Business structure
How S corps are taxed: pass-through income, salary, basis and Form 1120-S
An S corporation generally pays no federal income tax itself. Income passes to shareholders at their own rates. See the reasonable salary rule, how distributions and basis work, the entity-level taxes, Form 1120-S deadlines and penalties.
Prepared by Aldro Accounting · Updated · Sources checked
The quick answer
An S corporation passes its income, losses, deductions and credits through to its shareholders, who report them on their personal returns and pay tax at their individual income tax rates, so the IRS says corporate income avoids double taxation. The S corporation files Form 1120-S by the 15th day of the 3rd month after its tax year ends (March 16, 2026 for 2025 calendar-year returns) and owes entity-level tax only on certain items such as built-in gains and passive income.
S corp income is taxed on the shareholders' returns
S corporations are corporations that elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. Shareholders report that income on their personal returns and are taxed at their individual income tax rates. The IRS says this lets S corporations avoid double taxation on corporate income.
So there is no separate S corp income tax rate for ordinary business income. Each shareholder's share shows up on a Schedule K-1 and goes onto Form 1040 or 1040-SR with Schedule E. Shareholders use Form 1040-ES for estimated tax.
Scroll sideways to see all columns.
| Filer | Tax | Form |
|---|---|---|
| S corporation | Income tax | Form 1120-S with Schedule K-1 for each shareholder |
| S corporation | Social Security, Medicare and income tax withholding | Form 941 or Form 943 |
| S corporation | Federal unemployment (FUTA) tax | Form 940 |
| Shareholder | Income tax | Form 1040 or 1040-SR with Schedule E |
| Shareholder | Estimated tax | Form 1040-ES |
The corporation itself files Form 1120-S and, if it has employees, employment tax returns: Form 941 (or Form 943 for farm employees) for Social Security, Medicare and income tax withholding, and Form 940 for federal unemployment tax.
Salary first, then distributions
S corporations must pay reasonable compensation to a shareholder-employee for services before non-wage distributions can be made to that shareholder. The Form 1120-S instructions say distributions and other payments to a corporate officer must be treated as wages to the extent they are reasonable compensation for services.
Non-wage distributions aren't subject to employment taxes. Wages are. The IRS has the authority to reclassify payments from distributions to wages, and several court cases support it.
The IRS looks at the source of the corporation's gross receipts: the shareholder's own services, the services of non-shareholder employees, or capital and equipment. Receipts from the shareholder's personal services point to wages. Its list of factors includes:
- Training and experience
- Duties and responsibilities
- Time and effort devoted to the business
- Dividend history and payments to non-shareholder employees
- Timing and manner of paying bonuses to key people
- What comparable businesses pay for similar services
- Compensation agreements and the use of a formula to set pay
Health insurance for owners with more than 2%
Health and accident insurance premiums paid for a shareholder-employee who owns more than 2% are deductible by the S corporation and reported as wages on that person's Form W-2, subject to income tax withholding.
When the premiums are paid under a plan for a class of employees, those wages go in Box 1 of the W-2 but not Boxes 3 and 5, so they aren't subject to Social Security, Medicare or FUTA tax. For the shareholder to take the above-the-line deduction, the premiums must ultimately be paid by the S corporation and reported as taxable compensation on the W-2. A 2% shareholder-employee can't take part in a QSEHRA.
Distributions, losses and shareholder basis
A non-dividend distribution is tax-free to the extent it doesn't exceed the shareholder's stock basis. Any amount above stock basis is taxed as a capital gain on the shareholder's return, long-term if the stock was held for more than one year.
Stock basis changes every year, so it has to be figured every year. Tracking it is the shareholder's job, not the corporation's. Form 7203 can be used. Basis is adjusted as of the last day of the S corporation's year in this order: increased for income items and excess depletion, decreased for distributions, decreased for non-deductible, non-capital expenses and depletion, then decreased for losses and deductions.
Before a shareholder can claim a pass-through loss, it has to clear four limits in order: stock and debt basis, at-risk, passive activity loss and the excess business loss limit. A shareholder gets debt basis only for money personally lent to the S corporation. Guaranteeing a loan isn't enough.
