Buried within the U.S. Internal Revenue Code -- specifically, in Subtitle A, Chapter 1 -- are the tax rules for corporations. Subchapter C defines the rules for traditional corporations, which is why such companies are referred to as C corporations. Subchapter S creates a special kind of corporation, the S corporation. The biggest difference is that S corporations pay no corporate income taxes.
C Corporation Income Taxes
A business organized as a C corporation pays corporate income taxes on its profit. When it files its income tax return, it adds up all its revenue, including net sales, dividends received, interest received, rents, royalties, and any profit it made from the sale of capital assets. It subtracts from revenue all its expenses, such as rent, wages, contributions to employee benefits programs and maintenance. The end result is the company's pretax profit, which is its taxable income. After taking out taxes, the company is left with net income. This is the profit figure the company reports to investors.
S Corporation Income Taxes
S corporations don't pay corporate income taxes on their profits. Instead, those profits flow through to the corporation's shareholders, who pay personal income taxes on them. For example, if an S corp had a $1 million profit, a shareholder who owned 10 percent of the company would report $100,000 in income. A shareholder who owned 2 percent would report $20,000 in income, and so on. It's important to note, however, that these shareholders haven't received any cash from the S corp. In many cases, a company's profit exists only on paper, with that money tied up in unpaid accounts receivable or unsold inventory. S corp shareholders have to pay taxes on their share of the profit as if they'd received it as cash.
Filing S Corp Taxes
Although it doesn't pay income tax on its operating profit, an S corporation still has to file a tax return. One reason is that it pays specific taxes on certain investment gains and inventory-related charges. The tax return identifies the total amount of profit the company earned -- and then, on accompanying schedules, it identifies how much of that profit is attributable to each individual shareholder. This last part isn't as hard as it seems, because S corps cannot have more than 100 shareholders. Subchapter S corporations use IRS Form 1120S to file their taxes.
One other key difference between C corp taxes and S corp taxes is double taxation. Many C corporations regularly distribute a portion of their after-tax profits to shareholders as dividends. The shareholders then report these dividends on their personal tax returns and pay income taxes on them. So that profit, in effect, gets taxed twice: once on the corporate level, and again as a shareholder dividend. Because S corporations pay no income taxes, their profits get taxed only once -- on shareholders' personal returns.
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