Instead, the owners usually cover the federal income tax bill on their share of the company's profits. This happens whether or not the business actually pays out cash that year.
If you're reading this from Australia, a word of caution: S corporation taxation is a US tax concept with no direct Australian equivalent. Eligibility rules, state-level obligations, and how this all interacts with your Australian tax position each need separate review before you rely on anything here.
Key Takeaways
- S corp income, deductions, credits, and losses generally flow through to shareholders' personal tax returns
- Shareholder-employees need reasonable W-2 wages; extra distributions are taxed differently for payroll purposes
- The company can still owe payroll, state, excise, or other entity-level taxes
- Form 1120-S and Schedule K-1 anchor the annual reporting cycle
- Your actual tax outcome hinges on eligibility, basis, salary levels, and state rules
What Is an S Corporation?
An S corporation isn't a separate type of business entity under state law. It's a federal tax election made under Subchapter S of the US Internal Revenue Code, available to a corporation (or an eligible entity that chooses corporate tax treatment) once it meets the relevant tests.
This matters because people often confuse the tax label with the legal structure. You first form a corporation or LLC under state law, then separately elect S corp tax treatment with the IRS.
S corp vs. C corp, in plain terms:
- A C corporation pays tax at the entity level on its profits, and shareholders pay tax again on dividends
- An S corporation generally skips that first layer, passing ordinary income straight through to shareholders
Pass-through treatment prevents ordinary profit from facing two rounds of federal tax. It doesn't make the business tax-free. Payroll obligations, certain special entity-level taxes, and state requirements still apply.
One more distinction worth flagging: limited liability protection comes from the underlying corporate structure, not from the tax election. You can lose the S election while keeping liability protection, or vice versa, because they're governed by entirely separate rules.
Who Can Use S Corp Tax Treatment?
Not every business qualifies. The IRS imposes specific eligibility conditions, and getting these wrong can unwind the election entirely.
Eligibility Requirements
According to IRS Form 2553 instructions, a qualifying corporation generally must:
- Be a US domestic corporation (or an eligible entity electing corporate treatment)
- Have no more than 100 shareholders
- Limit shareholders to individuals, certain estates, and certain trusts or tax-exempt organisations
- Issue only one class of stock (voting-rights differences are fine; distribution and liquidation rights must be identical)
The nonresident alien restriction is the one that trips up international owners most often. Nonresident aliens generally cannot hold S corp shares, with a narrow exception for certain beneficiaries of an electing small business trust. For Australian founders setting up alongside US partners, or multinational groups weighing a US subsidiary, this restriction deserves attention early, not after the entity is formed.
Making the Election
The usual sequence looks like this:
- Form the underlying corporation or LLC under US state law
- Obtain or confirm an EIN from the IRS
- File Form 2553, generally within two months and 15 days of the start of the tax year the election should apply to
- Secure consent from all shareholders
An LLC can elect S corp tax treatment if it qualifies, but forming the LLC and making the election are two distinct steps. Missing either one leaves you with a different tax outcome than intended.
Finally, the election can be lost if ownership changes, stock terms shift, or shareholder eligibility is violated down the track. Any change in ownership structure deserves a professional review before it happens, not after.
How Is S Corp Income Taxed?
Here's the core mechanics most owners actually want to understand.
The corporation calculates its taxable income for the year, reports it to the IRS, and allocates income, deductions, and credits to shareholders based on their ownership share. The company files Form 1120-S as an information return rather than paying ordinary federal corporate income tax on that operating profit.
Each shareholder then receives a Schedule K-1, showing their individual slice of income, deductions, credits, and losses. That K-1 data gets reported on the shareholder's personal return, regardless of how much cash actually landed in their bank account.
Phantom Income Explained
This creates what's often called "phantom income." A shareholder can owe personal tax on allocated profit even when the company keeps the cash for working capital, debt repayment, or expansion.
Say the business posts a healthy profit but the board decides to reinvest it all into inventory and equipment. Shareholders still pick up their share of that profit on their K-1 and owe tax on it, even though no distribution hit their account. Taxable income and cash distributions are two separate things; one doesn't trigger the other.
What Determines the Final Tax Bill
The shareholder's individual tax bracket determines how much tax that allocated income actually costs them. Rates are marginal and scale with total taxable income, so two shareholders in the same company can face very different effective rates depending on their other income, filing status, and deductions.
Current-year bracket thresholds shift annually, so check the IRS's published figures for the relevant tax year rather than relying on a number you saw last year.
Losses Aren't Automatically Deductible
Pass-through losses sound great until basis and other limitations get involved. A shareholder generally can't deduct a loss beyond their:
- Stock and debt basis in the company
- At-risk amount tied to their investment
- Passive-activity limits, if they're not materially participating
- Excess business loss rules, which cap how much business loss offsets other income in a given year
Those limits sit on top of how pass-through results are calculated. Revenue minus allowable business expenses produces the company's pass-through income or loss. For a working shareholder, W-2 salary and remaining K-1 profit are taxed under separate rules, and any K-1 loss still has to clear basis, at-risk, passive-activity, and excess-loss limits before it offsets other income.
