S corporations themselves do not pay federal taxes on their profits. Instead, it’s the corporation’s shareholders who pay those taxes. In other words, S corporations are pass-through tax entities. If your small business currently is set up as an S corporation and you’re one of the corporation’s shareholders, you’ll need to pay taxes each year on your share of the business’s profits.
Here’s a quick look at the basic steps for a shareholder to report and pay taxes on S corporation income.
As an S corporation shareholder, you can receive profits from the business in one of two forms:
If you are a passive investor in the S corporation, not serving as a corporation officer, and not otherwise providing the corporation with any services, then most likely you’ll receive your share of the profits as some kind of distribution. A distribution can fall under one of several categories, such as ordinary business income, real estate rental income, ordinary dividends, or royalties. However, regardless of the category, the distribution is subject to income tax but not employment tax.
If, on the other hand, you are not just a passive investor but are active in running the business, then the IRS will consider you an employee of the corporation. In that case, under IRS rules, you must receive at least some of your share of the corporation’s profits in the form of a salary. The same holds for any other shareholder-employees as well as for any corporation officers (regardless of whether they’re also shareholders). With small, closely-held businesses in particular, it’s common for the few shareholders to also run the business, so it’s important to be aware of the requirement to pay shareholder-employees a salary. Unlike distributions, shareholder-employee salaries are subject not only to the personal income tax but also to federal employment taxes.
At the end of each year, all S corporation profits are allocated to the corporation’s shareholders. Even if you and your fellow shareholders choose to leave some or all of the profits in the corporation, taking nothing as distributions or salaries, you will still be required to pay tax on those profits. In technical lingo, an S corporation is not permitted to have any retained earnings. This is different from a regular corporation, which can retain—and pay taxes on—its earnings.
However, S corporation shareholders may be able to deduct 20% of their business income with the pass-through deduction established under the Tax Cuts and Jobs Act. See The 20% Pass-Through Tax Deduction for Business Owners for more information.
After the end of your S corporation’s tax year, the corporation must send you and every other shareholder a Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc. The corporation also must provide each shareholder with an accompanying set of Shareholder’s Instructions for Schedule K-1. Each Schedule K-1 is specific to a particular shareholder and, among other items, provides information about that shareholder’s share of the income from the S corporation for the preceding tax year. The corporation also must include copies of the Schedule K-1s issued to its shareholders with its corporation tax return.
If you receive distributions from your S corporation, you’ll rely on the information provided on your Form K-1 to report and pay tax on that income. You’ll need to use the information from the K-1 to complete one or more required IRS schedules. In most cases, you’ll use the K-1 at least to complete Schedule E, Supplemental Income and Loss. Part II of Schedule E covers income or loss from partnerships and S corporations.
You may also need to attach other schedules to your individual federal tax return. For example, short-term capital gains or losses related to your S corporation are reported on Schedule D, Capital Gains and Losses. As with information for Schedule E, information for Schedule D also should be available from your Form K-1.
You attach your Schedule E, along with any other required schedules or forms, to your IRS Form 1040, U.S. Individual Income Tax Return. The total S corporation income (or loss) that you show on Schedule E is included on your personal Form 1040 on the line for income from rental real estate, royalties, partnerships, S corporations, trusts, etc.
As mentioned above, any shareholder in your S corporation who provides services to the corporation must be paid a salary. Shareholder-employee salaries are subject to employment taxes in the same way as the salaries of other employees. If you are being compensated for services to your S corporation, the corporation should report your wages to you on a Form W-2, Wage and Tax Statement. If you’ve ever worked as an employee, you’re probably familiar with this form. You typically receive one by the end of January from each employer you’ve worked for during the previous calendar year.
If you receive a W-2 from your S corporation, you’ll report the information it contains directly on your personal Form 1040. More specifically, the amount on that W-2 is added to any other income you may have received as an employee (shown on other W-2s you would have received) and entered on the line for wages, tips, and other compensation.
Example: Janet is one of four owners of Topp Summittz, Inc., an S corporation that manufacturers hiking gear. She owns 25% of the business. Janet also works part-time for the corporation. In addition, Janet is also employed as a manager at Azalea Boots Outdoor Store. Last year, Topp Summittz had total income of $250,000 and total expenses of $50,000. The S corporation’s entire net profit of $200,000 was distributed equally to each of its four shareholders. Each shareholder received half of that profit as a salary (wages) and the other half as ordinary business income. Consequently, Janet received a salary of $25,000 and ordinary business income of $25,000. Janet also earned $30,000 in salary from her job at the outdoor store.
After the end of the year, Janet received a Schedule K-1 from Topp Summittz that shows her $25,000 in ordinary business income. Using the K-1, she completes and attaches Schedule E to her personal Form 1040. She also enters the appropriate amount from Schedule E on the line on her personal Form 1040 for income from rental real estate, royalties, partnerships, S corporations, trusts, etc. Janet also receives one W-2 from Topp Summittz, which reports on her $25,000 salary from her S corporation, and another W-2 from Azalea Boots, which reports on her $30,000 salary from the outdoor store. She enters the total amount of wages from her W-2s on the line for wages, tips, and other compensation on her personal Form 1040. Ultimately, she uses her Form 1040 to report and pay taxes on her combined gross income of $80,000 ($30,000 as wages from Azalea Boots, $25,000 as wages from Topp Summittz, and $25,000 in ordinary business income from Topp Summittz.)
This article covers how a shareholder pays taxes on S corporation profits but does not deal with S corporation losses. Like profits, S corporation losses pass through the corporation to the individual shareholders, who claim those losses on their respective personal tax returns. In fact, many owners of small incorporated businesses choose S corporation status during periods when they expect to operate at a loss in order to reduce their personal tax bills. You can find out more about dealing with S corporation losses and other S corporation tax matters in Tax Savvy for Small Business, by Frederick W. Daily, J.D.
You can also find more quick information about S corporations here on the Nolo website. Check the S Corporations section for additional articles.