When an S corp pays tax itself
S corporations are responsible for tax on certain built-in gains and passive income at the entity level. The IRS estimated tax rules name three entity-level taxes: the tax on built-in gains, the excess net passive income tax and investment credit recapture tax. If those total $500 or more, the S corporation makes estimated tax installments. For a calendar-year corporation, the 2026 payments are due April 15, June 15, September 15 and December 15.
The built-in gains tax can apply when an S corporation has net recognized built-in gain during a 5-year recognition period, for example on an asset it held when it was a C corporation.
The S election ends automatically if, for 3 consecutive tax years, the corporation has accumulated earnings and profits and gets more than 25% of its gross receipts from passive investment income.
Who can be taxed as an S corp
To qualify, the corporation must be domestic, have only allowable shareholders (individuals, certain trusts and estates, not partnerships, corporations or non-resident aliens), have no more than 100 shareholders and have only one class of stock. For the 100-shareholder test, a married couple and their estates can count as one shareholder, and so can all members of a family.
The election is made on Form 2553, signed by all the shareholders. It is due no more than 2 months and 15 days after the start of the tax year it should take effect, or at any time in the tax year before. An entity eligible to be treated as a corporation that makes the election is treated as a corporation from the effective date and doesn't need to file Form 8832. Late election relief generally requires reasonable cause and filing within 3 years and 75 days of the effective date on line E of the form.
Form 1120-S deadline and penalties
Form 1120-S is due by the 15th day of the 3rd month after the tax year ends. For calendar-year corporations filing 2025 returns, that was March 16, 2026, because March 15 fell on a Sunday. Form 7004, filed by the regular due date, requests an automatic extension of time to file. S corporations required to file 10 or more returns of any type in a calendar year must e-file.
Aldro's flat yearly price covers everything tax for the year, including Form 1120-S, the shareholders' K-1s and the state returns. Our team prepares and files them.
Worked example
Say a shareholder starts the year with $10,000 of stock basis and their Schedule K-1 shows $40,000 of ordinary income. Basis first goes up by the $40,000 to $50,000. If the corporation distributes $45,000 to them, the whole distribution is tax-free because it doesn't exceed stock basis, and basis falls to $5,000. Had it distributed $55,000, the $5,000 above basis would be taxed as a capital gain. Separately, if the corporation has two shareholders and files a no-tax Form 1120-S three months late, the penalty is $255 times 3 months times 2 shareholders, or $1,530.
Common questions
What is the S corp tax rate?
There is no separate rate on ordinary S corp income. It passes through to shareholders, who pay tax at their individual income tax rates. The corporation pays entity-level tax only on items such as built-in gains and excess net passive income.
Do S corp owners have to take a salary?
A shareholder who works for the corporation must be paid reasonable compensation before non-wage distributions are made. The IRS can reclassify distributions as wages subject to employment taxes.
Are S corp distributions taxable?
A non-dividend distribution is tax-free up to the shareholder's stock basis. The excess is taxed as a capital gain.
Does an S corp make estimated tax payments?
Only when its built-in gains tax, excess net passive income tax and investment credit recapture tax total $500 or more. Shareholders make their own estimated payments on Form 1040-ES.
When is the S corp return due?
By the 15th day of the 3rd month after the tax year ends. For 2025 calendar-year returns it was March 16, 2026. Form 7004 requests an automatic extension.
The cheapest way to get your business taxes done: $399 flat.
Business tax filing is $399 USD a year, and it covers everything tax for that year.
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What's included
$399 a year covers everything tax for that tax year.
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Basic inventory tracking for online stores, such as Shopify, is included. Full cost-of-goods reconciliation is quoted separately. Payroll processing and sales-tax filing aren’t included in bookkeeping. Prices are in USD. Our team prepares and files your return.
Sources
- IRS: S corporations · checked October 31, 2026
- IRS: S corporation compensation and medical insurance issues · checked October 31, 2026
- IRS: S corporation stock and debt basis · checked October 31, 2026
- IRS: Estimated tax FAQs · checked October 31, 2026
- IRS: Instructions for Form 1120-S · checked October 31, 2026
- IRS: Instructions for Schedule D (Form 1120-S) · checked October 31, 2026
- IRS: Instructions for Form 2553 · checked October 31, 2026
This guide explains general rules from the sources listed. It isn’t tax advice for your situation.