An S corporation owner's personal return is one of the first "business" returns a new preparer meets, and one of the easiest to get wrong. This sample tax return walks through the shareholder's side of it: the W-2 the owner gets from their own company, the Schedule K-1 (Form 1120-S), reasonable compensation, the qualified business income deduction, and stock basis on Form 7203. It follows the practice tax return on this site for Aaron Feldman, the sole owner of a small marketing agency, so you can read the method here and then prepare the return yourself.
The sample tax return: who the S corporation owner is
Aaron is single and lives in Reno, Nevada. He formed Riverstone Marketing Inc., owns 100% of it, and works in it full time. The corporation files its own return, Form 1120-S. What you are preparing is Aaron's Form 1040.
He brings you two documents from the company, plus a few facts:
- A Form W-2 for his salary: $70,000 in box 1, with federal income tax, Social Security and Medicare withheld.
- A Schedule K-1 (Form 1120-S) showing his share of the company's profit, a cash distribution, and Section 199A information.
- His stock basis at the start of the year, and the estimated tax payments he made.
Nevada has no state income tax, so there is no state return to prepare.
Two income streams from one company
The key idea: an S corporation owner who works in the business is paid two different ways, and both land on the 1040.
- Wages. The company runs payroll on the owner like any other employee. Social Security and Medicare are withheld from each paycheck and the company pays its matching share. The W-2 box 1 amount goes on Form 1040, line 1a, just like any other W-2.
- The K-1. Whatever profit is left after the owner's salary and other expenses passes through to the shareholder. It is taxed on the owner's return whether or not the cash was taken out.
Both are taxable income. They are not the same income counted twice. The salary is an expense on the 1120-S, so it has already been subtracted before the profit reaches the K-1.
Reasonable compensation
Why not skip the salary and take everything as profit? Because the IRS requires an S corporation to pay a shareholder-employee reasonable compensation for the services they provide before it makes non-wage distributions. Wages carry payroll taxes. K-1 profit and distributions do not. That gap is exactly why the IRS watches this, and it has authority to reclassify distributions as wages, a position courts have upheld.
There is no percentage or dollar rule for what is reasonable. The IRS looks at facts, including:
- The owner's training, experience, duties and time spent in the business.
- Where the company's gross receipts come from: the owner's own services, other employees, or capital and equipment.
- What comparable businesses pay for similar services.
- Dividend history, bonus practices, and pay to non-shareholder employees.
The 1040 preparer does not set the salary, but should notice and raise it when an owner who does all the work takes a tiny W-2 and large distributions.
A Schedule K-1 1120-S example, box by box
| K-1 item | What it is | Where it goes |
|---|---|---|
| Box 1, ordinary business income | His share of the company's trade or business profit | Schedule E, Part II, line 28. Nonpassive income goes in column (k) |
| Box 16, code D, distributions | Cash the company paid out to him | Not taxable income. It reduces stock basis on Form 7203, line 6 |
| Box 17, code V, Section 199A information | QBI and the company's W-2 wages for the QBI deduction | Form 8995 or 8995-A |
Follow box 1 through the forms. It enters Schedule E, line 28, with "S" in column (b). Schedule E totals Part II on line 32 and carries the total to line 41, then to Schedule 1, line 5. Schedule 1, line 10 goes to Form 1040, line 8.
Which column on line 28? A loss or income from an activity in which the shareholder materially participates is nonpassive. One of the IRS tests is working in the activity more than 500 hours in the year. An owner running his own agency full time clears that, so the income goes in column (k), not the passive column (h).
Not subject to self-employment tax
The Shareholder's Instructions for Schedule K-1 (Form 1120-S) state it directly: your share of S corporation income is not self-employment income and is not subject to self-employment tax. There is no Schedule SE for the K-1. This is the main difference from a sole proprietor with the same profit, and why reasonable compensation matters.
The QBI deduction
Box 17, code V gives the shareholder what is needed for the Section 199A deduction, generally up to 20% of qualified business income (QBI). Two points trip up learners.
The owner's W-2 wages are not QBI. The Form 8995 instructions list reasonable compensation received from an S corporation as an item that is not QBI. QBI here comes from the K-1 business income, not the salary.
The W-2 wage limit only matters at higher incomes. For 2025, if taxable income before the QBI deduction is at or below $197,300 ($394,600 married filing jointly), and the taxpayer is not a cooperative patron, use the simplified Form 8995. Above that threshold, Form 8995-A applies, and QBI from each business may be limited to the greater of 50% of the W-2 wages the business paid, or 25% of those wages plus 2.5% of the UBIA of qualified property. The limit phases in up to $247,300 ($494,600 joint). The wages reported in box 17, code V are the business's wages, which for a one-person S corporation are the owner's own salary.
