How S Corporations Are Taxed and File Form 1120-S

Does an S corporation pay income tax itself, or is it taxed twice?

An S corporation generally does not pay federal income tax on its ordinary business profit. The profit passes through to shareholders and is taxed on their returns, so a later cash distribution is generally not taxed again if it is covered by stock basis. IRS: S corporations.

An S election changes federal tax treatment. A corporation remains a corporation under state law; an eligible LLC that elects S treatment remains an LLC. Either files Form 1120-S while the election is in effect, runs payroll for employees, and may owe federal tax on certain income or recapture items. States may also tax the business. A former C corporation needs extra care because old earnings can make a payment to shareholders a taxable dividend. IRS: LLC filing rules; IRS: Form 1120-S instructions.

How does profit reach shareholders' tax returns?

Each shareholder reports their share of S corporation income even if the corporation keeps every dollar. The share generally follows daily stock ownership, not cash taken out. If a shareholder fully exits, the corporation and affected shareholders may make a section 1377(a)(2) closing-of-the-books election; a qualifying-disposition election covers certain large stock changes and requires every shareholder's consent. Either election needs a statement with a timely original or amended Form 1120-S. The corporation reports each owner's share on Schedule K-1. Because tax can be due without cash, an owner may need more wage withholding or estimated tax payments. IRS: Form 1120-S instructions; IRS: estimated taxes.

Ordinary business profit in K-1 box 1 generally goes on Schedule E of an individual shareholder's Form 1040. Rental results, interest, capital gains, deductions, and credits have separate K-1 instructions. The shareholder's share of S corporation income is not self-employment income, but wages paid to a shareholder employee are subject to payroll rules. A loss on a K-1 is not automatically deductible: basis and other limits still apply. See Business losses for those limits. IRS: Schedule K-1 instructions; IRS: stock and debt basis.

How are S corporation distributions taxed?

A cash distribution from an S corporation with no accumulated C corporation earnings is generally a tax-free return of investment up to the shareholder's stock basis. It lowers that basis; it does not lower the profit already reported on the shareholder's return. Debt basis does not protect a distribution from tax. US Code: section 1368; IRS: stock and debt basis.

If the S corporation has accumulated earnings and profits from C corporation years, part of a distribution can instead be a taxable dividend. Distributions normally use the S-year accumulated adjustments account before old C corporation earnings. With all shareholders' consent, the corporation can make an earnings-first election by attaching a statement to a timely original or amended Form 1120-S. A dividend is generally reported on Form 1099-DIV, not as an ordinary K-1 distribution. Distributing appreciated property can also create gain at the corporate level that passes through to owners. US Code: section 1368; IRS: Form 1120-S instructions; IRS: Schedule D instructions.

What is shareholder basis, and how do I track it?

Shareholder basis is the running tax investment in S corporation stock and direct loans to the corporation. Stock basis controls whether a nondividend distribution is taxable; stock basis plus eligible debt basis can support a loss deduction. The shareholder, not the corporation, must keep the basis calculation. IRS: stock and debt basis.

Purchased stock usually starts with its cost. Stock received for contributed property generally starts with the property's carryover tax basis, adjusted for liabilities the corporation assumes and any gain recognized. Add your share of taxable and tax-exempt income. Then subtract distributions, nondeductible expenses, and losses in the required order; basis cannot fall below zero. Keep the prior basis schedule, each K-1, records of contributions and distributions, and loan documents. The K-1 reports activity but does not state whether your distribution is taxable. IRS: Form 7203 instructions; IRS: stock and debt basis.

A genuine loan made directly by the shareholder can create debt basis for losses. A bank loan to the corporation does not become shareholder debt basis merely because the shareholder guarantees it; basis from a guarantee generally arises only when the shareholder pays under it. If losses reduced a shareholder loan's basis, repayment can be taxable; track each loan's remaining basis. File Form 7203 when claiming an aggregate S corporation loss, receiving a nondividend distribution or loan repayment, or disposing of stock. IRS: Form 7203 instructions; IRS: stock and debt basis.

What if a distribution exceeds my stock basis?

For an S corporation without accumulated C corporation earnings, the excess over stock basis is generally capital gain reported on Form 8949 and Schedule D of the shareholder's return. Debt basis cannot absorb the excess. The holding period of the stock determines whether the gain is short term or long term. IRS: Schedule K-1 instructions; IRS: stock and debt basis.

