In an S corporation tax structure, income passes directly to shareholders, who then add it to their personal tax returns. S corporations are one of the fastest-growing types of pass-through businesses.

What Are S Corporations?

S corporations choose to pass the company's income, losses, credits, and deductions through to shareholders, who then pay the federal taxes. Taxes are assessed at individual income tax rates. S corporations, therefore, avoid double taxation. However, the S corporation does have to pay some taxes, including on passive income at the entity level and built-in gains.

S corporations function like regular C corporations, issue stock, and have directors and officers. The shareholders have the same liability protection as that afforded to a C corporation. This means shareholders' personal assets cannot be seized to pay business debts.

Characteristics of S Corporation Taxation

  • S corporations have restrictions, including a cap of 100 shareholders, all of whom must be U.S. citizens or residents.
  • Active shareholders are those who participate in day-to-day activities of the business; passive shareholders do not.
  • All shareholders are subject to federal income tax and any applicable state and local tax on the S corporation's income.
  • The amount of tax differs for each owner based on how payroll taxes, such as Medicare and Social Security, and ACA Net Investment income tax affect them.
  • Active shareholders typically report two income types from an S corporation — wage-earning income and profit distribution.
  • Payroll tax applies to wage income but not profit distribution.

To keep companies from trying to avoid paying taxes, the IRS requires they pay active employee shareholders a reasonable salary and then distribute the remaining amount as profits. Passive shareholders don't pay payroll tax on income because they don't earn a wage. However, they are liable for ACA's Net Investment Income Tax at 3.8 percent, which is only applicable to income higher than $200,000 for single or $250,000 for married filing jointly.

S corporations pay the following corporate taxes:

  • LIFO recapture tax
  • Built-in gains tax
  • Excess net passive income

LIFO recapture tax and excess net passive income tax apply if the S corporation was once a taxable C corporation or it underwent a tax-free reorganization with a C corporation. The term LIFO stands for the "last in, first out" method of inventory measurement for tax purposes.

Passive income is that stemming from annuities, rents, royalties, and dividends. The excessive net passive income tax applies if the passive income is greater than 25 percent of an S corporation's gross receipts. IRS Form 1120S comes with a worksheet on how to calculate excessive net passive income tax.

S corporations are subject to built-in gains tax in some cases. When an S corporation gets rid of an asset within five years and other conditions apply, the S corporation will be liable for built-in gains.

Advantages and Disadvantages

Advantages of forming an S corporation include:

  • Limited liability for company employees, officers, and shareholders
  • Pass-through taxation
  • No double taxation
  • The ability to exist even if the owner dies or leaves

There are also some disadvantages to S corporations. These include:

  • Strict requirements on who can be shareholders (must be U.S. residents or citizens).
  • Cannot have more than 100 shareholders.
  • Must incorporate, which results in annual and ongoing fees that are more expensive than the cost of a partnership or sole proprietorship.
  • If you make a mistake with taxes, you could lose S corp status.
  • IRS scrutiny to ensure S corporations aren't distributing income as dividends to avoid payroll taxes.

Comparing LLCs and S Corporations

LLCs and S corporations are relatively similar in some cases. Both offer limited liability protection for owners who are not personally responsible for the company's liabilities and debts. Other features and distinctions between the two include:

  • Both offer pass-through taxation. S corporations must file a corporate tax return, whereas LLCs only need to if they have more than one owner.
  • Both are required to follow similar guidelines, such as filing annual reports.
  • LLCs are not restrictive on ownership.
  • LLCs have recommended, internal formalities, while S corporations have more extensive guidelines.
  • LLC owners can choose to have a member-managed or manager-managed structure. S corporations have officers and directors.
  • S corporations continue to exist after the owner dies or leaves, whereas LLCs might be required to dissolve once a member leaves or on a certain date.

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