Key Takeaways

  • S corporations are pass-through entities: They do not pay corporate-level income tax. Instead, shareholders pay tax on their share of profits, even if earnings are not distributed.
  • No true retained earnings: Unlike C corporations, S corporations cannot indefinitely retain profits without taxation. Shareholders must report income whether distributed or not.
  • Tax reporting tools: Shareholders receive Schedule K-1 each year, which shows their share of income and deductions, and use it to complete Schedule E on Form 1040.
  • Salary vs. distribution: Shareholder-employees must receive a reasonable salary subject to employment taxes, while distributions are taxed only as income.
  • Basis limitations: A shareholder’s stock and debt basis determines whether losses and deductions can be claimed, and limits tax-free distributions.
  • Accumulated Adjustments Account (AAA): Tracks the earnings that can be distributed tax-free, ensuring shareholders are not taxed twice.
  • Planning matters: Improper handling of retained profits can cause tax mismatches, audit risks, or unintended double taxation if distributions exceed basis.

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.

Retained Earnings in C Corps vs. S Corps

C corporations can keep profits as retained earnings, paying corporate tax before deciding whether to distribute dividends. These retained earnings remain in the company for reinvestment or future use. S corporations, however, cannot accumulate tax-deferred retained earnings in the same way. All profits are allocated annually to shareholders, who must report them on personal tax returns, even if no distributions are made. This distinction is central to understanding the s corporation retained earnings tax treatment.

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.

Why Retained Earnings Are Taxed Differently in S Corporations

With C corporations, retained earnings are taxed at the corporate level and then taxed again when distributed as dividends. S corporations avoid this double taxation because the IRS requires that all earnings “pass through” to shareholders. The effect is that shareholders may pay taxes on income they never physically received if profits are left in the business. While this ensures avoidance of double taxation, it can create cash flow challenges for owners responsible for paying tax on undistributed income

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.

The Role of Shareholder Basis in Retained Earnings

A shareholder’s basis—their investment in the company—plays a critical role in determining how retained earnings are taxed.

  • Loss deductions: Losses can only be deducted to the extent of stock and debt basis.
  • Distributions: If distributions exceed basis, they may be taxed as capital gains.
  • Tracking: Shareholders must carefully monitor both stock and loan basis to avoid overstating deductions or underreporting taxable income.

The IRS emphasizes that basis must be calculated each year, making it a cornerstone of proper s corporation retained earnings tax treatment.

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 Accumulated Adjustments Account (AAA)

The AAA is an internal account that tracks the corporation’s previously taxed but undistributed earnings. It ensures that distributions from an S corporation are not taxed twice. When profits have already been reported by shareholders, future distributions from the AAA can generally be received tax-free (to the extent of stock basis). However, if distributions exceed both the AAA and shareholder basis, the excess may be taxed as capital gains

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.

Practical Issues With Retained Earnings in S Corporations

Although S corporations do not technically retain earnings like C corporations, businesses often keep cash in the company for operations. This can create tension between:

  • Shareholder taxation: Owners pay tax annually on their share of profits, even if the cash remains in the business.
  • Corporate needs: Companies may want to hold back funds for expansion, debt repayment, or emergencies.

Good planning is essential to balance these goals. Many S corporation owners set aside personal funds to cover taxes on pass-through income or arrange periodic distributions to offset tax liability

Frequently Asked Questions

1. Does an S corporation pay taxes on retained earnings?

No. S corporations do not pay corporate income tax on retained earnings. Instead, shareholders must report and pay taxes on all allocated profits, whether distributed or not.

2. What happens if an S corporation keeps profits in the business?

Even if profits are not distributed, shareholders must report their share of income on their tax returns. This may create tax liability without cash in hand.

3. Can S corporation shareholders deduct losses against other income?

Yes, but only up to the amount of their stock and debt basis. Losses exceeding basis cannot be deducted until additional basis is established.

4. What is the Accumulated Adjustments Account (AAA)?

The AAA tracks previously taxed earnings so shareholders can later receive tax-free distributions. If distributions exceed both AAA and basis, capital gains tax may apply.

5. How do S corporations avoid double taxation?

By passing income directly to shareholders, who report it on personal tax returns. Unlike C corps, S corps are not taxed at the entity level, eliminating corporate-level double taxation.

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