S Corporation

S corporations are not taxed at the corporation level. They pass corporate income, losses, deductions and credits through to their shareholders for tax purposes, making them a pass-through entity. S corporation shareholders report the income and loss on their personal tax returns and are assessed tax at their individual income tax rates, allowing the S corporation to avoid double taxation on corporate income.



Self-employment tax and distributions. One major benefit of an S corporation is that not all earnings are subject to self-employment tax. An S corporation shareholder is an owner-employee of the business. This means that the net profit from the business is a blend of self-employment income and a return of capital from the shareholder’s investment in the business.



The self-employment component is paid out as wages and is subject to self-employment tax. The return on the investment is paid out as a distribution and is not subject to self-employment tax.



Reasonable compensation. To prevent all of the business earnings from being treated as distributions that are not subject to self-employment tax, S corporation shareholders are required to be paid “reasonable compensation.” Amounts taken as reasonable compensation are treated as wages, and the shareholder and corporation pay FICA and Medicare taxes on those wages.



Since only a portion of the net profit is subject to self-employment taxes, business owners can see significant savings on self-employment taxes. These savings are available as long as the S corporation is in business. All net profit, whether distribution or wages (reasonable compensation), is still subject to income tax.