The most valuable S corporation tax planning happens before December 31, not at filing time. Payroll, retirement plan setup, health insurance reporting and California’s elective pass-through tax all have year-end steps that cannot be fixed after the fact.
________________________________________________________________-
Year-end action items
November or early December would be a good time to discuss:
- Projection of your business and personal income for the year
- Determine your reasonable W-2 salary
- Calculate your appropriate income tax withholding and/or estimated tax payments
- Determine your retirement contributions – and set up any new plans as appropriate
- Estimate and pay California passthrough entity tax before December 31 to get the deduction in the current year.
- Prepare instructions for payroll service regarding income tax withholding and reporting of 401(K) contributions and deductible health insurance
Filing deadlines – S Corporation filing deadlines are March 15, not April 15… and you can request an extension to September 15
________________________________________________________________-
This is a summary of how the S Corporation is designed to work, and how, with careful planning, you can take advantage of opportunities… and avoid unintentional costs and penalties.
How an S corporation works as a pass-through entity
An S corporation generally pays no federal income tax itself. Its profit or loss “passes through” to the shareholders, who report it on their personal returns whether or not the cash is distributed.
- The corporation files an information return. Form 1120-S (federal) and Form 100S (California) report income, deductions and credits for the year.
- Each shareholder receives a Schedule K-1. It shows the owner’s pro-rata share of income, deductions and credits, allocated by ownership percentage. S corporations cannot make special allocations.
- Shareholders pay the tax. K-1 items flow onto Form 1040 and the California Form 540, and are added to the shareholder’s taxable income.
- Owner-employees are paid two ways. 1) W-2 wages for services are subject to payroll taxes. 2) The remaining profit passes through on form K-1 and is not subject to Social Security, Medicare or self-employment tax. Cash distributions of that profit are generally tax-free – assuming you have sufficient stock basis.
- Stock basis tracks your investment. Your stock (and loan) basis rises with income and contributions and falls with losses and distributions. Basis limits the losses you can deduct and determines whether a distribution is taxable. See discussion below.
Important features of this structure include:
- There is no payroll tax on profit in excess of a reasonable salary – payroll tax applies to all of the profit from an LLC or a sole proprietor, but not an S Corporation.
- Qualified Business Income deduction (QBI) of 20% applies to profit in excess of a reasonable salary, with restrictions related to your total income and the type of business you are in.
- The California passthrough entity tax deduction results in a federal deduction of 9.3% of your California income. See discussion below. Many other states have similar programs.
- California taxes S Corporation income at 1.5%, with a minimum of $800. See discussion below.
What is the correct W-2 salary?
Every shareholder who works in the business must receive a “reasonable” W-2 salary before taking distributions. The right number is the lowest salary you can defend as reasonable that still supports your retirement and QBI goals. It is a balancing act, not simply “as low as possible.”
There is no precise definition of reasonable. The reason for the requirement is that you need to pay payroll taxes on the income you receive for services provided. The basic idea is to pay yourself what you would have to pay someone else to do your job. That’s not always easy to determine. Paying little or no salary while taking large distributions is a common audit issue, and the IRS can reclassify distributions as wages and assess back payroll taxes, penalties and interest.
Why salary level matters in 2026:
- Payroll taxes. Wages are subject to 15.3% combined Social Security and Medicare tax (employer plus employee portion) up to the 2026 Social Security wage base of $184,500, and 2.9% above it, plus 0.9% Additional Medicare Tax on wages over $200,000 ($250,000 if married). California adds 1.3% SDI on all wages with no cap.
- Retirement contributions. Employer 401(k) and SEP contributions are limited to 25% of W-2 wages. Too low a salary can restrict what you are able to put away. See discussion below.
- Qualified Business Income (QBI) deduction. Higher wages reduce the K-1 income that qualifies for the 20% QBI deduction. For some owners with higher incomes, though, the deduction is limited to 50% of the W-2 wages the business pays, so too low a salary can shrink it. This does not apply to Special Service Trades or Businesses (SSTBs) including entertainment, consulting, medical – including therapists, legal and others.
- Social Security benefits. Wages build your future Social Security benefit; distributions do not.
