How is an S corp taxed?

Like partnerships, S corps are pass-through entities. This means that there are no federal taxes levied upon the corporation. Instead, the S corp passes on all profits directly to the shareholders, and then the shareholders are responsible for paying their own tax.

Although there is not tax levied at the federal level, each state has its own rules for how S corps are taxed. For example, in California, S corps are taxed at 1.5%, whereas in New York, S corps are required to pay the full tax rate of 8.85%.

Even though shareholders are responsible for their own tax on profits, any shareholder that is employed by the S corp is required to receive a “reasonable salary.” The salary is subject to normal employment taxes and withholdings. What is considered a “reasonable salary” is a widely debated topic that does not have a clear answer. Salary paid to shareholder employees should be comparable to their duties and responsibilities, and should also take into consideration average market salaries. Small salaries with large profit distributions are likely to catch the attention of the IRS.

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