1. The Rationale Behind S Corp Taxation
2. Taxes That S Corporations Pay
3. Taxation of S Corporation Shareholders

The taxation of S corps is based on the pass-through principle. Taxes on S corps include FICA taxes at a rate of 15.3 percent of each employee's wages and Federal Unemployment Taxes at a rate of about 6 percent of wages. An S corp shareholder must also pay taxes on his or her earnings to the tune of 10-37 percent. Some high-earning inactive shareholders may also qualify for the Net Investment Income tax.

States also levy a number of taxes, and these may include franchise tax, sales tax, unemployment tax, workers compensation taxes, and more. Some states also tax the personal income of S corp shareholders. The outstanding tax difference between S corps and C corps is that the IRS does not levy corporate income tax on the S corporation.

The Rationale Behind S Corp Taxation

The S corp business type is an entity type that was launched to reduce the tax burden on small corporations. This corporation taxation type gets its name from Subchapter S of the Internal Revenue Code, which regulates these types of corporations. Small businesses that choose to get S corporation treatment communicate their decision to the IRS using Form 2553. Such businesses are required to meet a number of requirements, including the following:

  • The corporation must have a maximum of 100 shareholders.
  • The corporation should not have non-U.S. citizen shareholders unless they reside in the U.S.
  • The corporation should have only one type of stock.
  • The decision to file as an S corporation must be unanimous.

Despite the fact that S corporations are not required to pay corporate tax, the corporation must still pay most of the other taxes that traditional corporations pay.

Taxes That S Corporations Pay

  • Medicare and Social Security (FICA) Taxes. S corps that have employees must withhold and pay Medicare and Social Security taxes. The corporations also add their contribution to each employee's tax and pay a total of about 15.3 percent of the employee's wages. These taxes must be paid by employee-shareholders of the S corp.
  • Federal Unemployment (FUTA) Tax. The federal unemployment tax is paid by most S corporations that have permanent employees. It is charged at a rate of about 6 percent of the wages paid to the employees.
  • Excess Net Passive Investment Tax. The IRS does not want businesses whose income comes from predominantly passive means to file as S corporations. While S corporations that get their incomes actively do not pay corporate tax, S corporations which earn more than 25 percent of their gross receipts from passive ventures must pay corporate tax on the passive income beyond the 25 percent threshold. Income from passive means includes all income from investment or rental properties.

Taxation of S Corporation Shareholders

  • Federal Income Tax. S corporation shareholders must pay income tax on their share of the corporation's earnings. This tax is paid at rates that range from 10 to 37 percent of the income and is due even if the earnings are not distributed to the shareholders.
  • Net Investment Income Tax. The net investment income tax, which launched in 2013, is levied on high-earning S corp shareholders who are not employees of their S corporations. To be eligible for this tax, the shareholder must earn over $200,000 from the S corp in a year. Couples that file jointly must earn over $250,000 to qualify for this tax. It is charged at a rate of 3.8 percent of the income beyond the threshold.
  • State Income Tax. Some states require S corp shareholders to pay income tax. The rate for this tax differs from state to state.
  • State Franchise Tax. Most states require S corporations to pay franchise tax. The rates depend on the state and on the income of the S corporation.
  • State Sales Tax. S corporations that are involved in selling goods or services are normally required to pay sales tax to the state. The rates vary from state to state.
  • Excise Tax. Some S corporations that are involved in manufacturing are required to pay state excise tax.
  • Unemployment and Workers' Compensation Insurance. Many states require S corporations in their states to pay taxes to state workers' compensation funds and unemployment funds.

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