How Are S-Corp Profits Taxed?

Choosing to structure a business as an S Corporation comes with a distinct tax advantage owners find appealing: avoiding the double taxation that C Corporations face. Instead of the business paying tax on its earnings and shareholders paying tax again on dividends, an S-Corp's profits and losses are "passed through" to the shareholders' personal tax returns. This article explains precisely how S-Corp profits are allocated, taxed, and distributed, covering everything from pass-through mechanics and reasonable compensation to the importance of shareholder basis.

The Heart of the S-Corp: Pass-Through Taxation

Unlike a C Corporation, which is a separate tax-paying entity, an S-Corp is a pass-through entity. This is the most fundamental concept to grasp. The business itself generally does not pay federal income tax. Instead, the firm’s net profit or loss for the year is divided among its shareholders, who then report that income or loss on their individual tax returns and pay the corresponding tax at their personal income tax rates.

Let's compare this with a C-Corp to see the difference clearly:

• C Corporation Scenario (Double Taxation): A C-Corp earns $200,000 in profit. The corporation first pays corporate income tax (a flat 21% federal rate) on that profit. If it then distributes the remaining profit as dividends to its shareholders, those shareholders must pay tax on the dividend income on their personal returns. The same dollar is taxed twice.
• S Corporation Scenario (Pass-Through): An S-Corp earns $200,000 in profit. The corporation itself pays no federal income tax. The $200,000 profit is passed directly to the shareholders' tax returns. If there is one shareholder, they report the full $200,000. If there are two 50/50 shareholders, each reports $100,000. The tax is paid just once at the individual level.

Each year, the S-Corp files an informational tax return with the IRS using Form 1120-S, U.S. Income Tax Return for an S Corporation. This form details the company's income, deductions, and profits. However, its primary purpose is to report how those financial results are allocated among the shareholders.

Allocating Profits to Owners: Understanding the Schedule K-1

You might wonder how each shareholder knows exactly what amount of profit or loss to report. That’s where the Schedule K-1 comes in. After the S-Corp files its Form 1120-S, it provides a Schedule K-1 to each shareholder.

This document itemizes the shareholder’s individual portion of the company's earnings, losses, deductions, and credits for the year. The allocation is done on a pro-rata basis, meaning it's based on the percentage of stock each shareholder owns. For example:

• Alex owns 75% of ABC Inc., an S-Corp.
• Maria owns 25% of ABC Inc.

If ABC Inc. has a net profit of $100,000 for the year, Alex will receive a K-1 showing $75,000 in income, and Maria will receive a K-1 showing $25,000. This is the amount they are legally required to report on their personal tax returns—specifically on Schedule E of Form 1040—and pay income tax on.

It is very important to note that the taxable income shown on the K-1 is not tied to the amount of cash the shareholder actually received from the business. Alex owes tax on $75,000 of profit regardless of whether he took a $10,000 distribution, a $75,000 distribution, or no distribution at all. This "phantom income" can sometimes catch new S-Corp owners by surprise, so planning for tax payments on undistributed profits is a key part of S-Corp management.

Reasonable Compensation: The Salary vs. Distributions Split

The "pass-through" K-1 income is just one part of the story. For shareholders who also work in the business (as most S-Corp owners do), money is received in two distinct ways: a salary and distributions. Understanding the difference is central to leveraging the S-Corp's primary tax advantage.

1. W-2 Salary: Any shareholder who performs more than minor services for the corporation must be paid a reasonable salary. This compensation is reported on a Form W-2, just like any other employee. This salary is considered an operating expense for the S-Corp and is subject to FICA taxes (15.3% for Social Security and Medicare), split between the employee and the employer.

2. Distributions: After paying all expenses, including the shareholder’s salary, the remaining profit can be paid out to shareholders as distributions. These distributions are not subject to FICA taxes. Herein lies the opportunity for tax savings.

What is "Reasonable Compensation"?

The IRS requires shareholder-employees to be paid a fair market salary for the work they perform before any profits are taken out as distributions. You can't pay yourself a $1 salary and take the rest of the company's $200,000 profit as a distribution just to avoid payroll taxes. This practice is a major red flag for IRS audits.

