Key Takeaways

  • S-corporations offer pass-through taxation, meaning business income and losses are reported on shareholders’ personal tax returns, avoiding double taxation.
  • Owners must pay themselves a “reasonable salary,” which is subject to payroll taxes, while distributions above that salary are generally exempt from self-employment tax.
  • Strict eligibility rules apply, including limits on shareholder types, numbers, and stock classes.
  • Even though S-corps don’t pay corporate income tax, shareholders are taxed on their share of company profits whether or not they receive distributions.
  • Good business planning and tax strategies—such as tracking deductible expenses and using fringe benefits—can help optimize tax savings for S-corp owners.

When researching S-corporations for dummies, it is important to know how this type of corporation works and the steps to take. Every S-corporation starts out as a regular corporation. S-corporations are only formed when normal corporations elect a specific small-business tax status through the IRS. This can be done when a business files Form 2553 a few months before the corporation forms.

S-Corporation Taxes

An S-corporation has pass-through tax status. Similar to partnership taxation or sole proprietorship taxation, the expenses and revenue of the company will pass through to the tax returns of the shareholders. S-corporations are required to file their own tax return due to their status. That said, the company still needs to issue K-1s out to the shareholders, similar to a partnership. Small businesses may prefer to be taxed as S-corporations, but before choosing this option, it's important to make sure your businesses intends to stay small for a while (about five years).

Common S-Corp Tax Forms and Deadlines

S-corporations have several IRS filing requirements beyond their annual Form 1120-S. Key forms and deadlines include:

  • Form 1120-S (U.S. Income Tax Return for an S Corporation): Due by March 15 for calendar-year corporations or the 15th day of the third month after the tax year ends.
  • Schedule K-1 (Shareholder’s Share of Income, Deductions, Credits): Issued to each shareholder to report their share of the S-corp’s income and deductions.
  • Form 941 (Employer’s Quarterly Federal Tax Return): Used to report wages paid and payroll taxes withheld.
  • Form 940 (Annual Federal Unemployment Tax Return): Required if the business paid wages subject to FUTA tax.
  • State Filings: Some states require separate S-corp returns or annual reports, often with franchise or excise tax obligations.

Meeting these deadlines helps avoid costly IRS penalties and interest charges.

Reasonable Salary

The primary difference between the taxation of S-corporations and other entities is that the shareholders or owners can work for the business and give themselves a salary that's subjected to the same payroll taxes that are taken out from all paychecks. All profit given to the shareholders that's above a "reasonable salary" that's already been paid isn't subject to the self-employment tax of 15.3 percent.

If the company makes more than the salary a shareholder pays themselves, the savings can be huge. What is considered a "reasonable salary" according to the IRS isn't clearly defined. However, if the company ever gets audited, the IRS would ensure that the salary is similar to that of a professional in the industry with similar responsibilities.

How to Determine a Reasonable Salary for Owners

The IRS expects S-corp shareholder-employees to be paid a “reasonable salary” for the work they perform. To determine this amount, consider:

  • Industry Standards: Compare compensation for similar roles in your industry and region.
  • Duties and Responsibilities: The greater your role in day-to-day operations, the higher your salary should be.
  • Business Profitability: Salaries should align with what the company can afford without jeopardizing operations.
  • Time Commitment: Full-time owners generally warrant higher salaries than those who work part-time.
  • Credentials and Experience: Advanced skills, certifications, and years in the field can justify higher pay.

Failing to pay a reasonable salary can trigger IRS audits, payroll tax assessments, and penalties.

Restrictions

If your business or LLC has chosen to be an S-corporation for its tax status, you must abide by the following rules: 

  • No more than 100 shareholders in the corporation.
  • Shareholders can only be individual trusts, natural people, or tax-exempt non-profit organizations (excluding other entities or business structures, such as limited liability corporations).
  • Shareholders must be resident aliens or citizens of the United States.
  • Only one class of stock is allowed in the corporation.
  • Insurance companies and banks can't be shareholders.
  • Every shareholder needs to consent to the S-corporation tax designation, so a majority vote won't work.

