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 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 nonseparately 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.)
S-Corporations might be subject to special taxes if the S-Corporation has retained earnings from any previous tax year in which the company was taxed as a C-Corporation. C-Corporations that are converting to an S-Corporation should consult with an experienced tax professional prior to analyze the tax impact of converting to a subchapter S corporation.
