The following is an excerpt from my book LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less.

S-corporations, like 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

Form 1120S is the form used for an S-corporation’s annual tax return. (This makes sense, given that Form 1120 is used for a regular corporation’s annual return.) As with a partnership, Schedules K and K-1 are used to show how the business’s different types of income and deductions are allocated among the owners.

No Self-Employment Tax!

The big benefit of S-corp taxation is that S-corporation shareholders do not have to pay self-employment tax on their share of the business’s profits.

The big catch is that before there can be any profits, each owner who also works as an employee must be paid a “reasonable” amount of compensation (e.g., 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 a result, the savings from paying no self-employment tax on the profits only kick in once the S-corp is earning enough that there are still profits to be paid out after paying the mandatory “reasonable compensation.”

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. Therefore, 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 in her area and with her level of experience earns roughly $70,000 annually. As such, she’s going to have a difficult time making the case that $40,000 is a reasonable level of compensation.

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? This exact question is frequently the topic of 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.

What makes the situation tricky is that the tax code itself does not provide any specific guidelines for what’s reasonable. That said, the following factors are frequently considered by courts when ruling on the issue:

The duties and responsibilities of the shareholder-employee,

The training and experience of the shareholder-employee,

The amount of time and effort devoted to the business,

The amount of dividends paid to shareholders (especially as compared to compensation paid to shareholder-employees),

The wages of the business’s other employees (i.e., those who are not shareholders), and

What comparable businesses pay for similar services.

Cost Basis in an S-Corporation

Much like owners of a partnership, shareholders of an S-corporation are taxed on their allocated share of the business’s profits — no matter whether or not those profits were actually distributed to them. But, also like an owner of a partnership, a shareholder of an S-corporation is not taxed on distributions from the business, so long as those distributions do not exceed his cost basis in the S-corp.

A shareholder’s cost basis in an S-corporation is increased by his allocated share of the business’s income and by contributions he makes to the business. His basis will be decreased by his share of the business’s losses and by distributions he receives from the business.

EXAMPLE: Austin forms an S-corporation and contributes $40,000 cash to the business. In the calendar year in which the business is formed, the business pays Austin a salary of $30,000, after which it has remaining ordinary business income of $20,000. During the year, the corporation also makes a distribution to Austin of $25,000.

When Austin forms the corporation, his cost basis in the business is $40,000 (the amount he contributed). The $20,000 ordinary business income increases his basis to $60,000, and the $25,000 distribution reduces his basis to $35,000. $35,000 is his cost basis at the end of the first year.

The $30,000 salary will be taxable to Austin as ordinary income, and it will be subject to normal payroll taxes as well. The $20,000 ordinary business income will be taxable to Austin as ordinary income, but it will not be subject to payroll taxes or self-employment tax. The $25,000 distribution will not be taxable to Austin at all, because his cost basis before the distribution was greater than $25,000.

Deduction for Pass-Through Income

Because S-corporations are pass-through entities, profit from an S-corporation qualifies for the deduction for pass-through business income. That is, you may qualify for a deduction of up to 20% of your share of the S-corporation’s profit. Of note, any compensation (e.g., wages/salary) that the S-corporation pays to you is not considered to be pass-through income. It is only allocations of profit from the S-corporation that are considered to be pass-through income.

State Taxation of S-Corporations

Of course, each state has its own rules regarding S-corp taxation. Some work like the federal income tax in which shareholders pay taxes on their share of the income. Other states tax the S-corp directly. For instance, in Illinois, S-corporations pay a 1.5% tax on the S-corp’s Illinois income. This tax is in addition to the income tax that shareholders pay on their share of the S-corp’s income.

In Summary