1. Taxes on S Corporation: Basics
2. How an S Corporation Operates
3. What Is Reasonable Compensation?
4. Wage Income and Profit Distributions

S corporation taxes are surprisingly uncomplicated in terms of reporting and paying but put the burden of paying taxes on the shareholder or owner. The reason for this is that S corporations, so called because the rules come from Subchapter S of Chapter 1 of the Internal Revenue Service Code, are pass-through businesses that pass income directly to the owners. The limitations of an S corporation can make it less preferable than a C corporation, but the tax advantages may make it more attractive. 

Taxes on S Corporation: Basics

Shareholders take profits directly from the company via the pass-through mechanism. They then pay personal taxes on that profit. How much they pay depends on their participation in the business. However, all shareholders have to pay individual income taxes on the federal level along with state and local taxes. They are also subject to the Pease limitation on itemized deductions, which adds to the total tax rate. 

Paying taxes based on shareholder participation works like this: as a shareholder, you own 30 percent of a business. In the event you engaged in a commensurate amount of work in the business, you have to take 30 percent of the profits, losses, and any credits on your personal tax return. Or you own 30 percent of the business and wound up taking on the lion's share of the work to run the business over the course of the year. It may be that you are granted 75 percent of the profits for fair compensation. The profits pass through to you as personal income, and you are then responsible for the personal income taxes on that profit. 

Another taxation option for an S corporation is the ability to divide the profits into salaries as well as distributions that are considered passive income. The salaries are subject to FICA (Social Security and Medicare) taxes, while distributions have no such tax liability. 

How an S Corporation Operates

As previously mentioned, S corporations pass through financials to shareholders that include:

  • Corporate income
  • Losses
  • Deductions
  • Credits

The corporation is responsible for taxes on some built-in gains and passive income at the corporate level. However, before profits can be recognized, each owner/employee has to be paid what is considered to be a reasonable amount of compensation. This compensation is subject to FICA taxes, half of which is paid by the corporation and the other half paid by the owner/employee. For those who look at an S-corp as a means to avoid paying self-employment taxes, there may not be a benefit until the corporation can pay out profits after paying a mandatory reasonable compensation. 

What Is Reasonable Compensation?

Reasonable compensation has no firm definition despite many court cases between the IRS and business owners. In these cases, the IRS has alleged that the business owners are paying themselves a lower salary to avoid paying self-employment taxes, while the owners argue otherwise. Complicating matters is the fact the tax code has no specific guidelines to define "reasonable."

Courts use the following criteria to determine what is reasonable compensation:

  • Responsibilities and duties of the shareholder/employee.
  • Training and experience of shareholder/employee.
  • Amount of time and effort put into the business by said individual.
  • Wages of non-shareholder employees.
  • Salaries paid by similar businesses for similar services.

Do a search to determine what an average salary consists of for people in your position in your geographic area to avoid running afoul of the IRS.

Wage Income and Profit Distributions

All active shareholders are subject to receive two types of income from an S-corporation: profit distribution and wage income. Wage income is taxed through payroll taxes that consist of contributions to Social Security, Medicare, and income taxes. The profit distribution is not burdened by payroll taxes directly. Instead, as previously mentioned, the shareholder who receives the profit is responsible for paying personal income taxes, as it is considered income. 

Passive shareholders, or shareholders who don't have an active role in the corporation, don't pay income tax as they don't take a wage from the business. Instead, they are responsible for paying the ACA's Net Investment Income Tax of 3.8 percent. A passive shareholder may be liable for higher top marginal tax rates than a shareholder who is active.

If you need help with understanding S corporation taxes,  you can 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.