Key Takeaways

  • S corp taxes operate under a pass-through model, meaning the business itself isn’t taxed at the federal level, but shareholders report income on their personal tax returns.
  • While S corporations avoid double taxation, they may still owe specific federal, state, and payroll-related taxes, including FICA, FUTA, LIFO, and built-in gains taxes.
  • Shareholders are taxed on their share of corporate income whether or not it is distributed and may also be subject to Net Investment Income Tax if they exceed certain income thresholds.
  • Reasonable compensation rules require S corp owners who work in the business to take a fair salary subject to payroll taxes before taking distributions.
  • Strategic tax planning — such as utilizing deductions, structuring distributions efficiently, and managing passive income — can reduce overall S corp tax liability.

Taxes for S corps include FICA taxes, Federal Unemployment Tax, LIFO tax, and excess net passive income tax. S corporations are not subject to federal double taxation. Therefore, they are not eligible for federal corporate tax. The shareholders of S corps are not exempt from taxes arising from the S corp and must pay personal income tax at rates similar to all other U.S. citizens.

S Corps and Pass-Through Status

S corps have pass-through status and do not pay tax to the IRS. This means the IRS does not levy taxes on the S corp as a business. However, any income the S corp earns is passed through to the shareholders of the business who must pay personal income tax. Although the shareholders of an S corp still need to pay personal income tax and other taxes, the S corp arrangement can enable owners of some small corporations to save thousands of dollars on taxes every year.

All new corporations are initially given the C corp tax treatment by the IRS. C corporations do not have pass-through tax treatment and must pay corporate tax on the corporation's profits at rates as high as 21 percent. Owners of S corporations that meet the requirements can apply using IRS Form 2553 to get S corp status.

S corp treatment is not given to corporations with the following characteristics:

  • Corporations that have more than 100 shareholders.
  • Corporations that have non-U.S. citizens that do not reside in the U.S.
  • Corporations that have more than one type of stock.
  • Corporations that have corporate shareholders.

Eligibility and Filing Requirements for S Corp Status

To qualify for S corporation taxation, a business must first be a domestic corporation and meet IRS eligibility requirements. These include:

  • Having no more than 100 shareholders
  • Issuing only one class of stock
  • Having shareholders who are U.S. citizens or resident aliens
  • Ensuring all shareholders are individuals, certain trusts, or estates (not other corporations or partnerships)

Corporations elect S corp status by filing IRS Form 2553, usually by March 15 of the tax year. Once approved, the business becomes a pass-through entity, and all income, losses, credits, and deductions flow directly to shareholders’ individual returns.

S Corporation Taxes

  • Excess Net Passive Income Tax. S corporations whose income from passive activities exceeds 25 percent of the corporation's gross receipts must pay corporate tax on the excess income from the passive activities. The tax is charged at a rate of about 21 percent of the excess passive income. Passive income includes income from royalties, interest, and rent. This tax practically disqualifies real estate businesses and investment firms from filing as S corporations.
  • Federal Unemployment (FUTA) Tax. FUTA tax is paid by S corporations that have employers and have paid $1,500 or more to employees in any quarter, or corporations that have at least one employee who has worked for part of a day for 20 or more weeks in any quarter. S corporations with farm employees have less stringent requirements. This tax, charged at a rate of about 6 percent of the wages, is paid using IRS Form 940. Other taxes S corporations may pay include the LIFO tax and built-in gains tax. LIFO tax is paid if the S corporation used the LIFO accounting method in its last year as a C corp, while built-in gains tax may be paid by some S corps that sold assets within five years of obtaining them.
  • FICA Taxes. These taxes are part of payroll taxes and were established by FICA. They include Medicare and Social Security taxes. They are charged at a rate of about 15.3 percent of the wages, with the employee and the S corporation contributing half of the tax. The taxes are filed quarterly using Form 941.
  • State Franchise Tax. Some states require their S corporation to pay a franchise tax. The rates and method of calculating the tax differ from state to state. You can find details about the tax from your state's Revenue Department or Corporations Division.
  • State Excise Tax. Some states require manufacturing corporations to pay excise tax. Details about the filing of this tax can be obtained from the state's Department of Revenue.

