How Do S Corporations Get Taxed?

One of most frequent questions we hear from business owners is around how an S Corporation works. Now, almost every business we work with has a tax structure of a S Corporation. Most of the time, they exist as LLCs taxed as S Corporations. Remember, LLCs are legal entities while S Corporation is a tax designation. You can be an LLC or a Corporation and elect to be a S Corporation — however you can’t form a S Corporation.

Nonetheless, that’s not the question, but rather, how is my S Corporation taxed? Let’s dive in.

What is A Pass-Through Entity?

S Corporation taxation is confusing because it is something called a pass-through entity. What this means is that income is passed from the business directly to your personal tax return.

So how does that work?

Your profit and loss from your business is reported on the S Corporation tax return (1120S), which doesn’t pay taxes (well, kind of, but we will get to that later). Then, based on the P&L, it generates a form called a K-1. Think of the K-1 like a W-2 for your business. A K-1 serves to report the net income from the business on your personal return.

So that’s a super oversimplified view of how an S Corporation works.

Let’s cover the other questions we hear.

How do I get paid from a S Corporation?

Owners or shareholders of S Corporations get paid in two ways:

1. You get paid a salary (paycheck) and receive a W-2. Generally, this is the least tax efficient way to pay yourself because you have to pay FICA taxes and lose something called a qualified business income deduction you get on profits.

So why don’t you just not take a salary then?

The IRS mandates S Corporation shareholders that are employees of the S Corporation (provide services) get paid a reasonable compensation. So yes, you have to take a salary. However, keep it to what’s absolutely necessary, because profits are more tax efficient.

2. You take profit distributions. That’s where things get confusing. Circle back to how we talked about how S Corps are taxed. Distributions are not taxed, profits are. You distribute out taxed profits. So if you leave the profits in the business, they still get taxed. This is why it’s important to plan with your tax advisor because it takes a certain nuance to calculate taxability of S Corporation profits.

There it is. Two ways to pay yourself: wages and distributions. It’s simple when you structure things correctly, but when you wing it...that’s when things get out of hand.

Do S Corporations pay State Taxes?

Earlier, we brought up that S Corporations don’t pay taxes, while that’s generally true, individual states handle this differently.

State taxation is the wild, Wild West of taxes. There is no consistency state by state. For explanation purposes, let’s look at Illinois. Illinois has effectively three types of income taxes for S Corporations.

First is replacement taxes. They charge 1.5% on the profits of the business. This is to replace personal property taxes that most states charge.

Second, there is pass through entity taxation. This is an optional election to pay your state tax at the S Corporation level. This gets you a tax deduction on the state tax since the personal state tax deduction is limited to $10k per year. The states came out with this rule as a loophole to derive more benefits.

Finally, there is composite tax. This allows out of state shareholders to pay tax at the S Corporation level so they don’t have to file an Illinois return personally. This is optional and meant to simplify your personal tax filing.

Conclusion

Well, that’s it. You can now call yourself an expert in S Corporation taxation.

S Corporations can be a tax-efficient way for small businesses to operate. However, it's important to understand the rules and limitations before making the switch.

Do you want help determining if a S Corporation is the best option for your business? Click on the ‘Let’s Chat’ button to see if Kaizen CPAs + Advisors is the right fit for you.