Let's look at an example to see how this works in practice:

Chloe is the sole shareholder and an employee dentist. Her S-Corp has a net profit of $250,000 before her own compensation is considered. To determine a reasonable salary, she researches what other dental practice owners in her area with similar experience and duties are paid. She determines a reasonable salary is $120,000.

• The Salary Portion: Chloe pays herself a W-2 salary of $120,000. She personally pays 7.65% in FICA taxes, and her corporation pays the other 7.65% on this amount. This salary is then reported on her personal return as wage income.
• The Distribution Portion: After her salary, the S-Corp has a remaining profit of $130,000 ($250,000 - $120,000). Chloe can take this $130,000 as a distribution. This amount is not subject to FICA taxes, saving a potential $19,890 (15.3% of $130,000).

Factors the IRS considers when evaluating "reasonable compensation" include the shareholder’s duties, the time and effort devoted to the business, their experience and training, the amount that would be required to pay a non-shareholder for comparable work, and the pay structure of similar roles at comparable companies.

Don't Forget Shareholder Basis

"Basis" is a technical but critically important concept for every S-Corp shareholder. In simple terms, your basis is your financial investment in the business. It determines how much you can take out of the company in distributions tax-free and how much of the company's losses you can deduct on your personal return.

A shareholder’s basis starts with their initial capital contribution (the money or a property value put into the business) and is adjusted annually:

• Basis increases when the company earns a profit (your pro-rata share) or when you contribute more capital or personally loan the company funds.
• Basis decreases when you receive a distribution or when the company has a loss (your pro-rata share).

Basis is crucial for two reasons:

1. Limits on Tax-Free Distributions: An S-Corp shareholder can only receive distributions tax-free up to their stock basis amount. For example, if your basis in the company is $50,000, you can take distributions up to that amount without incurring additional tax. If you receive a distribution of $60,000, the $10,000 that exceeds your basis is typically taxed as a long-term capital gain. This is where meticulous basis tracking becomes essential.
2. Limits on Deducting Losses: Similarly, you can only deduct S-Corp losses on your personal tax return up to your total basis (both stock and any direct loans you made to the corporation). If your share of the business's losses for the year is $30,000 but your basis is only $20,000, you can only deduct $20,000 that year. The remaining $10,000 loss is suspended and carried forward until you have sufficient basis to absorb it.

Beyond Federal Income Tax: State-Level Considerations

While S-Corps are exempt from federal income tax, they are not immune from all taxes at the entity level, especially when it comes to state and local governments. How profits are treated can vary significantly by state.

Most states respect the federal S-Corp election and follow the pass-through concept. However, some states impose an entity-level tax on S-Corps:

• Franchise or Capital Taxes: Some states like Texas and Delaware impose a franchise tax on S-Corps based on revenue or net worth, unrelated to profit. California charges a 1.5% franchise tax on an S-Corp's net income, with a minimum fee of $800.
• Pass-Through Entity Taxes (PTET): In response to the $10,000 federal cap on State and Local Tax (SALT) deductions, many states have introduced an optional Pass-Through Entity Tax. This allows the S-Corp to elect to pay state income tax at the entity level. The corporation can then deduct this payment as a business expense, and the shareholders receive a credit or an exemption for tax paid on their personal state returns, benefiting high-income shareholders in high tax states.

Furthermore, S-Corps are responsible for all other standard business taxes, including sales taxes on applicable goods and services and payroll taxes associated with employee wages (including shareholder salaries).

Final Thoughts

The S-Corp structure offers a powerful tax benefit by combining the pass-through income of a partnership with the limited liability of a corporation. Shareholders are taxed on their share of profits at their personal rates, avoiding double taxation. This structure allows for the opportunity to take FICA-free payments of dividends, but it demands adherence to the rules involving reasonable compensation, meticulous bookkeeping, and a complete understanding of how shareholder basis operates.

Understanding concepts like reasonable compensation, state tax rules, and shareholder basis is not a one-time task. As official guidance changes and your business evolves, having quick access to reliable information becomes key. Instead of spending hours searching through IRS publications, tools like Feather AI allow us to get immediate, citation-backed answers to these very specific tax questions. This helps us spend more time focusing on sound judgment and offering the strategic guidance our clients need.