What Is an S Corporation and How Is It Taxed?

The S corporation definition fits in one sentence of the tax code. The tax mechanics take longer: what the corporation files, what its owners pay and at what rate, which S corporation taxes can still land on the company, and why a number called basis decides whether cash comes out tax-free. This guide walks through each with 2026 figures and a single-member example. Choosing between structures is covered in S corp vs LLC and S corp vs C corp; making the election is covered in the Form 2553 guide.

S corporation definition: a tax status, not a type of company

Section 1361(a)(1) of the Internal Revenue Code defines an S corporation as “a small business corporation for which an election under section 1362(a) is in effect for such year” (IRC 1361). Any corporation that is not an S corporation for a year is a C corporation for that year. The S points to Subchapter S of Chapter 1 of the Code, titled “Tax Treatment of S Corporations and Their Shareholders” (26 U.S.C. Subchapter S), which is why the same business gets called a Sub S corporation, a Subchapter S corporation or an S corp. State law does not change when the election is made. The company is still the corporation or LLC its owners formed; the election changes how federal income tax reaches its profit.

A company becomes an S corporation by filing Form 2553 with the consent of every person who is a shareholder on the day of the election (IRC 1362(a)(2)). The filer can be a corporation or another entity eligible to be taxed as one, such as an LLC. For an LLC, the S election is also treated as an election to be taxed as a corporation (Treas. Reg. 301.7701-3(c)(1)(v)(C)), so a single-member LLC that elects stops being a disregarded entity. The general corporate rules in subchapter C, such as those for distributions of property and redemptions of stock, still apply to an S corporation and its shareholders except where they conflict with subchapter S (IRC 1371(a)).

The eligibility limits, in brief: a domestic corporation, no more than 100 shareholders, only individuals, estates, certain trusts and certain tax-exempt organizations as owners, no nonresident alien shareholders and one class of stock, with banks using the reserve method for bad debts, insurance companies taxed under subchapter L and DISCs excluded (IRC 1361(b)). The limits are about ownership and stock. Nothing in section 1361 caps revenue, profit or assets, and nothing requires more than one shareholder. The tests are compared with C corporation rules in S corp vs C corp.

How an S corporation is taxed: the pass-through mechanics

The starting rule is short: “an S corporation shall not be subject to the taxes imposed by this chapter,” except as Subchapter S provides (IRC 1363(a)). The corporation still computes its taxable income, in the same manner as an individual, but it states separately every item whose separate treatment could change a shareholder's tax, such as capital gains, charitable contributions and section 179 deductions (IRC 1363(b); IRC 1366(a)(1)). Each shareholder then takes a pro rata share of those items, and of the rest of the income or loss, for the shareholder's tax year in which the corporation's year ends. The character of each item carries through, so a capital gain to the corporation is a capital gain to its owners (IRC 1366(b)). Pro rata means per share and per day (IRC 1377(a)): an owner who held 30% of the shares all year takes 30% of every item.

Two consequences catch new owners. Tax follows the profit, not the cash: the Form 1120-S instructions say shareholders “must include their share of the income on their tax return whether or not it is distributed to them.” And the profit escapes one tax that partnership income usually carries: “Unlike most partnership income, S corporation income isn't self-employment income and isn't subject to self-employment tax.” An owner who works in the business pays Social Security and Medicare tax through payroll on a salary instead, which is where the reasonable compensation rules come in.

Form 1120-S is filed for every year the election is in effect, generally by the 15th day of the 3rd month after the tax year ends; for calendar-year 2025 returns that was March 16, 2026, because March 15 fell on a Sunday (Form 1120-S instructions). The dates, extensions and late-filing penalties are covered in when the S corp tax return is due. An S corporation required to file 10 or more returns of any type in a calendar year must e-file its Form 1120-S (IRS S corporations page).

What is the S corporation tax rate?

For ordinary business income there is no federal entity-level rate. The profit is taxed on the owners' returns, at the individual rates that apply to each owner's total taxable income, which run from 10% to 37% for 2026 (Rev. Proc. 2025-32). The two taxes Subchapter S imposes on the corporation itself, on built-in gains and on excess net passive income, are figured at the highest rate in section 11(b), which is 21% (IRC 11(b); IRC 1374(b)(1), 1375(a)).

Three things move the effective rate. The qualified business income deduction can take up to 20% of the K-1 profit off taxable income (IRC 199A), with wage limits and a phase-out for service businesses above $201,750 of taxable income, or $403,500 on a joint return, in 2026; the QBI deduction guide explains the rules. The owner's salary carries Social Security tax of 6.2% from the owner and 6.2% from the company on wages up to $184,500 in 2026, plus Medicare tax of 1.45% from each with no cap (Publication 15); the FICA tax limit guide has the detail. And each state decides for itself how to tax the corporation and its owners.

