Learn how S corporation taxation works, who can elect it, how wages differ from distributions, and what federal and California forms apply.
An S corporation is an eligible corporation — or another eligible entity classified as a corporation — that has made a valid federal election to pass income, losses, deductions, and credits through to its shareholders. It is named for Subchapter S of the Internal Revenue Code.
S corporation primarily describes a federal tax status. A state-law corporation can elect it. An eligible LLC can also elect corporate classification and S status while remaining an LLC under state law.
The legal entity affects ownership, governance, and liability. The tax election affects the returns, payroll, owner payments, and federal tax treatment. Keeping those layers separate prevents the common mistake of assuming every LLC or small corporation is automatically an S corporation.
The IRS generally requires an S corporation to:
Eligibility must continue after the election. A prohibited owner, second class of stock, or other violation can terminate S status. Late-election relief may be available in qualifying circumstances, but it should not be assumed.
The S corporation generally files Form 1120-S. It reports income and deductions, separately states items requiring shareholder-level treatment, and gives each shareholder a Schedule K-1.
Shareholders generally report their shares of pass-through items whether or not the corporation distributes cash. The S corporation can owe entity-level federal tax in special situations, including certain built-in gains and passive-income circumstances.
A shareholder's ability to deduct a loss depends on stock and debt basis, at-risk rules, passive-activity rules, and other limitations. A K-1 loss is therefore not automatically deductible in full.
Wages compensate a shareholder-employee for services. They are deducted by the corporation and generally subject to payroll taxes and withholding. Distributions are transfers to a shareholder because of ownership; they are not deductible merely because cash leaves the company.
Distributions generally are not subject to self-employment tax, but that fact cannot be used to avoid reasonable wages. The IRS can reclassify purported distributions as wages when compensation is unreasonably low.
Assume Coastline Consulting has $120,000 of profit before owner wages and related employer payroll costs. Its sole shareholder works full time.
The corporation determines that $70,000 is reasonable compensation based on duties, experience, time, comparable pay, and the business's facts. It processes $70,000 through payroll and deducts the wages plus employer payroll taxes. Remaining business income passes through on Schedule K-1, subject to final return adjustments.
A later $30,000 cash distribution does not create a second deduction and does not determine the K-1 profit. The shareholder reports W-2 wages and K-1 items through different parts of the individual return. Basis determines whether a distribution exceeds the shareholder's available tax basis.
This is illustrative, not a reasonable-salary formula. A percentage of revenue, a fixed 60/40 split, or the amount of cash the owner wants is not automatically reasonable.
Both commonly pass taxable items through to owners, but their ownership, allocation, basis, compensation, and employment-tax rules differ.
Partnerships can often use flexible allocations when the agreement and tax rules support them. S corporations generally allocate items per share, per day and must maintain one class of stock. Partners generally are not W-2 employees of their partnership. Working S corporation shareholders can be employees and may need W-2 wages.
A C corporation generally pays federal income tax on its taxable income. Shareholders can then owe tax on dividends, creating two levels of tax. An S corporation generally passes ordinary income through without regular federal corporate income tax, although special entity-level taxes can apply.
A C corporation may accommodate a broader range of investors and equity rights. An S corporation's owner and stock restrictions can be limiting.
An S corporation generally files:
California generally recognizes a valid federal S election but does not make the entity entirely tax-free. A California S corporation generally files Form 100S and pays a 1.5% tax on net income, subject to the $800 minimum franchise tax and applicable exceptions. Shareholders also report pass-through items on their California returns. Financial S corporations use a different rate.
An LLC taxed as an S corporation may also need California LLC-related filings depending on classification and structure. Confirm the entity's FTB account and filing requirements rather than assuming the federal election updates every state record automatically.
Heath Income Tax can prepare S corporation and shareholder returns, coordinate bookkeeping and payroll, track basis, and help working owners document compensation and distributions.
Does an S corporation pay federal income tax?
Ordinary income generally passes through, but special federal entity-level taxes can apply.
Are S corporation distributions tax-free?
Not universally. Basis, accumulated earnings from prior C corporation years, and other rules determine the result.
Can an LLC be an S corporation?
An eligible LLC can elect to be classified and taxed as an S corporation while remaining an LLC under state law.
Is there one IRS-approved reasonable salary formula?
No. Reasonableness depends on facts such as duties, time, experience, comparable pay, and the company's circumstances.
The definitions and examples on this page are for informational purposes only and do not constitute tax advice. Tax laws change frequently and individual circumstances vary. Consult a qualified tax professional before making decisions based on this content.
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