An S corporation generally pays no federal income tax of its own. Instead, the way S corps are taxed is through pass-through treatment: the company’s profits, losses, deductions, and credits flow to the shareholders in proportion to their ownership, and each shareholder reports that share on a personal return and pays at individual rates. That single layer of tax is the whole point of the structure, but it comes attached to rules about owner compensation, basis, estimated payments, and a few entity-level exceptions that shape what shareholders actually owe.
How Pass-Through Taxation Works in Practice
Each year the corporation files Form 1120-S, an information return reporting the company’s income, deductions, and credits.1Internal Revenue Service. About Form 1120-S, U.S. Income Tax Return for an S Corporation The business itself generally does not owe federal income tax on those amounts. Every shareholder receives a Schedule K-1 showing their allocated share of each item for the year, and those numbers get reported on Schedule E of the shareholder’s Form 1040.2Internal Revenue Service. Shareholder’s Instructions for Schedule K-1 (Form 1120-S)
An important consequence follows from that structure. You owe tax on your allocated share of the corporation’s income whether or not the company actually distributes cash. If the corporation keeps profits inside the business for reinvestment, you still pay tax on your share, a situation sometimes called phantom income.
For calendar-year S corporations, Form 1120-S is due March 15, and Schedule K-1s must reach shareholders by the same date. A six-month extension to September 15 is available by filing Form 7004.3Internal Revenue Service. Publication 509 (2026), Tax Calendars
Salary Versus Distributions for Working Shareholders
If you work in an S corporation you own, the IRS expects you to pay yourself a reasonable salary before taking distributions. The agency looks at your training and experience, time devoted to the business, duties performed, what comparable businesses pay for similar work, and the company’s dividend history when it evaluates whether the salary is adequate.4Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues
That salary is treated like any other wage. The corporation and the shareholder-employee each pay 6.2% for Social Security and 1.45% for Medicare, a combined 15.3%.5Social Security Administration. Social Security and Medicare Tax Rates The Social Security portion applies only to the first $184,500 of wages in 2026; Medicare has no cap.6Social Security Administration. Contribution and Benefit Base Higher earners also owe an Additional Medicare Tax of 0.9% on wages above $200,000, or $250,000 for married couples filing jointly.7Internal Revenue Service. Topic No. 560, Additional Medicare Tax
Profits remaining after reasonable compensation can be paid out as shareholder distributions, and those distributions are not subject to payroll or self-employment tax. This split between salary and distributions is the main tax-planning advantage of the S corporation. Setting salary artificially low to shrink the payroll-tax bill invites scrutiny. If the IRS decides your salary was unreasonably low, it can reclassify distributions as wages, with back taxes, interest, and penalties following.
The 20% Qualified Business Income Deduction
Shareholders may claim a deduction of up to 20% of their share of the corporation’s qualified business income under Section 199A. The deduction was originally scheduled to expire after 2025 and was made permanent by legislation signed in July 2025.8Internal Revenue Service. Qualified Business Income Deduction You take it on your personal return, and it reduces taxable income without reducing adjusted gross income.
Income limits apply. When taxable income rises above roughly $200,000 for single filers or $400,000 for married couples filing jointly in 2026, the deduction begins to phase out. For specified service businesses, including law, medicine, accounting, consulting, and financial services, the deduction can disappear entirely at higher income levels. For non-service businesses over the threshold, the deduction is limited by reference to W-2 wages paid by the business or the value of its qualified property.
Basis Limits on Deducting Losses
When the corporation runs a loss, your ability to use it depends on your tax basis. Basis begins with what you contributed in cash or property, rises with additional contributions and your share of corporate income, and falls with distributions and losses claimed.