S corporation taxes the company can still owe

“No federal income tax” has exceptions, and the Form 1120-S shows them on lines 23a to 23c. Most come from C corporation history, so a company that has been an S corporation since it was formed usually meets none of them. When the built-in gains tax, the excess net passive income tax and investment credit recapture tax together reach $500 or more, the corporation also makes quarterly estimated payments (Form 1120-S instructions).

Built-in gains tax (IRC 1374)

A C corporation that elects S status brings its appreciated assets with it. If it sells or otherwise disposes of one during the 5-year recognition period that begins on the first day of its first S year, the gain that existed on that first day is taxed to the corporation at 21% (IRC 1374(a), (b)(1), (d)(3), (d)(7)). Appreciation after the election is not built-in gain, the total taxed is capped at the net unrealized built-in gain measured on the first S day (IRC 1374(c)(2)), and the tax does not apply to a corporation that has been an S corporation for every year of its existence (IRC 1374(c)(1)). An S corporation that picks up assets from a C corporation with a carryover basis starts a separate 5-year clock for those assets (IRC 1374(d)(8)). The corporation figures the tax on Schedule D (Form 1120-S) and enters it on line 23b. The tax it pays is then treated as a loss passed through to shareholders, allocated to the gains that caused it (IRC 1366(f)(2)).

Excess net passive income tax (IRC 1375)

This tax needs two conditions in the same year: accumulated earnings and profits from C corporation years at the close of the year, and passive investment income above 25% of gross receipts (IRC 1375(a)). Passive investment income means gross receipts from royalties, rents, dividends, interest and annuities, with exceptions such as interest on notes from inventory sales, income of certain lending businesses and banks, and some dividends from C corporation subsidiaries (IRC 1362(d)(3)(C)). The taxable amount is net passive income multiplied by the share of passive income above the 25% line, capped at the corporation's taxable income, and the rate is 21% (IRC 1375(b)). Each item of passive income passed through to shareholders is then reduced by its share of the tax (IRC 1366(f)(3)).

The stakes go beyond the tax. Three consecutive years with C corporation earnings on hand and passive income above 25% of gross receipts end the S election at the start of the fourth year (IRC 1362(d)(3)). The IRS may waive the tax when the corporation decided in good faith that it had no accumulated earnings and profits and paid them out within a reasonable period after learning otherwise (IRC 1375(d)).

Other entity-level items

• LIFO recapture. A C corporation that used LIFO inventory in its last C year adds the LIFO recapture amount to that year's income, and the extra tax is paid in four equal installments (IRC 1363(d)).
• Investment credit recapture. The S corporation stays liable for recapture of credits it took as a C corporation (IRC 1371(d)(2)).
• Payroll taxes. As an employer, the corporation withholds income tax, Social Security and Medicare tax from wages, pays its own share of Social Security, Medicare and federal unemployment tax, and files Forms 941 and 940 (IRS S corporations page).

State taxes on S corporations

Federal rules stop at the federal return. Each state sets its own rules for S corporations and their owners, including whether the corporation owes tax at the entity level, so check the tax agency of each state where the business operates. Treasury regulations acknowledge that state laws may require a corporation to pay or withhold state income tax for some or all of its shareholders (Treas. Reg. 1.1361-1(l)(2)(ii)). The IRS noted in Notice 2020-75 that certain jurisdictions “have enacted, or are contemplating the enactment of, tax laws that impose either a mandatory or elective entity-level income tax on partnerships and S corporations.” The notice says state income taxes imposed on and paid by an S corporation are deductible by the corporation in computing its non-separately stated income or loss.

Reasonable compensation for shareholder-employees

A corporate officer is an employee for payroll tax purposes: section 3121(d)(1) lists “any officer of a corporation” first (IRC 3121(d)), and Publication 15 says that when a business is incorporated, “corporate officers who work in the business are employees of the corporation.” The IRS applies that to S corporations directly: they “must pay reasonable compensation to a shareholder-employee in return for services that the employee provides to the corporation before non-wage distributions may be made” (IRS S corporation compensation guidance). The salary runs through payroll with withholding; the profit left after it can be distributed without employment taxes. How to set the number, and what the Tax Court has done with salaries that were too low, is in what is a reasonable salary for an S corp owner; the payroll steps are in how to pay yourself from an S corp.

