Yes, an S corporation is a pass-through entity for federal income tax purposes. The business itself generally pays no federal income tax on its earnings. Instead, profits, losses, deductions, and credits flow through to shareholders in proportion to their ownership, and each shareholder reports their share on a personal tax return. Because S corp status is a tax election rather than a separate legal form, the corporation’s liability protection stays intact while the double taxation that applies to C corporations goes away.1Internal Revenue Service. S Corporations
How Pass-Through Taxation Actually Works
Once a corporation elects S status, it stops being responsible for federal income tax on most of its earnings. The company’s net income, losses, deductions, and credits pass through to shareholders based on their ownership stakes.1Internal Revenue Service. S Corporations Each shareholder includes that share on their individual return and pays tax at their own rate.
This structure keeps the same dollar from being taxed twice. A standard C corporation pays corporate income tax on profits, and shareholders pay income tax again when dividends arrive. With pass-through treatment, the corporate layer disappears for most income. The trade-off: shareholders owe tax on their share of the company’s income even in years when the business distributes no cash to them.
Reporting Pass-Through Income on Schedule K-1
Every year, the S corporation gives each shareholder a Schedule K-1 (Form 1120-S) that breaks down that person’s share of income, deductions, and credits. Shareholders use the K-1 to complete their personal returns. The corporation files the K-1s with the IRS, but keep your copy — you’ll need it to reconcile what shows up on your own return.2Internal Revenue Service. Shareholders Instructions for Schedule K-1 (Form 1120-S)
Salary vs. Distributions if You Work in the Business
If you own shares and also work in the company, the pass-through structure creates one of the S corp’s best-known tax advantages, along with its most common problem. You must pay yourself a reasonable salary before taking profit distributions. Wages are subject to Social Security and Medicare (FICA) taxes; distributions of the remaining profits are not subject to self-employment tax.2Internal Revenue Service. Shareholders Instructions for Schedule K-1 (Form 1120-S)
The IRS decides whether a salary is reasonable by weighing your training and experience, the duties you perform, the time you devote to the business, what comparable businesses pay for similar work, and the company’s dividend history.3Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues Setting the salary artificially low to shrink payroll taxes invites reclassification: the IRS treats some or all of the distributions as wages, and back employment taxes, interest, and penalties follow.
Health Insurance for Shareholders Owning More Than 2%
If you own more than 2% of the S corporation’s stock, health insurance premiums the company pays on your behalf must appear as wages in Box 1 of your W-2, though they are not subject to Social Security, Medicare, or unemployment taxes.3Internal Revenue Service. S Corporation Compensation and Medical Insurance Issues You can then claim an above-the-line deduction for those premiums on your personal return, provided the S corporation established the health plan and you were not eligible to participate in a subsidized plan through a spouse’s employer.
Limits on Deducting Pass-Through Losses
Pass-through treatment sends losses to shareholders too, which can offset other income. But three separate limits control how much of a loss you can actually deduct in any given year.
Stock and Debt Basis
Your deductible losses in a tax year cannot exceed the combined adjusted basis of your S corporation stock plus any money the corporation owes you directly. Anything above that combined basis is suspended and carried forward to a year when you have enough basis to absorb it.4Office of the Law Revision Counsel. 26 USC 1366 – Pass-Thru of Items to Shareholders Basis rises when the company earns income or you contribute capital, and falls when it distributes cash or passes losses through to you.
At-Risk and Passive Activity Rules
Even with enough basis, two more hurdles apply. The at-risk rules cap your deductible losses at the amount you have personally at risk in the business, typically cash you’ve invested and amounts you’ve personally guaranteed. The passive activity rules stop you from using losses from a business you don’t materially participate in to offset wages, interest, or other active income. Losses blocked by either rule carry forward until you have qualifying income or dispose of your interest.
The 20% Qualified Business Income Deduction
Because S corp income is pass-through income, shareholders may qualify for the Section 199A deduction, which lets eligible taxpayers deduct up to 20% of qualified business income (QBI). The deduction is taken on your personal return and is available whether you itemize or take the standard deduction. Reasonable compensation paid to you as a shareholder-employee does not count as QBI; only the pass-through profit does.5Internal Revenue Service. Qualified Business Income Deduction
The deduction was originally set to expire after 2025 but was extended. For 2026, the full deduction phases out at higher incomes. Once taxable income tops $201,750 (or $403,500 filing jointly), limits tied to the type of business, W-2 wages paid, and the cost of business property begin to apply. For specified service businesses such as law, accounting, and consulting firms, the deduction phases out completely at $276,750 (or $553,500 filing jointly).
When the S Corp Itself Owes Federal Tax
Pass-through does not mean the corporation never pays a federal tax bill. The main exception is the built-in gains tax. When a C corporation converts to S status, any assets that had appreciated in value before the conversion carry a built-in gain. If the S corporation sells those assets within five years of the conversion, the net recognized built-in gain is taxed at the 21% corporate rate.6Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains7Office of the Law Revision Counsel. 26 USC 11 – Tax Imposed After the five-year recognition period ends, the built-in gains tax no longer applies to those pre-conversion assets.
The S corporation also must file an annual information return on Form 1120-S even when it owes no tax. For calendar-year corporations, the return is due March 15, and the penalty for a late or incomplete filing is $255 per shareholder for each month (or partial month) the return is late, up to 12 months.8Internal Revenue Service. Failure to File Penalty Schedule K-1s go to shareholders by the same deadline.
State Tax Treatment Doesn’t Always Follow the Federal Rule
Federal pass-through treatment does not automatically carry over to your state. Several states impose their own taxes on S corporations, including franchise taxes, minimum taxes, or taxes on built-in gains. Some states do not fully recognize the S election and tax the entity closer to how they’d tax a C corporation. Annual entity-level state taxes on S corporations run from nothing in some states to several hundred dollars or more in others.
Beyond entity-level taxes, most states with an income tax require shareholders to report pass-through income on their individual state returns, mirroring the federal treatment. If the S corporation operates in more than one state, shareholders may owe income tax in each state where the business earns revenue. State rules vary significantly, so check your state’s specific treatment or ask a tax professional before assuming the federal answer applies.