An S-Corporation is not subject to corporate tax rates. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income, according to the Internal Revenue Service. 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 only taxed 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. (Whereas a shareholder of C-corporation is taxed on dividends only when those dividends are actually paid out.)