Stock and debt basis: the limit on losses and tax-free cash

Every shareholder has a stock basis that starts with what the shareholder paid for the shares or contributed. It rises each year with the shareholder's share of income, including tax-exempt income, and falls with distributions, nondeductible expenses and losses, in that order (IRC 1367(a); Shareholder's Instructions for Schedule K-1). Money the shareholder personally lends to the corporation creates a second amount, debt basis. Signing as guarantor on a bank loan does not create debt basis by itself; payments the shareholder later makes on that loan as guarantor can add debt basis to the extent of those payments (Treas. Reg. 1.1366-2(a)(2)).

• Losses. A shareholder deducts losses only up to stock basis plus debt basis; the rest carries forward indefinitely (IRC 1366(d)(1), (2)). Losses that pass the basis test still face the at-risk, passive activity and excess business loss limits, in that order.
• Distributions. For a corporation with no C corporation earnings, cash and property distributions are tax-free up to stock basis, and the excess is taxed as capital gain (IRC 1368(b)). Debt basis does not count for this test (IRS stock and debt basis page).
• Who tracks it. The IRS is direct: “It is not the corporation's responsibility to track a shareholder's stock and debt basis but rather it is the shareholder's responsibility.”

Form 7203 is where the tracking happens. The Form 7203 instructions require it from shareholders who claim a deduction for their share of an aggregate loss, receive a non-dividend distribution, dispose of stock, or receive a loan repayment from the corporation. A two-year worked example, including what happens when a distribution exceeds basis in a loss year, is in how S corp distributions are taxed.

Single-member S corporation: an illustration

One owner changes nothing in the mechanics. The owner signs Form 2553 as the only shareholder, the corporation files Form 1120-S every year, and the owner receives two documents: a W-2 for the salary and a Schedule K-1 for the profit. The same person is shareholder, officer and employee, so the corporation runs payroll for the owner like any other employee.

The corporation's return shows $113,838 of income and no income tax. The owner's Form 1040 carries both pieces, $80,000 of wages and $113,838 of K-1 income, and the $29,791 of income tax on them is owed whether the owner took the $90,000 out or left it in the company. Taxable income before the QBI deduction is $177,738, under the $201,750 single threshold for 2026, so the W-2 wage limit does not apply and the deduction is a flat 20% of the K-1 income. The $90,000 of distributions is tax-free because stock basis before distributions was $118,838 ($5,000 plus $113,838). Together, income tax and both halves of Social Security and Medicare come to $42,031 on $200,000 of profit, before state taxes.

Sources: 26 U.S.C. Subchapter S, Tax Treatment of S Corporations and Their Shareholders (table of sections); 26 U.S.C. 1361, S corporation defined; 26 U.S.C. 1362, election, revocation, termination; 26 U.S.C. 1363, effect of election on corporation; 26 U.S.C. 1366, pass-thru of items to shareholders; 26 U.S.C. 1367, adjustments to basis of stock; 26 U.S.C. 1368, distributions; 26 U.S.C. 1371, coordination with subchapter C; 26 U.S.C. 1374, tax imposed on certain built-in gains; 26 U.S.C. 1375, tax on excess net passive income; 26 U.S.C. 1377, pro rata share; 26 U.S.C. 11, corporate tax rate; 26 U.S.C. 199A, qualified business income; 26 U.S.C. 3121, definition of employee; 26 CFR 1.1361-1, S corporation defined (state tax payment and withholding rule); 26 CFR 1.1366-2, limitations on deduction of passthrough items; 26 CFR 301.7701-3, classification of certain business entities; IRS, S corporations (reviewed June 11, 2026); IRS, S corporation compensation and medical insurance issues (reviewed March 3, 2026); IRS, S corporation stock and debt basis (reviewed June 7, 2026); IRS, Form 1120-S (2025); IRS, Instructions for Form 1120-S (2025); IRS, Schedule K-1 (Form 1120-S) (2025); IRS, Shareholder’s Instructions for Schedule K-1 (Form 1120-S) (2025); IRS, Instructions for Form 7203 (Rev. December 2022); IRS, About Form 8869, Qualified Subchapter S Subsidiary Election; IRS, Rev. Proc. 2025-32 (2026 rate tables, standard deduction, QBI thresholds); IRS Publication 15 (2026), Employer’s Tax Guide; IRS, Notice 2020-75 (state income taxes paid by partnerships and S corporations). Figures and rules checked against these sources on September 26, 2026. This is general information, not tax advice for your situation. Tax services are provided by licensed tax professionals under a separate engagement agreement. BEG does not provide tax advice.