Introduction
"It's a pass-through, so the business owes nothing." Owners hear this often, and it's wrong. An S corporation usually escapes regular federal corporate income tax, but payroll taxes, state taxes, shareholder-level income tax and filing penalties still apply.
This article separates three things: taxes the S corporation pays, taxes shareholders report on their own returns, and compliance duties that trigger penalties. Penalties bite quickly.
A late Form 1120-S costs $255 per shareholder for each month or part-month, according to the IRS 1120-S instructions.
Australian owners face both systems at once. U.S. and Australian tax rules apply separately, and the two interact in ways that need advice before you commit to a structure.
Key Takeaways
- Income passes through to shareholders, but tax still follows it.
- Working owners need reasonable payroll wages before taking distributions.
- Entity-level payroll, state and special federal taxes can still apply.
- Nonresident aliens cannot hold S corp shares, so Australian residents must check eligibility first.
How S Corporation Taxation Works
An S corporation is a federal tax election, not a separate type of legal entity. An eligible domestic corporation, or an eligible LLC that elects corporate classification, files Form 2553 with all shareholders signing. The underlying entity stays a corporation or LLC under state law. Only its federal tax treatment changes.
How income, deductions and losses pass through
The company reports income, deductions, credits and losses on Form 1120-S and issues a Schedule K-1 to each shareholder. Shareholders then report their share on their individual return, generally Form 1040.
Taxable income passes through even if the company keeps the cash. That gap is often called "phantom income". A shareholder allocated $60,000 of profit owes tax on it, whether or not a dollar was distributed.
Salary, distributions and shareholder tax
Wages paid to an owner-employee go through payroll, with withholding and employment taxes. Distributions are different. They are not wages, but they are not automatically tax-free either.
A non-dividend distribution is tax-free only up to the shareholder's stock basis. The excess is generally taxed as capital gain, and debt basis does not change that, per the IRS basis guidance.
Pass-through taxation is not tax exemption
Here is a simple hypothetical, not tax advice. An S corporation earns $200,000 before owner pay. It pays the sole owner a $90,000 salary and distributes $80,000.
- Payroll taxes apply to the $90,000 wage, shared between employer and employee.
- The remaining profit of about $110,000 (less employer payroll tax) appears on the K-1.
- The owner reports wages plus K-1 income on Form 1040, even if only $80,000 was distributed.
Three separate liabilities arise from one business.
What Tax Liabilities Can an S Corporation Have?
Employment and payroll taxes
The corporation must withhold and report federal income tax, Social Security and Medicare for every employee, including shareholder-employees. For 2026, Social Security is 6.2% each for employer and employee up to a $184,500 wage base, and Medicare is 1.45% each with no cap, per IRS Publication 15.
Unemployment tax (FUTA) is 6.0% on the first $7,000 per employee, usually reduced to 0.6% by the state credit. The relevant forms are:
- W-2 for annual wage reporting
- Form 941 for quarterly payroll returns
- Form 940 for annual FUTA
Deposit schedules depend on your lookback-period liability. Confirm current thresholds and state payroll rules each year.
Federal taxes that may apply in special circumstances
These apply only on specific facts, not to every S corporation:
- Built-in gains tax: 21% on net recognised built-in gain during a five-year period after conversion from C corporation status
- Excess net passive income tax: 21% where the company has accumulated C corporation earnings and passive income above 25% of gross receipts
- LIFO recapture: applies when a former C corporation used LIFO, payable in four equal instalments
- Excise taxes: depending on the business's activities
State and local taxes
State treatment varies widely. California, for example, taxes S corporations at 1.5% of California-source income with an $800 minimum franchise tax. Other states have composite or nonresident filings, or pass-through entity tax elections that can shift the state tax deduction to the entity level.
Sales tax, property tax and registration also depend on where you have employees, property or customers. Wisconsin, for instance, sets a $100,000 remote-sales threshold, but each state sets its own.
Shareholder-level income and estimated tax
Shareholders owe federal and state income tax on wages and allocated income, whether or not cash is distributed. Review estimated payments and withholding each quarter. Distributions are not a measure of tax due.
Filing failures, interest and penalties
- Late Form 1120-S: $255 per shareholder per month, up to 12 months
- Incorrect or late K-1: $340 per failure, rising to $680 or 10% for intentional disregard
- Late payroll deposits: 2% to 15% depending on lateness
- Interest accrues on underpayments at the federal short-term rate plus 3 points
Form 7004 gives an automatic six-month extension to file. It does not extend the time to pay.
How Compensation, Distributions and Deductions Affect Liability
Reasonable compensation for shareholder-employees
An owner who performs services must receive reasonable pay before non-wage distributions. The IRS looks at duties, time, experience, industry practice and comparable market pay. It publishes no fixed salary-to-distribution ratio, so beware anyone selling a "60/40 rule".
In Watson v. United States, the company paid the owner $24,000 while the court accepted $91,044 as reasonable and treated the shortfall as wages.
