S Corporation
A pass-through tax election under Subchapter S of the Internal Revenue Code that avoids corporate double taxation while allowing shareholder-employees to reduce self-employment tax.
Detailed Explanation
An S-Corporation is a pass-through entity for federal tax purposes. The corporation itself does not pay federal income tax; instead, it files an informational return on Form 1120-S, and each shareholder receives a Schedule K-1 reporting their pro-rata share of income, deductions, and credits to flow through to their personal Form 1040. The election is made by filing Form 2553 with the IRS, generally within 75 days of formation or the start of the tax year. Eligibility requires (1) being a domestic corporation or LLC electing corporate tax treatment, (2) having no more than 100 shareholders, (3) all shareholders being US citizens, US residents, or eligible trusts and estates (no corporations, partnerships, or non-resident aliens), and (4) having only one class of stock. The primary tax advantage is self-employment tax savings: an active shareholder-employee must take a "reasonable salary" (W-2 wages, subject to FICA and Medicare), but profits beyond that wage flow through as distributions that are NOT subject to payroll tax. The IRS aggressively audits unreasonably low salaries and routinely reclassifies distributions as wages with back payroll tax, penalties, and interest. Reasonable salary should reflect what an unrelated employee would be paid for the same duties, supported by comparable wage data. Each shareholder must track stock and debt basis annually on Form 7203; distributions exceeding basis become taxable capital gains, and losses are deductible only to the extent of basis. The QBI deduction (Section 199A) is available to S-Corp shareholders, with W-2 wage limits at higher income levels making the salary-vs-distribution split a multi-variable optimization. Form 1120-S is due March 15 (six-month extension via Form 7004 to September 15).
Key Points
- Pass-through: no entity-level federal tax. Income flows to shareholders via K-1.
- Election filed on Form 2553 within 75 days. Late relief generally available under Rev. Proc. 2013-30.
- Reasonable salary required for active shareholder-employees. IRS routinely audits and reclassifies low salaries.
- Form 1120-S due March 15. Extension via Form 7004 to September 15.
- Eligibility: max 100 shareholders, US persons only, single class of stock, domestic corporation.
- Shareholder basis tracked on Form 7203 (required for losses, distributions, dispositions).
- Break-even with sole prop typically around $40K-$80K of consistent net profit after a defensible salary.
Practical Example
A consultant nets $200,000 in profit. As an S-Corp electing $80,000 reasonable salary: payroll tax on $80K = ~$12,240 (employee + employer FICA combined, ignoring Additional Medicare). Distribution of $120K avoids the 15.3% SE tax that a sole prop would owe, saving roughly $18,360. Subtract ~$1,500 payroll service and any state minimum tax, the net savings are typically $15,000+ annually at this profit level. The IRS audit risk is mitigated by documenting that $80K matches comparable consultant salary data and running formal payroll throughout the year.
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Learn about Business Tax PreparationRelated Terms
Form 1120-S (S Corporation Income Tax Return)
The annual federal income tax return filed by S corporations, which pass income, deductions, and credits through to shareholders via Schedule K-1.
Form 2553 (S Corporation Election)
The IRS form used to elect S corporation tax status for an eligible domestic corporation or LLC, generally due within 75 days of the start of the tax year.
Pass-Through Entity
A business entity that does not pay federal income tax at the entity level; instead, profits and losses pass through to owners who report them on their individual returns.
Schedule K-1
A tax document issued by partnerships, S corporations, estates, and trusts to report each owner's share of income, deductions, credits, and other tax items.
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