S Corporation Taxation: A Complete Guide for Business Owners

An S corporation (S corp) is a special tax status for a corporation that lets business income and losses flow through to individual shareholders, avoiding the “double taxation” of C corporations. For federal purposes, an S corp itself generally pays no corporate income tax. Instead, all income, losses, deductions, and credits “pass through” to the shareholders, who report them on their personal tax returns. (The IRS notes that this structure “avoids double taxation” on corporate income.) However, the S corp may owe tax on certain built-in gains (if the corporation converts from C status with appreciated assets) and on excessive net passive investment income. Overall, the S-corp election means profits are taxed once at individual rates.

Pass-Through Taxation and Shareholder Reporting

Each S corp shareholder receives a Schedule K-1 showing their share of the company’s income, deductions, and credits. Shareholders must pay personal income tax on this K-1 income, even if the money isn’t distributed in cashirs.gov. In other words, if the S corp earns profit, each owner pays tax on their portion of that profit each year. This is a key feature: owners pay tax on their shares of profits regardless of distributions, so retained earnings aren’t “tax-sheltered” in the company. (Notably, a 2024 Tax Court case reaffirmed that a shareholder owes tax on their S-corp share of income whether or not it was distributed.)

Shareholders may need to make estimated tax payments on their S-corp income each quarter to avoid penalties. They report the pass-through income (and any losses) on Form 1040 (often on Schedule E) and reconcile it with any wages they’re paid (below). It’s essential for shareholders to keep track of their basis in the stock and loans to the S corp, because losses and deductions can only be used up to the amount of basis.

Shareholder-Employee Payroll Requirements

When an S corp owner (usually also an officer) provides services to the business, the IRS requires the company to treat that owner as an employee for payroll tax purposes. In practice, this means the owner must be paid a reasonable wage and have payroll taxes withheld and paid (Social Security, Medicare, and unemployment taxes). The IRS stresses that “an S corporation must pay reasonable compensation to a shareholder-employee in return for services that the employee provides” before taking non-wage distributions. In other words, distributions (dividends) are only allowable after the owner has received a fair salary for their work.

This reasonable-salary rule is crucial. S corp owner-employees still owe payroll taxes on their wages, but any additional profits taken as distributions are not subject to Social Security or Medicare tax. For example, if a business earns $80,000 profit, a sole proprietor would owe 15.3% (about $12,240) in self-employment tax on the full amount. In contrast, an S corp owner might pay themselves a $40,000 salary (incurring about $6,120 in payroll taxes) and take the remaining $40,000 as a distribution with no additional FICA tax. This yields about $6,120 in tax savings on that $80K of profit. (Our table below, adapted from a tax guide, shows the difference in taxes paid:)

Scenario	Net Profit	Owner’s Salary	Payroll Taxes (15.3%)	Distributions	Total Payroll Tax	Savings vs. Sole Prop.
Sole Proprietor	$80,000	N/A	$12,240	$0	$12,240	–
S Corporation	$80,000	$40,000	$6,120	$40,000	$6,120	$6,120

The IRS vigorously enforces this rule. If owners pay themselves too little (or nothing) in wages and take most income as distributions, the IRS can reclassify those distributions as wages, triggering back payroll taxes, interest, and penalties. Multiple court cases confirm that S-corp shareholders must pay employment taxes on “too-large” distributions if the wages were unreasonably low. In short, when running an S corp, it’s mandatory to run payroll for owner-employees. The exact wage amount depends on role, industry standards, hours, and business profits.

State-Level Taxation and Common Pitfalls

While federal law provides S corp status, state taxes vary widely. Many states follow the federal pass-through rule, but some impose separate taxes or even ignore the S election altogether. This is a key consideration when choosing your business location. 

For example, California treats S corps like other corporations for state tax: it levies a 1.5% tax on S-corp net income and a minimum $800 franchise tax each year. (The $800 minimum applies regardless of activity level, and it’s due in the first quarter; California waives the first-year fee only for very short initial years.) In contrast, Tennessee and Ohio do not recognize the S-election and tax S corps as regular C corporations. New York City also ignores S status, taxing an S corp at the corporate level while New York State taxes only shareholdersstripe.com. States like Illinois and Minnesota allow S corporations but still impose a small corporate-level “replacement tax” on profits.

These variations can eat into S-corp tax savings. As one tax adviser notes, “state-level fees and other costs may entirely cancel out savings”. When planning, always check your state’s rules (and any city taxes) for S corporations. Don’t forget payroll tax differences too: some states have their own unemployment taxes and specific S-corp reporting requirements.

Who Should Consider an S Corporation?

