  • Income is subject to federal and state taxes; however, it is not subject to payroll or self-employment taxes.   
  • Shareholders are taxed whether or not the S corporation paid out any income. 

When S corporations pay dividends to stockholders, it can provide them with money to pay the taxes on their personal tax returns. When talking about dividends, the benefit with S corps is that you don't pay Medicare or Social Security taxes on them, which can save 15.3 percent. However, S corporation owners are required to pay themselves a "reasonable salary" which means you can't call all profits dividends to avoid any taxes. Because of the 15.3 percent tax on dividends, some companies opt to wait until they generate more income to make the change to S corporation worthwhile. 

S Corp Tax Deadlines and Penalties

S corporations must file IRS Form 1120S by March 15 each year (or the next business day if it falls on a weekend or holiday). This deadline applies regardless of whether the S corp earned income during the year. Missing this deadline can lead to penalties—typically $235 per shareholder per month (for up to 12 months) for late filings.

Filing an extension using IRS Form 7004 can grant an additional six months to file the return, but it does not extend the time to pay any taxes owed. Therefore, estimated payments must still be submitted by the original due date.

S Corp Tax Filing Responsibilities for Shareholders

Each S corp shareholder receives a Schedule K-1 that breaks down their share of the corporation’s income, losses, deductions, and credits. Shareholders must report this information on their personal tax returns, regardless of whether distributions were actually made.

The income reported on a Schedule K-1 is taxed at the shareholder’s individual tax rate. Importantly, shareholders are responsible for setting aside enough funds to pay taxes on their share of the income—even if the corporation retains the profits.

Built-in Gain Tax

There is one caveat to note with S corporations where shareholders can have a greater tax liability in a particular situation. It rests on the concept of "basis," which is the amount personally invested in your S corporation stock. If an S corporation makes distributions that exceed a shareholder's basis, the amount above and beyond is considered a capital gain. In some instances, corporations become S corporations right from the start. For companies who were C corporations previously, several rules apply. 

The "built-in gain tax" is important to know for companies that convert from C to S corporations. If an S corporation sells an asset that appreciated, and the period of appreciation was from the time it was a regular corporation, the built-in gain is taxed at the highest corporate rate. This prevents C corporations from trying to avoid income tax by selling off assets and then converting to S corporation status. C corporations that are contemplating becoming an S corporation will want to retain a competent tax professional to help analyze the pros and cons. 

Self-Employment Taxes and Reasonable Compensation

One major tax advantage of S corporations is that distributions are not subject to self-employment taxes. However, this comes with an important condition: shareholders who work in the business must receive a reasonable salary for their services.

This salary must be reported through payroll and is subject to Social Security and Medicare taxes. The IRS scrutinizes S corps that try to minimize salary payments to avoid employment taxes. If a salary is unreasonably low, the IRS may reclassify distributions as wages and assess back taxes and penalties.

To determine a reasonable salary, consider factors such as industry standards, job responsibilities, time spent working, and company profitability.

Common Mistakes to Avoid with S Corp Taxes

S corp owners can run into trouble by:

  • Failing to file Form 2553 on time. This can delay or prevent S corp status.
  • Not issuing K-1s or filing Form 1120S. These are essential for IRS compliance.
  • Underpaying estimated taxes. Since taxes are passed through, shareholders must manage estimated tax payments quarterly to avoid underpayment penalties.
  • Calling all income "distributions." Skipping a reasonable salary is a red flag to the IRS.
  • Mishandling shareholder loans. If shareholders take money from the S corp and it isn’t treated as a loan or compensation, it may be reclassified as taxable income.

Frequently Asked Questions

  1. What taxes do S corps avoid?
    S corps avoid double taxation by not paying corporate income tax. Instead, income is passed to shareholders who report it on their personal tax returns.
  2. Do S corp owners pay self-employment tax?
    No, distributions are not subject to self-employment tax. However, shareholder-employees must be paid a reasonable salary subject to payroll taxes.
  3. Can an LLC file as an S corp?
    Yes, an LLC can elect S corp status by filing IRS Form 2553, provided it meets all eligibility criteria.
  4. What is the built-in gains tax?
    This tax applies when a corporation that converted from C corp to S corp sells appreciated assets within a five-year recognition period.
  5. When are S corp taxes due?
    S corp returns (Form 1120S) are due by March 15 each year. An extension can be filed with Form 7004, but taxes owed must still be paid by March 15.

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