Deductible operating expenses
Ordinary and necessary business expenses are deductible under IRC 162. Typical examples:
- Employee wages and rent
- Professional fees and software
- Advertising and business insurance
- Supplies, utilities and equipment
- Qualifying business travel
Deductibility depends on business purpose, substantiation, timing and classification. A personal expense does not become deductible because it left a business account.
Owner reimbursements, benefits and specialised deductions
Use a documented accountable plan for legitimate shareholder expenses. Properly reimbursed amounts are not wages.
Health insurance for more-than-2% shareholders, home office, retirement plans and vehicle use each have their own rules. Some items are deducted by the company, while others are adjusted on the shareholder's Form 1040.
Losses, basis and distribution limits
Passed-through losses are limited in order by stock and debt basis, at-risk rules, passive-activity rules and the excess business loss limit. For 2026, that limit is $256,000 for single filers and $512,000 for joint filers.
Keep annual basis records, including Form 7203 where required. Cash distributions alone do not replace a proper basis schedule.
Tax planning guardrails
- Keep accurate books and run payroll on time
- Document reimbursements
- Review deductions before year-end
- Coordinate shareholder estimated payments
Legitimate deductions reduce taxable income. Disguised personal spending, understated salary and treating all distributions as tax-free invite reclassification and penalties.
S Corporation Filing and Compliance Checklist
Annual federal and shareholder filings
Form 1120-S is due the 15th day of the third month after year-end (March 16 in 2026 for calendar-year 2025). K-1s go to shareholders by that date, who then report on Form 1040 and any state returns.
Form 7004 extends the filing deadline only, not the time to pay. Check whether your state needs its own extension or payment.
Ongoing payroll and bookkeeping controls
- Keep business and personal accounts separate
- Reconcile books monthly
- Retain payroll records, receipts, invoices and fixed-asset records
- Maintain shareholder basis schedules and salary-decision documentation
Build a calendar covering:
- Payroll deposits
- Form 941 (April 30, July 31, October 31, January 31)
- Form 940 and W-2s (generally January 31)
- Estimated taxes
- Annual reports and state registrations
When professional support becomes valuable
Seek help if any of these apply:
- Multi-state activity or prior C corporation status
- Foreign owners
- Inconsistent payroll or late filings
- Unclear basis or large distributions
- Incomplete books
VJM Global provides accounting outsourcing, financial reporting and tax compliance support for U.S.-connected businesses, including federal, state and local obligations. It helps keep records organised and filings on schedule, without promising any particular tax outcome.
Is S Corporation Status Suitable for Every Business Owner?
Eligibility and ownership restrictions
The company must be a domestic corporation with no more than 100 shareholders, one class of stock, and only eligible shareholders (individuals, estates, certain trusts and exempt organisations). Partnerships and corporations cannot be shareholders.
Australian caution: A nonresident alien cannot be an S corporation shareholder, and losing eligibility can terminate the election. Australian residents should also check ATO residency tests, controlled foreign company rules and foreign income tax offsets. The 1982 U.S.-Australia treaty provides double-tax relief but does not settle any particular outcome. ATO guidance on U.S. entities often covers LLCs rather than S corporations, so get specific advice.
S corp compared with LLC and C corporation treatment
| Structure | Ownership | Payroll / self-employment tax | Double taxation |
|---|---|---|---|
| S corporation | Restricted shareholders, one class of stock | Owner services taxed as wages; distributions are not wages | Generally avoided, apart from entity-level taxes |
| Multi-member LLC (default) | Flexible | Allocations may attract self-employment tax | Pass-through |
| C corporation | No eligibility limits | Wages for services; dividends not wages | Corporate and shareholder levels |
When the potential tax benefit may not justify the complexity
The election may not pay off when you face:
- Inconsistent or minimal profit
- Planned foreign or institutional investors
- Complex ownership structures
- Large retained earnings
- Multi-state operations
Before forming, converting or electing, get advice from professionals who know both U.S. tax rules and the relevant Australian rules.
Frequently Asked Questions
How are S corporations taxed?
Income, deductions and credits pass through to shareholders via Schedule K-1 and are taxed on their individual returns. The company can still owe payroll, state and other taxes.
Does an S corp pay federal income tax?
Generally not at the corporate level. Built-in gains tax and excess net passive income tax can apply in specific circumstances.
What expenses can be deducted from an S corp?
Ordinary and necessary expenses such as wages, rent, software, advertising and insurance. They need a business purpose, documentation and compliance with current IRS limits.
What tax forms does an S corp file?
Form 1120-S with Schedule K-1s, payroll forms (941, 940, W-2), information returns such as 1099-NEC, and any state or local filings.
How does reasonable compensation affect S corp tax liabilities?
Working shareholders need reasonable wages before distributions. Salary drives payroll taxes and deductions, and understated pay can be reclassified by the IRS.
Can Australian or other non-U.S. business owners be S corp shareholders?
Nonresident aliens cannot be S corp shareholders. Australian tax residency and cross-border consequences need separate professional advice.
