Building Your Business Business Taxes A Summary of S Corporation Taxation By William Perez William Perez Twitter William Perez is a tax expert with 20+ years of experience advising on individual and small business tax. He has written hundreds of articles covering topics including filing taxes, solving tax issues, tax credits and deductions, tax planning, and taxable income. He previously worked for the IRS and holds an enrolled agent certification. learn about our editorial policies Updated on September 17, 2020 In This Article View All In This Article Making the S Corp Election Taxation of S Corporations S Corporations vs. C Corporations Pass-Through Treatment of Tax Items The Corporate Tax Rate Taxes Paid at the Corporate Level Photo: Thomas Barwick / Stone / Getty Images U.S. corporations can elect to be taxed at the corporate level or at the shareholder level. Those that elect the shareholder option are referred to as S corporations. "S" stands for Subchapter S of Chapter 1 of the Internal Revenue Code. No income tax is applied at the corporate level. Instead, all income is taxed using the personal income tax rates. An S corporation files its own corporate tax return and measures its taxable income, but this income is then divided and distributed among its shareholders. Various deductions and tax credits also pass through to shareholders. Each shareholder includes his portion of the corporate income, deductions, and credits on his personal tax return. Making the S Corp Election Electing to have your business taxed as an S corporation requires filing Form 2553 with the IRS. The form must be signed by all shareholders. Your business must qualify under certain rules: It must be a domestic corporation. You must register with your state as a corporation prior to electing S corporation status.Its shareholders are all individuals, estates, or certain allowable trusts.No shareholders are partnerships, other corporations, or nonresident aliens.You have no more than 100 shareholders.Your corporation has just one class of stock. Taxation of S Corporations S corporations make an affirmative election to pass corporate income, credits, losses, and deductions down to their shareholders for federal tax purposes when they file Form 2553. Shareholders then report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. Note S corporations avoid double taxation on corporate income through this process. They can be responsible for tax on certain built-in gains and passive income at the entity level, however. S Corporations vs. C Corporations A corporation that elects to be taxed at the corporate level is called a C corporation, and it files its own corporate tax return. It measures its taxable income and calculates its tax according to corporate tax rates. Note The concept of "double taxation" is the result of C corporations distributing profits to their shareholders in the form of dividends after these profits have been taxed at the corporate level. Then these dividends also become taxable income to the shareholder. Pass-Through Treatment of Tax Items S corporations are referred to as "pass-through" tax entities because their incomes and other tax items flow from the corporate level to the personal tax returns of the shareholders. As an example, ABC Corporation is an S corporation and has a single shareholder, John Doe. ABC has net taxable income of $100,000. That one hundred thousand dollars is reported by the corporation to the shareholder, Mr. Doe, on Schedule K-1. Mr. Doe then takes this amount from Schedule K-1 and reports it on page 2 of Schedule E, which accompanies his Form 1040 tax return. He adds this income to the rest of his income on his return. Items of income, deductions, or credits retain their character as they flow from the S corporation to the shareholder's personal tax return. If the S corporation sold some assets that qualify for long-term capital gains treatment, that income is reported as long-term gains on the Schedule K-1 from the corporation to the shareholder. The individual shareholder would then report this income on his Schedule D as long-term gains. Now suppose that an S corporation donates money to charity. That item is reported as a charitable donation on the Schedule K-1. The shareholder would report his portion of the charitable donation as an itemized deduction for charity on his personal return if he chose to itemize his deductions. Note Individual taxpayers can either itemize their deductions or claim the standard deduction for the tax year, but they can't do both. The pass-through treatment of tax items requires that all items of income, deductions, and tax credits are handled in the appropriate way when these items are reported on the shareholder's personal tax return. The Corporate Tax Rate The Tax Cuts and Jobs Act (TCJA) slashed the tax rate for C corporations from 35% to 21% in 2018. Meanwhile, shareholders in an S corporation still pay a tax rate commensurate with their personal income, according to their own tax brackets, and this can be higher than the corporate rate. A single taxpayer pays 32% on taxable income in excess of $163,300 in 2020, and this increases to 35% for single taxpayers at incomes over $207,350. Not fair? The TCJA agreed. It established a Qualified Business Income Deduction effective in 2018 for owners of pass-through businesses of up to 20% of net business income. S corporations and their shareholders qualify for this deduction. Income limits and some other limitations apply. Taxes Paid at the Corporate Level S corporations are responsible for paying three taxes at the corporate level: excess net passive income, the LIFO recapture tax, and built-in gains tax. The excess net passive income tax and the LIFO recapture tax apply only when an S corporation was previously a taxable C corporation, or if the S corporation went through a tax-free reorganization with a C corporation. Excess Net Passive Income Tax Excess net passive income is a corporate-level tax on the passive income earned by an S corporation. Passive income includes income from interest, dividends, annuities, rents, and royalties. The excess net passive income tax applies if passive income is more than 25% of the S corporation's gross receipts. Note The IRS provides a worksheet for calculating this excess net passive income tax in its Instructions for Form 1120S. LIFO Recapture Tax "LIFO" refers to the last-in, first-out method of measuring inventory for tax purposes. LIFO recapture tax applies if a corporation used this inventory pricing method during its last tax year as a C corporation, or when a C corporation has transferred LIFO inventory to the corporation in a nonrecognition transaction in which those assets were transferred basis property. Built-In Gains Tax Built-in gains tax applies when an S corporation disposes of an asset within five years of acquiring it, and the S corporation acquired the asset when: The S corporation was a C corporation, orIn a transaction in which the basis of the asset was determined by reference to its basis in the hands of a C corporation NOTE: Tax laws change periodically. You should always consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and it is not a substitute for tax advice. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. IRS. "S Corporations." Accessed Aug. 29, 2020. Tax Foundation. "The Dual Tax Burden of S Corporations." Accessed Aug. 29, 2020. IRS. "IRS Provides Tax Inflation Adjustments for Tax Year 2020." Accessed Aug. 29, 2020. IRS. "Publication 535 Business Expenses." Page 42. Accessed Aug. 29, 2020. Cornell Law School Legal Information Institute. "26 CFR § 1.1375-1." Accessed Aug. 29, 2020. Cornell Law School Legal Information Institute. "26 CFR § 1.1363-2 - Recapture of LIFO Benefits." Accessed Aug. 29, 2020. Iowa Department of Revenue. "Built-In Gains Tax on S Corporations." Accessed Aug. 29, 2020.