Compute stock basis after adding the year's income but before subtracting the year's distributions. Do not compare the payment only with the cash you originally invested, and do not treat it as a deductible business expense. If the corporation has C corporation earnings or distributes property, the result needs a separate calculation. IRS: stock and debt basis; IRS: Form 1120-S instructions.

What goes on Form 1120-S, and when is it due?

An entity with an accepted S election in effect files Form 1120-S for each covered tax year. The form reports corporate income, deductions, credits, and other items; Schedule K totals the pass-through items, and a Schedule K-1 gives each shareholder their share. IRS: Form 1120-S instructions.

Before preparing the return, gather the IRS S election acceptance notice, prior Forms 1120-S and K-1, the books, payroll reports, asset records, shareholder contributions and loans, and distributions by owner. Schedule L and Schedule M-2 may be required or useful; they are corporate records and do not replace each shareholder's basis schedule. If the election is missing or unconfirmed, see Late S corporation election relief. For a first return, see Your first business tax return. IRS: Form 1120-S instructions.

When can the S corporation itself owe federal tax?

An S corporation can owe federal tax despite pass-through treatment, especially after operating as a C corporation. The corporation reports these taxes on Form 1120-S; they are separate from shareholders' tax on their K-1 items. IRS: Form 1120-S instructions.

If accumulated C corporation earnings and passive receipts over the threshold continue for three consecutive tax years, the S election ends at the start of the next tax year. That makes old C corporation returns and earnings records important before a conversion. IRS: Form 1120-S instructions.

Do states tax S corporations the same way?

No. A federal S election does not settle state or city tax treatment. Check every state where the corporation is formed, registered, doing business, or earning income, and each owner's state of residence. California Franchise Tax Board; New York: Form CT-6 instructions.

States may also require withholding on payments to nonresident owners. California requires S corporations to withhold on covered distributions of California-source income to nonresident shareholders, subject to exceptions. California FTB: Publication 1017. State pass-through entity tax elections are separate choices; see Pass-through entity tax election.

Where do owner salary and health insurance fit?

An owner who works for the S corporation may need reasonable wages before taking nonwage distributions. Wages are payroll items, while the owner's K-1 reports pass-through items; calling a payment a distribution does not settle its wage treatment. See S corporation owner salary. IRS: compensation issues.

For a shareholder employee who owns more than 2%, employer-paid health premiums generally go on Form W-2 as wages, and a personal health insurance deduction requires further conditions. See Health insurance for owners. IRS: medical insurance issues.

What can end S corporation status by accident?

An S election can terminate when the corporation stops meeting the eligibility rules. A transfer to an ineligible owner, such as a partnership, corporation, or nonresident alien, exceeding the shareholder limit, or issuing shares with different distribution or liquidation rights can do it. Moving abroad alone is not the test; the shareholder's US tax status matters. IRS: S corporations; IRS: Form 2553 instructions.

Unequal cash payments alone do not create a second class of stock if every share has identical distribution and liquidation rights under the charter, bylaws, applicable state law, and binding agreements. The payments still need correct tax treatment and records. Also monitor the passive-income rule described above. An automatic termination can change which corporate return is due; prompt review matters because a new S election may require IRS consent for several tax years. IRS: Revenue Procedure 2022-19; IRS: Form 1120-S instructions.

Example

Illustrative US dollars; assume one shareholder, cash distributions, no accumulated C corporation earnings, and no other basis adjustments. The shareholder starts with $10,000 of stock basis. The corporation earns $60,000 of profit after any wages and pays out $80,000. The shareholder reports $60,000 of pass-through profit even though the corporation distributes a different amount.

The profit raises stock basis to $70,000 before the payment. Of the $80,000 distribution, $70,000 uses up stock basis and $10,000 is capital gain. The corporation does not deduct the distribution. Any owner wages are a separate payroll calculation.

Different for you?

• You are deciding whether to elect S status: compare the structure and election in Should you elect S corporation status?.
• Your election was late or acceptance is missing: check Late S corporation election relief.
• Your K-1 shows a loss: apply the owner-level limits in Business losses.
• Your Form 1120-S was late: see Late filing and payment penalties.
• A Canadian resident owns or may acquire shares: nonresident-alien eligibility and two-country tax rules need review. See US business for a Canadian resident and cross-border tax.
• The corporation converted from C status, changed owners, or operates in several states: gather the election acceptance notice, prior returns and K-1s, stock and loan records, C corporation earnings and asset values, payroll, and state filings for tax preparation.