Income Tax Restrictions

An S-corporation doesn't pay income tax, but it must set aside $2.2 million of taxable income among the owners in an equal proportion of the number of stocks that each owner has. If a shareholder has one-tenth of the total shares, $220,000 of the taxable income of the business must be included on his or her personal income tax return for the year. This must happen whether a cash distribution is received from the profit or not.

The S-corporation can distribute the cash dividends to the stockholders to allow them to have money to pay the income tax for their shares of the taxable income for the company. The primary question companies have when it comes to taxes is how to decrease the overall income tax burden on the stockholders and business entity. 

Businesses must decide if they want to be an S-corporation and pass through any taxable income to their stockholders, which will leave the stockholders with taxable income. They can also decide to be a C-corporation and have their stockholders pay another tax on dividends that they receive on top of the income tax the business pays.

Deductible Expenses and Fringe Benefits for S-Corps

S-corporations can reduce taxable income by deducting certain business expenses and offering fringe benefits. Common deductible items include:

  • Operational Costs: Rent, utilities, office supplies, advertising, and insurance.
  • Employee Benefits: Health insurance premiums for employees and certain retirement plan contributions.
  • Business Travel and Meals: Travel expenses and 50% of eligible business meals.
  • Equipment and Depreciation: Purchases of machinery, computers, or vehicles used in business operations.

Some fringe benefits, such as employer-paid health insurance for more-than-2% shareholder-employees, are taxable to the individual but remain deductible to the S-corp. Strategic use of deductions can help offset income passed through to shareholders.

Business Plan Format

A business plan is important to show to potential investors and bankers. A good business plan should include the following:

  • Nothing that surprises investors.
  • A cover page that has contact information and a statement saying the plan is confidential.
  • A table of contents so that investors can quickly find information.
  • A company description.

A marketing plan should tell readers what the plan is to reach the business' potential market, including advertising, packaging, web marketing, distribution, and more. One section should include all the members' names and what their positions and credentials are. The competition section should focus on any competitors' strengths or weaknesses. Financial projections and statements should include many different numbers, such as the income statement, financial forecasts, balance sheet, and cash flow statement.

Tax Planning Strategies for S-Corp Owners

Effective tax planning can maximize the benefits of S-corp status. Strategies include:

  • Splitting Income Between Salary and Distributions: Pay yourself a reasonable salary and take the rest as distributions to reduce self-employment taxes.
  • Maximizing Retirement Contributions: Set up a SEP IRA or Solo 401(k) to defer taxes while saving for retirement.
  • Tracking Shareholder Basis: Maintain accurate records of stock and debt basis to determine loss deductions and avoid excess loss disallowance.
  • Considering State Tax Implications: Some states impose corporate-level taxes on S-corps; planning ahead can reduce the impact.
  • Timing Expenses and Income: Accelerating expenses or deferring income can reduce current-year taxable income.

Regular consultation with a tax professional can ensure compliance while optimizing savings.

Frequently Asked Questions

1. Do S-corps pay federal income tax? 

No. S-corps generally don’t pay federal income tax at the corporate level; profits and losses pass through to shareholders’ personal tax returns.

2. What happens if I don’t pay myself a reasonable salary? 

The IRS may reclassify distributions as wages, leading to back payroll taxes, penalties, and interest.

3. Can an S-corp deduct health insurance premiums? 

Yes. Premiums for employees are deductible, but more-than-2% shareholder-employees must include the premiums in taxable income.

4. When are S-corp tax returns due? 

Form 1120-S is due March 15 for calendar-year corporations, with Schedule K-1s issued to shareholders by the same date.

5. How can S-corp owners lower their tax bill? 

By balancing salary and distributions, maximizing deductible expenses, contributing to retirement plans, and planning for state tax obligations.

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