S-corporations, like sole proprietorships and partnerships, are pass-through entities. That is, there is no Federal income tax levied at the corporate level. Instead, an S-corporation’s profit is allocated to its shareholder(s) and taxed at the shareholder level.
Tax Forms for S-Corporations
An S-corporation’s annual tax return is filed on Form 1120S. (This actually makes some sense, given that a regular corporation’s return is filed on Form 1120.) This form consists of pretty much what you’d expect: A section detailing revenues, a section detailing expenses, and a section for calculating the amount of tax owed.
In addition to the above, Form 1120S also includes a Schedule K as well as a Schedule K-1 to be filled out for each shareholder. The Schedule K and Schedules K-1 fulfill the exact same purpose as they do on a partnership’s tax return. That is, they’re used to show how the business’s profit or loss is allocated among the owners.
No Self-Employment Tax!
The big catch is that, before any profits can be distributed, each of the owners who also work as employees must be paid a “reasonable salary.” This salary will of course be subject to social security and Medicare taxes to be paid half by the employee and half by the corporation. As such, the savings from paying no self-employment tax on the profits only kicks in once the S-corp is earning enough that there are still profits to be paid out after paying the mandatory “reasonable salary.”
EXAMPLE: Larissa is the sole owner of her S-corporation, an advertising agency. Her revenues from the business are $60,000 per year, and her annual expenses (not counting salary) total $10,000. As such, her S-corp’s profit for the year (before subtracting her own salary) is $50,000.
Larissa’s plan is to pay herself $40,000 in salary, and count the remaining $10,000 as profit, thus saving money as a result of not having to pay self-employment tax on the $10,000 profit.
Unfortunately, Larissa learns that the average advertising professional earns in the $60,000 range annually. As such, she’s going to have a difficult time making the case that $40,000 is a “reasonable salary.”
In the end, Larissa ends up setting her salary at $50,000 in order to avoid trouble with the IRS. Sadly, her S-corp’s profit (after paying her salary) ends up being $0, so she isn’t really saving any money on taxes as a result of S-corp taxation.
Determining a “Reasonable Salary”
So what’s a reasonable salary? Good question. This exact question is frequently the topic of great debate in court cases between the IRS and business owners who are, allegedly, paying themselves an unreasonably small salary in order to save on Self-Employment Taxes.
One way to get an estimate for reasonable salary is to visit salary.com. There you can run a search, and it will tell you the average salary earned by people in your profession and in your geographical area.
- S-corporations are pass-through entities. That is, the corporation itself is not subject to federal income tax. Instead, the shareholders are taxed upon their allocated share of the income.
- Form 1120S is the form used for an S-corp’s annual tax return.
- Shareholders do not have to pay self-employment tax on their share of an S-corp’s profits. However, before profits are calculated, any owners that work as employees for the S-corp will need to receive a “reasonable salary.”