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Subchapter S corporations are not taxed on income at the corporate level. Instead, net income (or losses) are allocated to the shareholders in proportion to each shareholder’s share ownership, and then each person is taxed on the profits (or will have a deduction for losses). Let’s consider an example:
Suppose a subchapter S corporation makes $100 in a year, and there are 4 equal shareholders, each of whom own 25 shares of stock. In this case, each shareholder would be allocated $25 of profit for tax purposes (one-fourth of the income), and each shareholder would have to pay tax on this $25 allocation at whatever their personal tax rate is. The corporation itself does not pay any income tax. If there was a loss of $100, each shareholder would have a $25 loss.
The tax due by shareholders from allocated profits is due even if the corporation does not make a distribution to the shareholder (an allocation of profits is not the same as a distribution, in which actual money is paid). Because of this requirement, subchapter S corporations generally will make a distribution (dividend) to their shareholders each year in an amount at least equal to the anticipated taxes based upon the allocation of income. Let’s see how this works.
If we assume that each of the shareholders in the example above is likely to be in the 20% tax bracket, that means that each of the shareholders will have a tax liability of $5 ($25 of income allocation x 20% tax rate). Since each shareholder owns 25 shares, the corporation could declare a dividend of $.20 per share. Shareholders would then receive a dividend of $5 (25 shares x $.20 dividend per share), so that they would have enough money to cover their tax liability.
With a regular corporation, the corporation is taxed on net income, and shareholders are only taxed when dividends are paid. So, if the corporation makes $100, it pays income tax on $100. If there are no dividends made, the shareholders are not taxed.
However, when dividends are paid, the shareholders are taxed on the dividends at whatever their tax rate is. This arrangement is often referred to as “double taxation” – income is taxed once at the corporate level, and then again at the shareholder level. Small business owners generally will want to avoid this “double taxation” through a subchapter S election.
There are more aspects to consider for choosing a subchapter S election beyond just the tax consequences. Once we learn more about your situation and business we can advise as to whether a subchapter S election will be the best option for you and your business.