S-Corp Taxation: How the Pass-Through Math Actually Saves You Money

An S-Corporation is a pass-through entity for federal tax purposes. The corporation itself does not pay federal income tax. Instead, the corporation files an informational return on Form 1120-S, and each shareholder receives a Schedule K-1 showing their pro-rata share of income, deductions, and credits. Those amounts flow through to the shareholder’s personal Form 1040.

The key tax planning move comes from how an owner is paid. Shareholders who actively work in the business are required to take a reasonable salary as a W-2 employee, with payroll taxes (Social Security and Medicare) withheld and matched. Any remaining profit is paid out as a distribution, which is not subject to payroll tax. That distribution gap is where the savings live.

Compare this to a single-member LLC or sole proprietorship. There, 100% of net profit is subject to self-employment tax of 15.3% (12.4% Social Security up to the 2026 wage base of $176,100, plus 2.9% Medicare with no cap). With an S-Corp, only the portion paid as wages is subject to those taxes.

A reasonable salary is whatever a similar business would pay a non-owner employee to perform the same work in the same market. The IRS does not publish a specific dollar amount or percentage, but auditors look at training, experience, duties, time devoted, comparable salaries paid by similar businesses, payments to non-shareholder employees, and timing and method of distributions.

Owners who pay themselves zero salary while taking large distributions are the most common audit target. The Tax Court has reclassified distributions as wages in dozens of cases, with back payroll tax, penalties, and interest stacking quickly. A common rule of thumb is to set wages at roughly 30 to 60% of net business income for service businesses, but the right number depends entirely on your role, industry, and supporting documentation.

An S-Corp starts to pay off once the savings on payroll tax exceed the additional cost of running the entity. Those costs include payroll service fees ($50 to $200 per month), preparation of a separate business return on Form 1120-S, possible state franchise taxes (California charges a $800 annual minimum, for example), unemployment insurance, and the administrative overhead of running formal payroll.

A practical break-even point is around $40,000 to $60,000 in consistent net profit after a reasonable salary. Below that, the costs typically wash out the savings. Above $80,000 in profit, the S-Corp election usually generates clear, recurring tax benefits, often $4,000 to $10,000 per year for solo owners and more for partnerships of two to four shareholders.

There are also non-tax reasons that may favor or disfavor the structure. The S-Corp limits deductions for fringe benefits paid to greater-than-2% shareholders (health insurance, life insurance, certain education benefits must follow specific reporting paths), and the IRS treats reasonable basis closely for loss deductions.

You start with a state-level entity (an LLC or a corporation) and then file Form 2553 with the IRS to elect S-Corp tax treatment. The deadline is generally within 75 days of formation, or by March 15 of the year you want the election to take effect. Late elections can sometimes be cured under Rev. Proc. 2013-30 if you have reasonable cause and intent to be treated as an S-Corp from the start.

After the election, the corporation reports its income on Form 1120-S each year, with a March 15 deadline (six-month extension to September 15 via Form 7004). Each shareholder receives a Schedule K-1 detailing their share of income, separately stated items, and basis adjustments to report on their personal Form 1040.

A Schedule K-1 from an S-Corp reports the shareholder’s share of ordinary income, separately stated items (interest, dividends, capital gains, Section 179 expense, etc.), credits, and basis adjustments. The shareholder is taxed on their share of income whether or not the cash was actually distributed.

Shareholder basis is critical. Distributions exceeding stock basis become taxable capital gains, and losses are deductible only to the extent of basis. Track basis annually using Form 7203 (Shareholder’s Stock and Debt Basis), which the IRS now requires from S-Corp shareholders claiming losses, distributions, or stock disposals.

Section 199A allows a deduction of up to 20% of qualified business income for pass-through owners, including S-Corp shareholders. The deduction is phased out for specified service trades or businesses (SSTBs, including law, health, accounting, consulting, and financial services) at higher income levels (the 2026 phase-in starts at $241,950 single / $483,900 joint, indexed annually).

For non-SSTB businesses above the phaseout, the deduction is capped at the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of unadjusted basis in qualified property. This makes the salary level not just a payroll-tax decision but a QBI optimization decision.