S-Corp Tax Guide

An S-Corporation is a tax election, not a business entity type. You can be an LLC or corporation that elects S-Corp tax treatment by filing Form 2553 with the IRS. The S-Corp itself does not pay income tax—profits and losses pass through to shareholders' personal tax returns via Schedule K-1.

The key advantage is that only wages paid to shareholder-employees are subject to FICA taxes (Social Security and Medicare). Distributions of remaining profits to shareholders are subject to income tax but not FICA or self-employment tax. This split between salary and distributions is where the tax savings come from.

The S-Corp files Form 1120-S annually, which is an informational return showing the company's income, deductions, and each shareholder's share. Each shareholder then reports their K-1 income on their personal return. Losses can pass through to offset other income, subject to basis and at-risk limitations.

The IRS requires S-Corp shareholder-employees to receive a reasonable salary for the services they perform. You cannot take all profits as distributions to avoid payroll taxes—the IRS considers this a red flag and has successfully challenged unreasonably low salaries in court.

A reasonable salary is based on what you would pay someone else to perform your role at your company, considering factors like duties, experience, time commitment, comparable salaries for similar roles in your area, and the company's revenue and profitability. Industry salary surveys, Bureau of Labor Statistics data, and job postings for similar roles provide evidence.

As a general guideline, salary should represent roughly 40–60% of the S-Corp's net income, adjusted based on the factors above. If your S-Corp earns $150,000 and a comparable role pays $70,000–$80,000, a salary in that range is defensible. Paying yourself $30,000 on $150,000 of profit would likely draw scrutiny.

To quantify the savings, compare your tax liability as a sole proprietor versus as an S-Corp. As a sole proprietor with $120,000 in net income, you pay SE tax of approximately $16,956 (on 92.35% of income at 15.3%). As an S-Corp with a $60,000 salary and $60,000 in distributions, payroll taxes total approximately $9,180 (15.3% of $60,000, split between employer and employee). The savings is roughly $7,776.

Subtract the additional costs of S-Corp compliance: payroll processing ($500–$2,000/year), S-Corp tax return preparation ($500–$1,500), and any state-level fees. If your compliance costs total $2,000, your net savings is approximately $5,776. The higher your income above the reasonable salary, the greater the savings.

The savings increase as income rises, but the reasonable salary must also increase proportionally. A business earning $300,000 cannot justify a $50,000 salary if the owner works full-time in a skilled role. The optimal salary-to-distribution ratio depends on your specific circumstances and should be evaluated annually.

Operating as an S-Corp requires several ongoing obligations. You must run payroll for shareholder-employees, withholding income tax, Social Security, and Medicare. Quarterly payroll tax returns (Form 941) must be filed, along with annual W-2s for employees and the corporate tax return (Form 1120-S) by March 15.

S-Corps must maintain shareholder basis tracking. Your basis starts with your initial investment and increases with income allocations and additional contributions, and decreases with distributions and loss allocations. Distributions exceeding basis are taxed as capital gains, and losses exceeding basis cannot be deducted in the current year.

S-Corps have eligibility restrictions: a maximum of 100 shareholders, all shareholders must be U.S. citizens or residents (no foreign ownership), only one class of stock is allowed, and certain entity types (corporations, partnerships) cannot be shareholders. Violating these rules can cause involuntary termination of the S-Corp election.