S Corporation 2026: The Return Is Only as Strong as the Shareholder’s Facts

Your 2026 S corporation return can preserve a 20% deduction and a $40,000 SALT cap, yet one state tax election or undocumented related-party loan can put far more at risk. The election, distribution, wage calculation, loan file, and loss claim need to agree with the shareholder’s return before the return goes out.

The 29.6% rate depends on the shareholder’s own facts

Congress made the 20% qualified business income deduction under Sec. 199A permanent in the One Big Beautiful Bill Act. An S corporation shareholder who qualifies for the deduction continues to face an effective top rate of 29.6% on ordinary income from the S corporation, according to the source.

That figure does not belong automatically to every S corporation owner. Sec. 199A excludes or limits the deduction for some specified service trades or businesses once income reaches the applicable levels. For taxpayers above certain income thresholds, the deduction is also limited by the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property.

The shareholder’s taxable income drives the result. Two owners in the same S corporation can have different Sec. 199A deductions because their other income, deductions, filing status, and business interests differ. The business’s wage and property records also feed into the calculation.

Do not use the 29.6% figure to price a sale, set a distribution, or estimate cash available for investment without modeling the shareholder’s individual return. The client’s CPA and attorney review every plan before execution.

A PTET election needs a review of stock rights and distributions

OBBBA temporarily raised the individual SALT deduction cap from $10,000 to $40,000. The increase phases out for filers with modified adjusted gross income above $500,000, or above $250,000 for married taxpayers filing separately.

Congress left state pass-through entity tax regimes in place. A PTET election may reduce an owner’s federal tax burden, but the federal deduction is only part of the decision. An S corporation must protect its one-class-of-stock status.

The unresolved issue sits with owner-level state tax payments. A nonresident owner may have to pay tax personally under a state regime. If the S corporation distributes money to that owner to cover the payment, the payment can raise questions about disproportionate distributions. The election itself can also raise a question about whether the corporation has created a second class of stock.

The IRS has issued no guidance resolving these concerns. Read the state rules alongside the shareholder agreement and the corporation’s distribution history. A state tax result does not justify putting the S election in doubt.

Nondeductible payroll cannot raise the Sec. 199A wage limit

The Tax Court drew a firm line in Savage for S corporations subject to Sec. 280E. The shareholders included payroll reported by their businesses in the W-2 wage amount used to calculate their Sec. 199A deduction. The court rejected the calculation because the businesses could not deduct those wages in computing taxable income.

Sec. 280E disallows deductions for a business trafficking in controlled substances, other than cost of goods sold. The shareholders argued that payroll reported on Forms W-2 should count without regard to whether the expense reduced taxable income.

Sec. 199A limits W-2 wages to amounts properly allocable to qualified business income. Qualified business income includes only income, gain, deduction, and loss included or allowed in determining taxable income. Wages that fail as deductions under Sec. 280E do not count as W-2 wages for this limit.

Payroll records alone will not carry the Sec. 199A result. The wage calculation must follow the expenses the tax law permits in taxable income.

A canceled related-party loan needs proof that it became worthless

In Kelly, the Ninth Circuit upheld the denial of bad-debt deductions tied to loans from a single-member LLC to two S corporations. The taxpayer reported an $87 million nonbusiness bad-debt loss, including $17.8 million tied to one S corporation and $2 million tied to another.

The taxpayer canceled the debts and treated the cancellation as creating both cancellation-of-debt income and a bad-debt deduction. The court held that discharge and worthlessness are different. A creditor’s decision to cancel a debt does not prove the debt had no value.

A taxpayer claiming a nonbusiness bad-debt deduction must establish that the debt was bona fide, that the taxpayer had sufficient basis in the debt, and that it became wholly worthless during the claimed year. The court required objective facts. A creditor’s belief that collection is unlikely does not meet that standard.

The court stated that even a modest recoverable fraction prevents a debt from being wholly worthless. A related-party loan needs records that support its terms, basis, and value before any cancellation reaches the return.

A shareholder cannot pass a forfeiture loss through the S corporation

An S corporation does not give a sole shareholder a separate route to claim a loss from a forfeiture tied to that shareholder’s conduct. In Hampton, U.S. Marshals seized an S corporation’s bank accounts to satisfy a forfeiture judgment against its sole shareholder. The corporation claimed a Sec. 165 loss that would have passed through to the owner.

The IRS increased the shareholder’s income by $855,882 after disallowing the loss. The Tax Court agreed. It applied the frustration-of-public-policy doctrine because a deduction would reduce the punitive effect of the forfeiture.

The shareholder argued that the S corporation had not faced charges and should be treated separately. The court focused on the facts behind the loss. The shareholder was the sole owner, the forfeited funds represented proceeds tied to that shareholder’s conduct, and the pass-through deduction would return part of the cost to the same person.

Disclosure on the S corporation return did not change the result. The loss claim needed to withstand review on the facts behind it.

The 2026 pressure points sit where an S corporation’s entity-level records meet the shareholder’s return. Before filing, have your tax adviser model the Sec. 199A result, review any PTET election against the shareholder agreement, and document the facts behind every related-party debt or unusual loss.