S CORPORATION TAXATION

Being a “Pass Through” entity, tax form 1120S and issuing schedule K-1 forms are important when discussing the taxation of an S-Corp.

Like LLCs, S Corps do not file a separate tax return and are treated as a “pass through” entity. That is, federal tax liability passes through the corporation and on to the individual shareholders. Not every corporation can qualify to be treated as an S Corporation. Please see the section on S Corporations for more information on what is required to form an S Corporation.

C Corporations are required to be taxed at both the corporate and shareholder level, resulting in double taxation. By being able to file as an S Corporation, the taxation at the corporate level is avoided. This is of course the major benefit of filing as an S Corporation. As in LLCs, the shareholders are taxed on their personal income tax for the S Corp’s earnings. Shareholders report income from the S Corp in proportion to their ownership in the S Corp. For example, an S Corporation has 5 shareholders and the S Corp made $250,000 in profit. Each shareholder would then receive a dividend of $50,000 – $250,000 divided by 5 shareholders. This would have to be reported on each shareholders’ personal tax return. How that $50,000 is categorized for tax purposes depends on factors explained below.

Another big advantage in filing as an S Corp is that there is no self-employment tax on each shareholders’ portion of the business profits as there is for LLCs (See LLC Taxation section). However, every member who is also an employee (shareholder-employee) of the S Corp must pay themselves a reasonable salary and are taxed as wages would be taxed as payroll (i.e., federal and state income taxes, Medicare and Social Security). What a reasonable salary would be for each shareholder/employee must be researched as the IRS will look at this number carefully. Also, there is no guidance given by the IRS for this which can make it more difficult to know what “reasonable” is. The IRS will want to make sure that the salary isn’t lower than what is industry standard for someone in that position or performing those skills. It can be tempting for the shareholder-employee to give themselves a lower than average salary to avoid being taxed on the profit as the salary is deducted from the profit and taxed at a lower rate. In the example below, an employee shareholder could try to give themselves a salary of $40,000 which would leave only $10,000 from the profit to be taxed as business income and not as wages. This can be a huge savings to the shareholder-employee which is why the IRS will give more scrutiny to the salaries of shareholder-employee to make sure they are reasonable.

Shareholders who are not employees of the S Corp (passive shareholders) don’t have to pay payroll tax on the profit that they receive since it is not considered a wage or salary. It is taxed as income and can result in a higher tax than that paid by the shareholder-employees. Thus, the benefit of being a shareholder-employee. Keep in mind since the S Corp is paying wages, it must withhold and periodically employment taxes and issue a W-2 to each employee.

Tax Form 1120S

S Corps must file a Form 1120S (regular corporations file a Form 1120) every year as its tax return. It is due on March 15 for S Corporations that have its fiscal year follow the calendar year. For those S Corps that don’t, the Form 1120S must be filed by the 15th day of the 3rd month after the end of its fiscal year. If an S Corp’s fiscal year ends in March, the form 1120S must be filed by June 15 of that year.
Because S Corps are not taxed themselves, the Form1120S acts more to serve informational purposes to the IRS than an actual tax return. Form 1120S reports the income, gains, losses, deductions, credits, and any other information for the S Corp.

Schedule K-1

S Corps have to issue K-1 forms (Shareholder’s Share of Income, Deductions, Credits, etc.) to all of its shareholders. Shareholders of an S Corp must file a K-1 form to report their income for income tax purposes. It is not filed with the shareholders personal income tax return but is instead filed along with the 1120S Form. Information from the K-1 will, however, be necessary to fill out Schedule E (Supplemental Income and Loss) on your personal tax return (Form 1040). Other Schedules may need to be filed with your personal tax return, like Schedule D, Capital Gains and Losses. Information for Schedule D will also be included in the K-1 form.