What Taxes and Tax Obligations Can an S Corp Still Have?
Pass-through treatment doesn't mean tax-free. Several obligations still land squarely on the company.
Payroll Taxes
Wages paid to shareholder-employees and other staff trigger federal income-tax withholding, Social Security, Medicare, and applicable unemployment tax. These sit entirely separate from income tax on the pass-through profit itself; payroll tax applies to wages, income tax applies to the shareholder's allocated earnings.
Reasonable Compensation
This is where the IRS pays close attention. Shareholder-employees performing more than minor services generally must receive commercially reasonable wages before taking additional distributions. According to the IRS compensation guidance, relevant factors include the shareholder's actual duties and how much of the company's revenue traces back to their personal services.
Skip this step, or set salary artificially low to dodge payroll tax, and the IRS can reclassify distributions as wages, with back taxes and penalties attached.
State and Local Obligations
Federal S corp status doesn't automatically carry over to every state. Depending on the jurisdiction, a business might face:
- State income or franchise taxes
- A separate state-level S election (some states require their own filing)
- Composite or nonresident shareholder filings
- Sales tax registration, which varies state by state
- Local business taxes
Special Entity-Level Taxes
A handful of situations create federal tax at the corporate level:
- Built-in gains tax: applies to certain gains recognised within five years of converting from a C corporation
- Excess net passive income tax: triggered when accumulated earnings and passive income exceed set thresholds
- LIFO recapture: relevant if the company used LIFO inventory accounting before electing S status
- Excise taxes: applicable in specific industry or transaction scenarios
Tax-exempt income also needs tracking, even though it isn't federally taxed outright. It still affects shareholder basis calculations and can influence how later distributions get taxed.
Filing deadlines, extension rules, and estimated-tax thresholds shift from year to year, so confirm the current figures rather than assuming last year's dates still apply.
For Australian owners specifically: none of the above determines your Australian tax position. US federal and state filings don't resolve Australian residency questions, foreign income reporting obligations, or treaty analysis. Those require a separate conversation with someone across both systems.
How Does an S Corp Report Income and Pay Owners?
The annual cycle follows a fairly predictable rhythm:
- Maintain accurate books throughout the year
- Calculate business income and allowable deductions
- Prepare and file Form 1120-S
- Issue Schedule K-1 to each shareholder
- Shareholders report their K-1 items on their individual returns
Two Payment Channels
An owner actively working in the business typically gets paid two ways:
- W-2 salary through standard payroll, with withholding applied
- Shareholder distributions from available corporate funds, taxed differently than wages
A commonly cited "60/40" salary-to-distribution split floats around online. It's not an IRS rule. Compensation should reflect actual duties, industry norms, hours worked, and the business's circumstances—not a fixed formula.
Good recordkeeping matters more than people expect:
- Keep business and personal accounts strictly separate
- Document every distribution
- Track stock basis year over year
- Maintain clean payroll records
These habits make annual filing smoother and protect the S election if the IRS ever asks questions.
For Australian businesses managing US S Corp compliance alongside local operations, coordination gets complicated quickly. VJM Global supports accounting, tax compliance, and financial reporting for international businesses navigating US-related requirements. The right approach depends on a tailored review of the entity and each owner's jurisdictions.
Conclusion
An S corporation generally passes ordinary federal business income through to shareholders instead of paying corporate-level federal income tax on it. That answers the core question, yet the structure is not tax-free.
The real work sits in the details:
- Confirming shareholder eligibility
- Setting defensible salary levels
- Staying on top of payroll compliance
- Tracking basis correctly
- Understanding how your specific state treats the election
Add an international ownership layer, and the analysis gets more involved still.
Before electing S corp status, or adjusting how you pay yourself through one, get advice from professionals who understand both US S corporation rules and Australian tax obligations. Getting it right from the outset costs far less than fixing it later.
Frequently Asked Questions
How much tax will an S corp pay on its profits?
Ordinary federal income tax generally passes to shareholders rather than being paid by the company. Total burden depends on shareholder rates, distributions, payroll, state rules, and any entity-level taxes.
How do S corps and LLCs differ for taxes?
By default, a single-member LLC is a disregarded entity and the owner pays self-employment tax on net earnings. Electing S corp treatment shifts shareholder-employee pay to W-2 wages and can reduce that tax exposure, with higher admin requirements.
Can my S corp pay my personal taxes?
The company can pay you via reasonable salary or shareholder distributions. Paying personal expenses from corporate funds creates bookkeeping and tax issues, and the IRS may treat those payments as additional compensation subject to employment tax.
What are some effective tax strategies for an S corp?
Common approaches include accurate deductions, defensible reasonable compensation, retirement and health-benefit planning, timely estimated payments, and careful basis tracking. No single strategy fits every business, so professional review matters.
Does tax-exempt income count as income?
Tax-exempt income generally isn't subject to federal income tax, but it is still reportable. It affects shareholder basis and how later distributions are taxed, so it shouldn't be ignored.
