An “S” Corporation” is a regular corporation that has between 1 and 100 shareholders and that passes-through net income or losses to shareholders under in accordance with Internal Revenue Code, Chapter 1, Subchapter S. Corporations must meet specific eligibility criteria, and they must notify the IRS of their choice to be taxed as an S Corporation within a certain period of time.
A regular corporation, called a “C” Corporation, as described above, is taxed as a separate business entity. Corporations have their own tax form (1120) and their own tax rates (C Corp tax rates). Corporations may choose to retain their profits and earnings as part of their operating capital, or they may choose to distribute some or all of their profits and earnings as dividends paid to shareholders. Dividends paid to shareholders are essentially taxed twice. They are taxed once at the corporate level (on the corporation’s Form 1120), and again at the individual level (on Form 1040).
Instead, an S Corporation passes-through profit (or net losses) to shareholders. The business profits are taxed at individual tax rates on each shareholder’s Form 1040. The pass-through (sometimes called flow-through) nature of the income means that the corporation’s profits are taxed only once – at the shareholder level. The IRS explains it this way: “On their tax returns, the S corporation’s shareholders include their share of the corporation’s separately stated items of income, deduction, loss, and credit, and their share of non-separately stated income or loss.” S corporations therefore avoid the so called “double taxation” of dividends.
S Corporations, like regular C Corporations, can decide to retain their net profits as operating capital. However, all profits are considered as if they were distributed to shareholders. Thus an S Corporation shareholder might be taxed on income they never received.