Estimated taxes and withholdings
Because the S Corporation income is taxed on your personal tax return, you need to make personal tax payments during the year. There are rules for the amounts that need to be paid or withheld, generally based on your previous year’s income. There are penalties for failure to pay estimated taxes. Payments can be made in two ways:
- W-2 tax withholdings. Taxes withheld from your W-2 can be paid any time during the year, so you don’t have to adhere to the deadlines required for direct estimated payments
- Estimated payments paid directly to the IRS and state tax departments. There are strict schedules for quarterly payments, and penalties can apply if you miss the scheduled dates.
Important – When you set up your payroll with a payroll service, they will probably tell you that they know how much tax to withhold… but you need to tell them the correct amount. The payroll service sees only your W-2 salary, but they don’t know how much total income you receive from the company and other sources. If you withhold taxes from your W-2 salary, they need to be enough to cover your entire income, not just your W-2 salary.
Also important – Because your S Corporation income is taxed on your personal tax return, you can take cash out of the company any time as a tax-free distribution (subject to basis limitations, of course). You do not have to take it in the form of salary.
My personal preference –
I have an S Corporation. I make quarterly estimated payments directly to the IRS and the California FTB. And I run payroll only once, at the end of the year, mostly because it’s kind of annoying. When I run the payroll, I have to pay the payroll taxes for the full year, plus my solo 401(K) personal contribution, so I have to have the funds available at that time. If I also had to pay tax on my entire income as W-2 withholdings, I would have to increase my salary to an amount greater than what I believe is reasonable.
Retirement contribution options
Retirement plans for S Corporation owners include:
- SEP-IRA – company contributions up to 25% of W-2 salary, to a maximum of $72,000
- Solo 401(K) – for sole shareholders (including married couples) a profit-sharing contribution up to 25% of W-2 salary PLUS personal contribution of up to $24,500 withheld from W-2 up to a combined maximum of $72,000 plus catch-up, if applicable.
- SIMPLE IRA – for businesses with employees
- Defined benefit plans – significantly higher maximum contributions, but higher cost, as amounts are actuarially determined
For most sole owners who want to make substantial retirement contributions, the solo 401(K) will typically be the best choice. With a $100,000 salary, a SEP allows $25,000, while a Solo 401(k) allows $25,000 (profit-sharing contribution) plus $24,500 (personal contribution) for a total of $49,500 (more with catch-up). Reaching the full $72,000 maximum takes about $190,000 of salary with a Solo 401(k), versus $288,000 with a SEP.
Important rules and deadlines:
- Personal 401(k) contributions must run through payroll. Your 401(k) deferral is withheld from W-2 wages, so it has to be paid by December 31, 2026. Unlike a sole proprietor, an S corporation owner cannot wait until tax time to make the employee contribution.
- Employer contributions – 401(k) profit sharing or SEP – can be deposited up to the March 15 due date of the 1120-S (or September 15 if you file an extension), and are deducted on the corporation’s return. So the payments can wait until you have calculated your income and your tax.
- New for 2026: ROTH catch-up rule. If your 2025 Social Security wages from the company exceeded $150,000, any 2026 catch-up contribution must be made as a ROTH contribution, which means it is not deductible in the current year. Check that your plan document and payroll service support this.
- Employees complicate the situation. A Solo 401(k) is only for businesses with no eligible employees other than owners and spouses. Once you hire employees, a SEP must cover eligible employees at the same percentage, and a standard or safe-harbor 401(k) may be needed.
- Form 5500-EZ is required once a Solo 401(k)’s assets exceed $250,000 at year end. Late-filing penalties are nasty.
- Defined benefit plans require an actuary and multi-year funding commitments
Reporting deductible health insurance
Health insurance for an owner of more than 2% of the company is deductible only if it runs through the S corporation and appears on your 2026 W-2. If it is missed on the W-2, the personal deduction can be lost, so this must be handled before year-end payroll closes.
- The corporation pays or reimburses the premiums. The policy can be in the company’s name or yours, as long as the company pays the insurer directly or reimburses you during 2026 with proper documentation. Premiums for your spouse and dependents qualify. Family members of a 2% owner (spouse, children, parents) are treated as 2% owners too.
- The premiums are added to your W-2 wages in Box 1 (federal taxable wages) and California Box 16. They are generally excluded from Social Security and Medicare wages (Boxes 3 and 5), so no social security or Medicare tax is due on them. The corporation deducts them as wages.