S corporations can be advantageous for certain businesses seeking tax savings, but they’re not ideal for everyone. Generally, S corp status benefits owners who expect substantial profits and are willing to handle the extra compliance. Common candidates include:

• Growing Sole Proprietors and LLCs. A sole owner (or partners) running an LLC or sole proprietorship can often save on self-employment taxes by converting to an S corp. (Any LLC can elect S status if it qualifies.)

• Profitable Small Corporations. Many businesses initially set up as corporations default to C status. If they’re consistently earning net income and don’t need retained earnings at the corporate level, an S election can avoid double corporate tax on distributed profits.

• Professional Practices. Engineers, doctors, consultants and other professional businesses often convert to S corp to split owner compensation between salary and distributions.

The break-even threshold depends on your profit level and costs. Studies show that S-corp tax savings become significant once net profits exceed a certain amount. For instance, on $80,000 of net income the sole-proprietor vs. S-corp example above saved over $6,000.

Below roughly $50,000–60,000 profits, the additional payroll and tax-filing costs may offset the savings. (Our Income Thresholds table shows that at $40K profit, S-corp saved only about $295 after extra payroll costs, but at $80K profit savings jumped to $4,120.)

Figure: Key differences between S corps, LLCs, and C corps. S corps offer pass-through taxation (no corporate tax) and potential savings on self-employment taxes, but have stricter requirements and restrictions.

Many owners compare S corps to other structures. Unlike an LLC or sole proprietor, an S corp requires formalities (articles of incorporation, annual meetings, minutes) and payroll. Unlike a C corp, an S corp cannot have more than 100 shareholders or foreign investors, and it must issue only one class of stock. In exchange, shareholders get liability protection and the benefit of pass-through taxation.

Example Tax Savings: To illustrate, a business with $150,000 net income might run as an S corp paying the owner an $80,000 salary (with $12,240 in payroll taxes) and distributing $70,000 (with no additional payroll tax). Versus remaining a sole proprietor (which would incur $22,950 in self-employment tax on the full $150K ), the S corp approach saves about $8,710. These savings increase with higher profits, as shown in the table above.

Potential Downsides and Common Pitfalls

The S-corp election brings compliance risks and limitations. Owners must heed IRS rules and corporate governance requirements. Key downsides include:

• Reasonable Compensation Scrutiny: The IRS closely watches S-corps to ensure owner-employees receive fair wages. Paying too little salary to maximize distributions can trigger audit and reclassification of past distributions as wages (with back taxes and penalties). Maintaining accurate time logs, comparable salary studies, and clean payroll records is essential.

• Ownership Restrictions: S corps can have no more than 100 shareholders, and all must be U.S. citizens or residentsirs.gov. Only individuals, certain trusts, and estates qualify as shareholders; S corps cannot be owned by other corporations, partnerships, or non-resident aliensirs.gov. If your business plans include angel investors, foreign owners, or going public, S corp status may disqualify you.

• Single Class of Stock: By law, S corps can issue only one class of stock. This means all shares must have identical rights to distributions and liquidation proceeds. Companies that want preferred stock, or stock grants with different dividend rights, cannot do so under S status.

• Additional Costs and Complexity: Electing S status means hiring payroll services, filing Form 1120-S each year, issuing K-1s, and often paying for more expensive tax preparation. You must follow corporate formalities (bylaws, meetings, minutes) and maintain separate business records and bank accounts. The administrative burden can outweigh tax savings for very small or irregular businesses.

• State Taxes and Fees: As noted above, some states impose their own corporate taxes or fees on S corps. California (1.5% tax plus $800 minimum) and Tennessee (no S recognition) can negate federal savings. Make sure to include state and local taxes in your decision.

• Built-In Gains Tax: If converting an existing C corporation with appreciated assets to S status, be aware of the built-in gains tax. If the S corp sells those assets within 5 years of the conversion, it can owe tax at the corporate rate on the gains.

In summary, S corps work best when the potential self-employment tax savings clearly exceed the added payroll and compliance costs. Careful planning is required to avoid IRS pitfalls (like underpaying wages) and to maintain the election year after year.

Electing S corporation status can yield significant federal tax benefits by letting profitable small businesses bypass double taxationirs.gov. However, the rules are strict. Business owners should weigh the savings against the downsides – payroll responsibilities, IRS scrutiny, and state rules. When done right, S corp taxation can reduce taxes and protect personal assets, but it’s wise to work with experienced tax counsel or CPAs to make the election, set up payroll correctly, and stay compliant.

For help navigating S-corp elections, payroll, or ongoing compliance, Brister Law Firm advises entrepreneurs nationwide. We can analyze whether an S corp makes sense for your situation and handle the tax filings so you can focus on running your business. To learn more, read our full blog post and contact us for a consultation.