Does an S corp pay taxes on retained earnings? S corporations aren't subject to corporate income tax, because the income tax debt passes through to the owners in a manner similar to the way partnerships are taxed on income. S corporations file for special election with the Internal Revenue Service or IRS.

C Corporations and S Corporations

Each corporation is formed under the laws of the state where it's filed. Two kinds of for-profit corporations exist for tax purposes under federal law.

  • C corporations: These are the traditional corporations and must pay corporate income tax. C corps are taxed as separate entities from shareholders.
  • S corporations: These corporations get to enjoy the limited liability protection of a corporation while avoiding taxation at the corporate level. Both income and losses in an S corp pass through to shareholders.

The only difference between a C corp and an S corporation is the difference in how each is taxed. Otherwise, they're identical entities under state law.

Form 1120

Corporations use Form 1120 to file an income report as well as to claim deductions and credits. The income a corporation earns is usually taxed at the corporate level based on corporate income tax rates. The organization's profits are what's left after taxes have been paid. C corporations then have the option to keep the profits as retained earnings to use for business purposes in the future, or to distribute part or all to shareholders as dividends.

Double Taxation

Payments made to shareholders are taxed as dividends. If income is paid to the shareholders as wages, those are also taxed as income on the shareholder's personal tax return. Since the dividends are taxed a second time when shareholder receive them, corporate profits in a C corporation are double taxed. The double taxation makes a traditional corporation one of the less desired business forms when compared to business types that let income and deductions pass through to owners.

Pass-Through Entities to Avoid Double Taxation

Pass-through entities provide a way to avoid double taxation at the federal tax level. These entities include:

The corporate structure does provide other advantages, and careful tax planning reduces the impact of double taxation. The C corporation's ability to retain earnings instead of passing the whole profit through to shareholders can sometimes provide the most tax advantages.

Salaries Aren't Subject to Double Taxation

The double taxation issue doesn't come into play when it comes to salary payments. Those operating a corporation have the right to withdraw a reasonable salary. Salaries are then deducted directly from the profits earned by the corporation. Salaries are taxed as personal income rather than at the corporate level. Sometimes, a corporation's full net profit is offset by operator's salaries, leaving a zero balance due on the corporation's income tax.

The S Corporation Under Federal Tax Laws

Federal tax laws treat the S corporation uniquely. An S corp is formed at the state level and incorporated in a specific state. After your corporation exists as an entity, you can use the Form 2553, Election by a Small Business Corporation to file as an S corporation under federal tax laws. S corporations are treated the same as C corporations in every way except for federal income tax purposes.

Deadline for Filing the S Corp Form

Corporation owners have the choice to make the business an S corp for the current year or next year for tax purposes. From the beginning of the tax year, you have up to two months plus 15 days to file form 2553 for your corporation if you want the tax to be in effect for the current year. If filed later, the S corp election takes effect the following year. The form can be filed any time during the year if you want your business to be taxed as an S corporation the following year.

How S Corporation Shareholders Receive Profits

There are two ways S corporation shareholders get profits. The profits can be received as a distribution or as a salary. Passive investors who don't serve as officers or work for the corporation typically receive a distribution. If you're working in the business, you have to receive at least part of the profits as salary.

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