- Depending on your payroll service, expect some confusion on this. You need to be very clear that you are a 2% shareholder of the company, and you need to confirm that the amount will appear in Box 1 of your W-2 and will NOT be reported in Box 12.
- You deduct health insurance on your personal return. You claim the self-employed health insurance deduction on Schedule 1 of Form 1040, which reduces adjusted gross income. The deduction cannot exceed your W-2 wages from the company
- The deduction is not allowed for any month you were eligible for a subsidized employer plan, including through a spouse’s job.
- Medicare and long-term care premiums, and HSA contributions are treated the same as health insurance.
Other year-end items to review
- Your basis limits the losses you can deduct and determines whether distributions are tax-free. Basis is generally the amount of your contributions and accumulated income, reduced by distributions and losses you have taken from the beginning. Generally speaking, if your business has no debt or credit card balances, it’s hard to lose or distribute more than your basis, but if your debt exceeds your assets, you have effectively lost or distributed funds that don’t belong to you… so a distribution is taxable, and you can’t deduct a loss until you have enough assets to create basis.
- Distributions must follow ownership percentages. Uneven distributions among shareholders can raise a question about a “second class of stock” and put the S election at risk.
- Shareholder loans. Money moving between you and the company should be documented as a loan (note, interest, repayment) or as a distribution. Unexplained balances on the books are a common audit issue.
- Accountable plan reimbursements. Home office, cell phone, mileage and business expenses you paid personally should be reimbursed by the company under a written accountable plan, with receipts and logs, by year end. Owner-employees cannot deduct these on their personal returns.
- Vehicles. Company-owned vehicles need a mileage log; personal use by an owner is added to W-2 wages. Personally owned vehicles are reimbursed at the IRS mileage rate.
- Equipment purchases. Federal law allows 100% bonus depreciation for qualifying property and equipment acquisitions, and Section 179 direct expensing of about $2.5 million. Property must be placed in service by December 31 to count for 2026. California does not follow these rules (see below).
- Form 1099 reporting. Beginning with 2026 payments, the reporting threshold for Forms 1099-NEC and 1099-MISC rises from $600 to $2,000. Collect a W-9 from every vendor and contractor now. You do not need to send 1099s to corporations or S Corporations, but you do send them to individuals, LLCs and partnerships.
- An S Corporation does not receive 1099s (although you can expect to receive a few anyway) so if a client or customer sends you Form W-9 be sure to check box 3(a) that you are an S Corporation.
Items especially important for California S corporations
California treats S corporations as only partly pass-through: the company pays its own entity-level tax, and the state departs from several federal rules:
Entity-level franchise tax
A California S corporation pays 1.5% of its California net income, with an $800 minimum, on Form 100S. Estimated payment requirements apply. Newly formed corporations are generally exempt from the $800 minimum in their first year but still owe 1.5% of any income.
Pass-through entity (PTE) elective tax.
An S corporation can elect to pay California tax of 9.3% on consenting shareholders’ share of income. The corporation deducts this payment on its federal return, which works around the federal SALT deduction cap, and each consenting shareholder receives a matching California credit.
- To elect for 2027 pay the greater of 50% of your 2026 PTE tax or $1,000 by June 15, 2027.
- New for 2026 – missing the June 15 prepayment no longer disqualifies the election. Instead, each owner’s credit is reduced by 12.5% of their share of the shortfall.
- The election is made only on a timely filed original tax return. It cannot be made on an amended return. The balance of the 2026 PTE tax is due March 15, 2027, even if the return is extended
- BUT if you pay the balance before December 31, you get the federal deduction on your 2026 return. It can be a good idea to estimate on the high side, because any excess payment is repaid to you at tax time.
- The credit cannot offset California’s 1% Behavioral Health Services Tax on income over $1 million.
California does not follow these federal rules
- No QBI deduction
- No bonus depreciation (often resulting in large differences between federal and California depreciation)
- California Section 179 expensing limited to $25,000
- HSA contributions are not deductible
Annual Statement of Information
Be sure to file the Statement of Information (Form SI-550) with the Secretary of State on time each year to avoid penalties and suspension. It’s easy to do online at the Secretary of State website, and there is a $25 annual fee.
Calsavers program
- Single owner S Corporations are not required to participate. If notified, indicate that you have an exemption.
- If you have employees and do not offer a retirement plan, the CalSavers program applies – a Solo 401(k), SEP or SIMPLE satisfies it.
