S-Corp Taxes for Beginners: How S Corporations Work and What You Need to Know

The S-corp gets its name from Subchapter S of the Internal Revenue Code. It’s not a type of business entity —. It’s a tax election. You can be an LLC or a corporation under state law and then elect S-corp tax treatment with the IRS. The election changes how your business income is taxed at the federal level. Everything else about your entity —. Liability protection, management structure, state-law status —. Stays the same.

People hear about S-corp taxes and immediately think “tax savings,”. Which isn’t wrong, but it’s incomplete. The S-corp saves money in a specific way: it reduces self-employment tax on business income above a reasonable salary. If that sounds confusing, don’t worry. We’re going to break it down piece by piece. For a side-by-side comparison with LLC taxation, see our S-Corp vs. LLC comparison for freelancers.

How S-Corp Taxes Work: The Basics

An S corporation doesn’t pay federal income tax at the entity level. Instead, it files an informational return (Form 1120-S), and the income “passes through”. To the shareholders, who report it on their personal tax returns via Schedule K-1. This is why S-corp taxes are described as “pass-through”. Taxation —. The business income passes through the entity and gets taxed only once, at the individual level.

This is different from a C corporation, which pays its own corporate income tax on profits (currently 21% federal), and then shareholders pay tax again when those profits are distributed as dividends. That double taxation is the main reason most small businesses avoid C-corp status. S-corp taxes eliminate the double tax by moving all the taxation to the individual shareholder level.

Here’s where it gets interesting. An S-corp shareholder who also works in the business must take a “reasonable salary”. Paid through payroll. That salary is subject to payroll taxes: the employee pays 7.65% (Social Security at 6.2% and Medicare at 1.45%), and the S-corp pays a matching 7.65% as the employer. But any profit above the salary flows through as a distribution, and distributions are not subject to payroll taxes or self-employment tax. That’s the S-corp tax advantage in a sentence.

The Reasonable Salary Requirement

The IRS requires that S-corp shareholders who perform services for the corporation pay themselves a reasonable salary before taking distributions. “Reasonable”. Means comparable to what someone with your skills and experience would earn doing similar work in your geographic market. A software developer in New York City billing $300,000 through an S-corp can’t take a $30,000 salary and distribute the rest. The IRS would reclassify those distributions as wages, assess back payroll taxes, and add penalties.

There’s no bright-line rule for what constitutes reasonable. The IRS looks at factors like the nature of the services, the amount of time spent, comparable salaries for similar roles, the company’s revenue and profitability, and what employees in similar positions earn at other companies. We use Bureau of Labor Statistics data, industry compensation surveys, and historical salary precedents to set defensible salary levels for clients. For most service-based S-corps, a reasonable salary falls somewhere between 40% and 60% of net profits, though the exact percentage varies by situation.

A Real Example of How S-Corp Taxes Save Money

Let’s say your business earns $180,000 in net profit. Without the S-corp election (operating as a sole proprietorship or single-member LLC), the entire $180,000 is subject to self-employment tax. The SE tax on $180,000 is roughly $22,950 (after the 92.35% multiplier and accounting for the Social Security wage base).

With the S-corp election, you pay yourself a reasonable salary of $90,000. Payroll taxes on $90,000: the employee share is $6,885, and the employer share is another $6,885, for a total of $13,770. The remaining $90,000 passes through as a distribution with no payroll tax or SE tax. Your total payroll tax bill with the S-corp: $13,770. Without it: $22,950. That’s $9,180 in annual savings on S-corp taxes —. Or about $765 per month.

The income tax portion is roughly the same either way, because the total income reported on your personal return is identical. The savings come entirely from the payroll/SE tax side.

S-Corp Tax Filing Requirements

S-corp taxes require more paperwork than a sole proprietorship. The S-corp files Form 1120-S by March 15 each year (not April 15). This is an informational return that reports the company’s income and each shareholder’s distributive share. Each shareholder receives a Schedule K-1 showing their piece of the income, which they then include on their personal Form 1040.

You also need to run payroll, which means filing quarterly payroll tax returns (Form 941), paying federal and state payroll tax deposits on time, issuing W-2s at year-end, and maintaining proper payroll records. Most S-corp owners use a payroll service like Gusto, ADP, or Paychex —. The cost runs $40 to $150 per month for a single-employee S-corp.

Late filing penalties for S-corp taxes are steep: $235 per shareholder per month (2024 rate), up to 12 months. A single-shareholder S-corp that files two months late owes $470 in penalties. Multi-shareholder S-corps accumulate penalties even faster. File on time or file an extension (Form 7004) by March 15 —. The extension gives you until September 15.

When S-Corp Taxes Don’t Make Sense

The S-corp election isn’t right for every business. If your net profit is below $40,000 to $50,000, the cost of running payroll, filing the 1120-S, and the additional accounting complexity can eat into the savings enough that you’re breaking even or losing money on the election. The payroll service costs $500 to $1,500 per year, and the 1120-S preparation adds $500 to $1,500 to your tax prep bill compared to a simple Schedule C. If your SE tax savings are only $2,000, you might be spending $2,000 on compliance to get there.

Businesses with irregular income also face challenges with S-corp taxes. The payroll needs to be consistent and paid regularly throughout the year. You can’t skip payroll for six months and then catch up in December with a lump-sum salary payment —. The IRS expects regular, timely payroll processing. If your revenue is highly seasonal or unpredictable, managing the payroll cash flow adds complexity.

Real estate businesses with passive income are another poor fit. S-corp distributions don’t qualify for the lower self-employment tax rates on passive income, and the S-corp structure can complicate Section 199A (QBI deduction) calculations and limit the ability to specially allocate income and losses among owners.