Additional Federal Taxes S Corps May Owe

While S corporations avoid corporate income tax, they are responsible for several federal taxes under certain circumstances:

  • Built-in Gains (BIG) Tax: If a corporation previously operated as a C corporation and converted to an S corp, it may owe a 21% tax on built-in gains from appreciated assets sold within five years of conversion.
  • Excess Net Passive Income Tax: Triggered when more than 25% of gross receipts come from passive income (e.g., rent, royalties, dividends). The tax applies to the excess amount and is calculated at the corporate tax rate.
  • Accumulated Earnings and Profits (E&P): If an S corp with accumulated E&P from C corp years fails to distribute a portion of its income, it may face a 15% tax on certain undistributed income.

Reasonable Compensation and Payroll Tax Considerations

The IRS requires shareholder-employees of an S corp to receive “reasonable compensation” for services performed before taking distributions. This salary is subject to FICA taxes (Social Security and Medicare) but can help reduce self-employment taxes compared to sole proprietorships or partnerships.

Factors influencing reasonable compensation include:

  • Duties and responsibilities
  • Industry standards and geographic location
  • Business profitability

Failure to pay a reasonable salary can lead to IRS penalties and reclassification of distributions as wages.

Taxes for S Corp Shareholders

  • Personal Income Tax. Each S corporation shareholder must pay income tax on his or her share of the corporation's earnings. Personal income tax is charged at a rate of 10-37 percent of the shareholder's income. This tax is filed using a Schedule K-1 received from the S corp. The S corporation must, in addition to its Form 1120S, file copies of each shareholder's Schedule K-1s to verify the income.
  • Net Investment Income Tax. The Net Investment Income Tax is levied on inactive S corp shareholders who earn over $200,000 ($250,000 for couples that file jointly) from the S corp in a tax year. The tax is charged at a rate of 3.8 percent of the income above $200,000 or $250,000 for couples that file jointly.
  • State Personal Income Tax. Some states require S corporation shareholders to pay state income tax. You can find out about the rates of such taxes from the state's revenue department.

Distribution Rules and Shareholder Basis

S corp shareholders are taxed on their share of corporate income whether or not it’s distributed. However, distributions are generally tax-free to the extent of a shareholder’s basis (their investment in the company). If distributions exceed basis, they are taxed as capital gains.

Shareholder basis adjusts annually based on:

  • Increases: contributions, allocated income, and capital gains
  • Decreases: allocated losses, deductions, and prior distributions

Maintaining accurate basis records is crucial for determining tax liability on distributions.

Tax Deductions and Planning Strategies

S corps offer several opportunities for tax savings through strategic planning. Common approaches include:

  • Section 199A Qualified Business Income Deduction (QBI): Eligible shareholders may deduct up to 20% of qualified business income.
  • Fringe Benefits: Certain employee benefits, such as health insurance premiums, may be deductible.
  • Retirement Contributions: S corps can sponsor tax-advantaged retirement plans like SEP IRAs or 401(k)s.
  • Income Splitting: Balancing salary and distributions can minimize payroll taxes while meeting IRS requirements.

Frequently Asked Questions

  1. Do S corps pay federal income tax?
    Generally, no. S corps are pass-through entities, so income is reported on shareholders’ individual tax returns. However, certain situations (like built-in gains or excess passive income) can trigger corporate-level taxes.
  2. What is “reasonable compensation” for an S corp owner?
    It’s a salary comparable to what similar businesses pay for similar work. The IRS expects owner-employees to pay themselves reasonable wages before taking profit distributions.
  3. Are S corp distributions taxable?
    Distributions are typically tax-free up to a shareholder’s basis. Amounts exceeding basis are taxed as capital gains.
  4. Do S corp shareholders pay self-employment tax?
    No, they don’t pay self-employment tax on their share of business income. However, wages paid as reasonable compensation are subject to FICA payroll taxes.
  5. Can S corps deduct business expenses?
    Yes. Ordinary and necessary expenses — such as salaries, rent, utilities, insurance, and retirement plan contributions — are deductible, reducing taxable income passed through to shareholders.

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