You can deduct passed-through losses only up to your stock basis. If the loss exceeds stock basis, you can use additional basis in loans you personally made to the corporation. Losses beyond both stock and debt basis are suspended and carry forward indefinitely until you have basis to absorb them. Sell all your stock before using those suspended losses and they are lost permanently.9Internal Revenue Service. S Corporation Stock and Debt Basis
Even after basis, a loss still has to clear the at-risk rules, the passive activity limitations, and the excess business loss limitation. Each filter runs in order, and a loss stopped at any step is suspended under that step’s own carry-forward rules.
Estimated Tax Payments
Payroll withholding covers your salary, but it does not cover distributions or your share of allocated profits. To avoid underpayment penalties, S corporation shareholders usually make quarterly estimated payments to the IRS. For the 2026 tax year the deadlines are April 15, 2026, June 15, 2026, September 15, 2026, and January 15, 2027. The January payment is not required if you file your 2026 return by February 1, 2027, and pay the full balance then.10Internal Revenue Service. Form 1040-ES – Estimated Tax for Individuals
One planning move is to raise salary withholding later in the year to cover the tax on pass-through income, since withholding is treated as paid evenly across the year regardless of when it actually happens.
The Built-In Gains Tax: The Main Entity-Level Exception
Pass-through treatment has one notable exception. If a C corporation converts to S corporation status, the company may owe a built-in gains tax on appreciated assets it held at conversion, but only if those assets are sold within five years of the election taking effect.11Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-in Gains
The tax runs at the highest corporate rate, currently 21%.12Office of the Law Revision Counsel. 26 U.S. Code 11 – Tax Imposed It applies to net recognized built-in gain, essentially the spread between an asset’s fair market value on the conversion date and its tax basis, to the extent recognized during the five-year window. Corporations that have always been S corporations do not face this tax. It reaches only businesses that converted from C to S status, or that acquired assets from a C corporation in certain tax-free transactions.
State Taxes on S Corporations
Most states follow the federal pass-through model. The S corporation owes no state income tax and shareholders report their share on personal state returns. Treatment varies in several ways worth checking.
Some states require a separate state-level S election on top of the federal one. A few states do not fully recognize the federal election and impose an entity-level income or franchise tax on S corporations. Others charge a flat minimum tax or annual fee regardless of income, generally ranging from a few hundred to several thousand dollars depending on the state and the corporation’s income or net worth.
More than 30 states now offer a pass-through entity tax (PTET) election, which lets the S corporation pay state income tax at the entity level on behalf of its shareholders. It functions as a workaround for the $10,000 federal cap on the state and local tax deduction: because PTET is a business-level tax, it is fully deductible on the corporation’s federal return, and shareholders take an offsetting credit on their state returns. Whether the election helps depends on each shareholder’s situation.
Many states also require S corporations to withhold state income tax for nonresident shareholders on income earned in the state. Missing state filing or withholding rules can bring penalties or cost the entity its good standing.
How the Tax Treatment Can End
S corporation treatment can end voluntarily or involuntarily. Voluntary revocation needs the consent of shareholders holding more than half the corporation’s shares. If it is made on or before the 15th day of the third month of the tax year (March 15 for calendar-year corporations), it takes effect at the start of that year; otherwise it takes effect the following year.13Office of the Law Revision Counsel. 26 U.S. Code 1362 – Election; Revocation; Termination
Involuntary termination is automatic the moment the corporation stops meeting an eligibility requirement, whether that is a 101st shareholder, a second class of stock, or an ineligible shareholder such as a partnership or nonresident alien. Termination takes effect on the date of the disqualifying event.
A third trigger is easy to miss. If the S corporation has accumulated earnings and profits from a prior C corporation period, and more than 25% of its gross receipts come from passive investment income (such as rents, royalties, dividends, and interest) for three consecutive years, the election terminates automatically at the start of the fourth year. Once terminated for any reason, the corporation generally cannot re-elect S status for five years without IRS consent.
From the day the election ends, the company is taxed as a C corporation, with entity-level tax on profits and a second layer of tax when earnings are distributed to shareholders as dividends.