S Corporation taxation is different from that of other corporations because an S-corp is a pass-through corporate structure. That is, the shareholders take the profits directly and pay personal income taxes on them. The only taxes the corporation pays are payroll taxes for employees.

Introduction to S Corporation Taxation

A corporation can decide to be taxed at the corporate level, but in order for it to be considered as an S corporation, it has to pass the corporate profits, income, deductions, and credits to its shareholders to meet federal standards. 

S corporation shareholders report the income and losses that flow through on their personal tax returns. They are then assessed taxes at the individual income tax rates. S-corporations can avoid double taxation on its income through this mechanism. In fact, the biggest benefit of an S corporation over a C corporation is the ability to avoid double taxation legally. 

A C corporation has to pay corporate income tax on its profits and the shareholders pay personal income taxes on the dividends and capital gains they get from their shares. When the shareholders are the primary owners, the proceeds are taxed twice. 

As previously mentioned, all of the net income from an S corporation flows directly to the owners and shareholders. They have to pay taxes on the income on the personal level, but because the personal tax rates are usually lower than corporate rates, this sometimes translates to lower taxes. It also means the profits are only taxed once. Keep in mind that the difference between an S-corp and C corporation has nothing to do with the percentage of income that is taxed, but where and when it is taxed. 

S corporations have the responsibility to pay taxes on some built-in gains and passive income at the corporate level. However, S-corporation shareholders are not liable for self-employment taxes on their portion of the business profits. The "too good to be true" part of this is that each owner who works as an employee also has to be paid what is known as a "reasonable amount" of compensation. This compensation is subject to FICA taxes, half of which is paid by the employee and the other half paid by the corporation. 

Savings from paying no self-employment taxes on the profits are only realized when the corporation is earning enough money to pay a reasonable compensation and have enough left over for profits. 

Tax Responsibilities of an S Corporation

All shareholders/owners of the corporation are required to submit individual income taxes at their appropriate tax rate. There is also a limit on itemized deductions. This limitation winds up putting on another tax on top of the original tax rate. Owner/shareholders are taxed according to how the payroll taxes and ACA Net Investment Income Tax affects their income.

Shareholders and Taxes

 Active shareholders are those who are active in the day-to-day operation of the corporation. They usually get two types of income: profits and wage income. The wage income is subject to payroll taxes, which start at 15.3 percent up until a certain amount. After that initial amount is reached, additional percentages are added.

The profit distribution is not subject to payroll taxes. If an owner receives $50,000 and half of it is income from payroll income, they have to pay $7,650 in payroll taxes (15.3 percent of $50,000). The rest of the money is exempted from payroll taxes. 

There's an inherent incentive to pay a low salary and distribute more profit with this structure. However, the IRS has a guideline that S corporations have to follow, known as "reasonable salary." All businesses have to pay their active shareholders a reasonable salary, one that's in line with what people in similar positions in the local area are paid. The top tax rates for an active shareholder varies depending on what category the final dollar was earned in: profit or wage.

Passive shareholders, or shareholders who have no function in the corporation other than to draw profit, are not subject to payroll taxes, as they do not receive a wage from the corporation. Instead, a passive shareholder is liable for the ACA Net Investment Income Tax of 3.8 percent. 

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