An S corporation is taxed as a pass-through: the business itself pays no federal income tax in most situations, and its profits, losses, deductions, and credits flow through to shareholders, who report their share on their personal returns and pay at individual rates from 10% to 37%.1Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 So the question of how S corps are taxed is really two questions: how income moves from the company to the owner, and how owner-employees split what they take out between salary (subject to payroll tax) and distributions (not).
Pass-Through Taxation, in Practice
Under Subchapter S of the Internal Revenue Code, the S corp is a conduit. It files an informational return, Form 1120-S, but owes no federal income tax itself.2Office of the Law Revision Counsel. 26 USC 1361 – S Corporation Defined Every item of income, loss, deduction, and credit is allocated to shareholders in proportion to ownership and reported to each on a Schedule K-1. Shareholders then pick up those amounts on their Form 1040.
This structure avoids the double taxation a C corporation faces, where profits are taxed at the corporate level and again when paid out as dividends. The trade-off is that shareholders owe tax on their share of profits whether or not the company actually distributes cash. If the business earns $200,000 and keeps every dollar in the bank, each shareholder still owes income tax on their portion of that $200,000. The K-1 breaks income into categories — ordinary business income, rental income, interest, capital gains — because each may be taxed differently on the personal return.3Internal Revenue Service. About Form 1120-S, U.S. Income Tax Return for an S Corporation
An LLC or corporation becomes an S corp by filing Form 2553 with the IRS, provided it has no more than 100 shareholders, issues only one class of stock, and limits ownership to U.S. citizens or residents who all consent to the election.4Internal Revenue Service. Instructions for Form 2553
Salary vs. Distributions: Where the Real Planning Happens
Any shareholder who works in the business must receive a reasonable salary before taking distributions.5Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers The motivation to keep salary low is direct: salary triggers payroll taxes, and distributions do not.
Salary is subject to FICA — 6.2% Social Security from both employer and employee (12.4% combined) and 1.45% each for Medicare (2.9% combined), a 15.3% total rate.6Internal Revenue Service. Topic No. 751, Social Security and Medicare Withholding Rates The Social Security portion applies only to wages up to $184,500 in 2026.7Social Security Administration. Contribution and Benefit Base Once wages exceed $200,000, an additional 0.9% Medicare tax kicks in on the employee side.
After paying reasonable compensation, remaining profits can be distributed to shareholders free of the 15.3% self-employment tax that sole proprietors and partners pay on all business earnings.8Internal Revenue Service. Self-Employment Tax (Social Security and Medicare Taxes) The shareholder still owes ordinary income tax on the profit (it was already reported on the K-1), but skipping the payroll tax component is the single biggest tax advantage of S corp status for most owners. Distributions themselves are tax-free to the extent they don’t exceed your stock basis; anything above basis is treated as capital gain.
What counts as “reasonable” depends on the shareholder’s role, hours, industry, and what similar businesses pay for comparable work. Revenue Ruling 74-44 established the IRS’s authority to recharacterize distributions as wages when salary is artificially low.9Internal Revenue Service. INFO 2003-0026 If the IRS makes that adjustment, the company owes back payroll taxes plus penalties, which can include a 20% accuracy-related penalty under Section 6662 and, for willful failure to remit withheld taxes, a trust fund recovery penalty equal to 100% of the unpaid amount, assessed personally against responsible individuals.10Internal Revenue Service. Information About Your Notice, Penalty and Interest (Notice 746) Most S corp tax problems start here.
How Losses Flow Through, and Where They Stop
Losses pass through the same way income does, but three limits gate how much you can actually deduct in a given year. The first is basis. You can deduct S corp losses only up to your combined stock basis (roughly what you invested plus accumulated profits minus prior distributions) and debt basis (money you personally lent to the corporation). A loan guarantee does not count; only direct loans from you to the business create debt basis.11Internal Revenue Service. S Corporation Stock and Debt Basis
Losses that exceed basis are suspended and carry forward indefinitely until you rebuild enough basis to absorb them. Sell all your shares before using them, and they vanish permanently.11Internal Revenue Service. S Corporation Stock and Debt Basis Beyond basis, losses must also clear the at-risk rules and the passive activity loss rules. If you don’t materially participate in the business, your losses are typically limited to offsetting other passive income.
The 199A Qualified Business Income Deduction
S corp shareholders may qualify for a deduction worth up to 20% of their share of the company’s qualified business income under Section 199A.12Internal Revenue Service. Qualified Business Income Deduction The deduction was originally set to expire after 2025 under the Tax Cuts and Jobs Act and was made permanent by the One Big Beautiful Bill Act.
Below certain income thresholds, the deduction is straightforward. For 2026, single filers with taxable income under $201,750 and joint filers under $403,500 can generally take the full 20% without additional limitations. Above those thresholds the deduction phases out, and two extra caps kick in: one based on W-2 wages the business pays, another on the original cost of depreciable property the business holds. The deduction is fully phased out for single filers above $276,750 and joint filers above $553,500 if the business is a “specified service” trade — law, accounting, consulting, health care, and financial services fall in this category.
