One of the big advantages of an “S” corporation is the ability to avoid the dreaded double taxation. Lets start with some background.
Under tax law a corporation is a state law corporation (1) or another eligible entity that elects to be taxed as though it is a state law corporation. Keep in mind the election to be taxed like a corporation only applies for tax purposes and not for other purposes such as legal liability protection.
An “S” corporation is a corporation, that elects to be taxed under Subchapter S of the Internal Revenue Code. By default corporations are taxed under Subchapter C and pay their own income taxes. Income paid out of a “C” corporation as a dividend is then taxed a second time on the recipient’s tax return. So the income is taxed at the corporate level and then a second time at the shareholder level. (2)
The beauty of an “S” corporation is that it does not pay income tax at the corporate level. (3) In exchange, the shareholder(s) annually pay income tax on the income earned by the “S” corporation that year. It is important to note that the “S” corporation shareholder(s) pay income tax on the “S” income even if they receive no cash.
Some shareholders have a difficult time understanding why they have to pay income tax when they did not receive any cash. This is the deal the shareholder makes when electing for their corporation to be taxed under Subchapter “S.” Keep this in mind when considering the “S” election.
(1) We ignore entities formed outside the U.S.
(2) There are some times when a dividend is not immediately taxed or only part is taxable.
(3) Again, there are some exceptions when an “S” corporation pays income tax – primarily when the “S” started out as a “C” corporation.