Form 8995 also caps the deduction at 20% of taxable income before the QBI deduction, minus net capital gain. The result goes on Form 1040, line 13a.
Illustration only, not Aaron's numbers: a made-up shareholder, Dana, has K-1 box 1 income of $50,000, no other QBI, and taxable income before the QBI deduction of $60,000 with no capital gains. Her QBI component is 20% of $50,000, or $10,000. The income limitation is 20% of $60,000, or $12,000. She takes the smaller, $10,000.
Stock basis and a Form 7203 example
Stock basis is the shareholder's running investment in the company. It starts with what they paid or contributed, goes up with income from the K-1, and goes down with distributions, nondeductible expenses and losses, in that order. The shareholder is responsible for tracking it, not the corporation.
Basis matters for two reasons. Losses are deductible only up to basis. And distributions are tax free only up to basis. A distribution that exceeds stock basis is treated as a capital gain and reported on Form 8949 and Schedule D.
Form 7203 must be attached when the shareholder:
- Claims a deduction for a share of an aggregate loss, including a loss disallowed last year for lack of basis.
- Received a non-dividend distribution.
- Disposed of stock.
- Received a loan repayment from the corporation.
Aaron received a distribution, so Form 7203 is required. When it is, also check the box in column (e) of Schedule E, line 28, which says a basis computation is required.
Here is how Part I works, again with Dana's made-up figures rather than Aaron's:
| Form 7203 line | Dana (illustration) |
|---|---|
| 1. Stock basis at the beginning of the year | $20,000 |
| 3a. Ordinary business income (K-1 box 1) | $50,000 |
| 5. Stock basis before distributions | $70,000 |
| 6. Distributions (K-1 box 16, code D) | $30,000 |
| 7. Stock basis after distributions | $40,000 |
| 8a. Nondeductible expenses (box 16, code C) | $500 |
| 15. Stock basis at the end of the year (no losses) | $39,500 |
Notice the order. Income is added before distributions are subtracted, so a profitable year protects that year's distributions. If Dana's distributions had been $80,000, line 6 would exceed line 5 by $10,000, and that $10,000 would be a capital gain. Her basis would stop at zero.
Aaron's return runs the same steps with his own beginning basis, box 1 income and distribution. Do the lines yourself and compare to the finished return.
Estimated tax
Aaron's paychecks had withholding, but nothing was withheld on the K-1 profit. That is why S corporation owners usually make estimated payments. Enter them on Form 1040, line 26, and check whether they were enough. A return like this one often ends with a balance due, and a 1040-ES voucher plan for next year.
Common mistakes on an S corporation owner's return
- Running K-1 income through Schedule SE. S corporation income is not self-employment income.
- Taxing the distribution. Box 16, code D is not income and is not a dividend. It reduces basis. Only the part over basis is taxed, as capital gain.
- Skipping Form 7203. Any non-dividend distribution triggers it, even in a profitable year with plenty of basis. Check the column (e) box too.
- Counting the owner's salary as QBI. Reasonable compensation is excluded from QBI.
- Applying the W-2 wage limit below the threshold. Under the 2025 threshold, Form 8995 has no wage limit.
- Using a stale beginning basis. Line 1 should equal last year's ending basis. If no one has tracked it, rebuild it before relying on it.
- Putting the income in the passive column. A working owner is almost always nonpassive.
Prepare this practice tax return
Now work from the source documents to a finished 1040, Schedule 1, Schedule E, Form 8995 and Form 7203, then check your figures against the completed return.
Sources
- Shareholder's Instructions for Schedule K-1 (Form 1120-S) (2025)
- Instructions for Form 7203 and Form 7203
- Instructions for Form 8995 (2025) and Form 8995 (2025)
- Instructions for Form 8995-A (2025)
- S corporation compensation and medical insurance issues
- Instructions for Schedule E (Form 1040) (2025) and Schedule E (Form 1040)
- Schedule 1 (Form 1040) (2025) and Form 1040 (2025)
- Instructions for Form 8582 (2025), material participation tests
Frequently asked questions
How is S corporation K-1 income taxed?
An S corporation’s profit passes through to the owner on a Schedule K-1 and is reported on the owner’s Schedule E. Unlike a sole proprietor’s profit, K-1 ordinary business income is not subject to self-employment tax.
Does an S corporation owner have to take a salary?
Yes. An owner who works in the business must take reasonable compensation as a W-2 wage, with payroll taxes, before taking distributions. Paying too little salary to dodge payroll tax is a well-known IRS audit issue.