Reasonable compensation intersects with 199A in a way many owners miss. Your salary does not count as qualified business income; only the pass-through profit does. But W-2 wages the S corp pays (including yours) feed the W-2 wage limitation that higher-income shareholders need to maximize their deduction. Setting compensation too low can shrink your 199A deduction once you’re above the phase-out thresholds.13Office of the Law Revision Counsel. 26 USC 199A – Qualified Business Income
The 3.8% Tax on Passive Shareholders
Shareholders who don’t materially participate in operations face an additional 3.8% net investment income tax on their share of the business income when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for joint filers.14Internal Revenue Service. Topic No. 559, Net Investment Income Tax The tax is calculated on the lesser of net investment income or the amount by which MAGI exceeds the threshold. Active shareholders who materially participate are not subject to this layer on their S corp income.
When the S Corp Itself Owes Tax: Built-In Gains
There is one major exception to the rule that S corps pay no entity-level income tax. When a C corporation converts to S corp status, any appreciation in its assets that existed on the conversion date can trigger a corporate-level tax if those assets are sold within five years. This is the built-in gains tax under Section 1374, and it applies at the highest corporate rate, currently 21%.15Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains
The tax targets only the gain that was built in at conversion, not later appreciation. Once the five-year recognition period ends, the company can sell without this extra layer. The same rule applies when an S corp acquires assets from a C corp in a carryover-basis transaction. Owners converting from C to S status should get a professional valuation on the conversion date; without it, the IRS can argue the entire gain on any later sale was built in.
Health Insurance and Fringe Benefits for 2% Shareholders
Shareholders who own more than 2% of the S corporation are treated like partners rather than employees for fringe benefit purposes. Health and accident insurance premiums the S corp pays for a greater-than-2% shareholder must be reported as wages on the shareholder’s W-2. The premiums appear in Box 1 (taxable wages) but are excluded from Boxes 3 and 5 (Social Security and Medicare wages), so they’re subject to income tax but not FICA.16Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues The shareholder can then claim an above-the-line deduction for self-employed health insurance on the personal return, effectively zeroing out the income tax hit.
Other fringe benefits that regular employees receive tax-free become taxable income for greater-than-2% shareholders, including adoption assistance, achievement awards, qualified transportation benefits, and lodging provided on business premises.17Internal Revenue Service. Employer’s Tax Guide to Fringe Benefits Group-term life insurance is partially affected: while the first $50,000 of coverage is income-tax-free for regular employees, the entire cost must be included in a 2% shareholder’s wages for Social Security and Medicare purposes. De minimis benefits remain excludable for everyone.
Filing and Estimated Payments
The S corporation files Form 1120-S by the 15th day of the third month after its tax year ends. For calendar-year companies that’s March 15, or the next business day if it falls on a weekend.18Internal Revenue Service. 2025 Instructions for Form 1120-S No tax accompanies the return; the corporation instead generates a Schedule K-1 for each shareholder.
Late filing is expensive. For returns due in 2026 and beyond, the IRS charges $255 per shareholder for each month or partial month the return is late, up to 12 months.19Internal Revenue Service. Failure to File Penalty – Section: S Corporation Returns (Form 1120-S) A five-owner S corp filing three months late owes $3,825 in penalties alone. The penalty can be waived for reasonable cause, but “I forgot” doesn’t qualify.
Because pass-through income isn’t subject to withholding, shareholders typically make quarterly estimated tax payments on April 15, June 15, September 15, and January 15 of the following year.20Internal Revenue Service. Estimated Tax You generally owe estimated tax if you expect to owe at least $1,000 after subtracting withholding and credits. To avoid underpayment penalties, pay at least 90% of the current year’s tax or 100% of the prior year’s, whichever is smaller. If prior-year AGI exceeded $150,000 ($75,000 if married filing separately), the safe harbor rises to 110% of the prior year’s tax.21Internal Revenue Service. 2026 Form 1040-ES – Estimated Tax for Individuals If you or your spouse has W-2 income from another job, increasing that withholding can offset the S corp income and eliminate the need for separate estimated payments.
State Treatment Doesn’t Always Match
Federal pass-through treatment doesn’t guarantee the same result at the state level. Most states recognize the federal S corp election, but details vary. Some states impose entity-level taxes, minimum franchise fees, or both, often regardless of whether the business is profitable. A handful of major cities don’t recognize the S corporation designation at all for local tax purposes, treating the entity as a standard corporation subject to local corporate income tax. Nexus matters too: employees, property, or significant sales in a state can trigger filing obligations there even if the business is headquartered elsewhere.
Losing S Corp Status
An S corporation can lose its status voluntarily or involuntarily. Voluntary revocation requires consent from shareholders holding more than 50% of the stock. Involuntary termination happens automatically if the company breaches an eligibility rule, such as issuing a second class of stock, admitting a foreign shareholder, or exceeding 100 shareholders.22Office of the Law Revision Counsel. 26 USC 1362 – Election, Revocation, Termination After either type of termination, the corporation cannot re-elect S status for five taxable years unless the IRS grants early consent. During that period the business is taxed as a C corporation, with double taxation on distributed profits.