S corporations (S corps) do not pay federal income tax at the corporate level. Instead, they operate as pass-through entities, meaning that the profits (or losses) are passed through to the shareholders. The shareholders then report this income on their personal tax returns and pay taxes at their individual income tax rates.
Here are the key points regarding how S corp profits are taxed:
1. *Pass-Through Taxation*: S corps themselves are not taxed on their profits at the federal level. Instead, profits are distributed to shareholders, who report their shares on their individual tax returns.
2. *Individual Tax Rates*: The profits passed through to the shareholders are taxed at the individual tax rates applicable to each shareholder. These rates can range from 10% to 37% depending on the taxpayer's income level and filing status.
3. *Qualified Business Income (QBI) Deduction*: Shareholders of S corps may also be eligible for a 20% deduction on qualified business income under the Tax Cuts and Jobs Act (TCJA), subject to certain limitations.
4. *State Taxes*: Some states impose a tax on S corporations at the entity level, but many states follow the federal treatment and allow S corps to be taxed as pass-through entities. It's important to check state-specific rules for any applicable taxes.
In summary, while S corp profits are not taxed at the corporate level, they are taxed at the individual shareholders' rates when they report the income on their personal tax returns.
When profits are "passed through to shareholders," it typically refers to a tax structure used by certain business entities, such as S corporations, partnerships, and limited liability companies (LLCs), where the business itself does not pay income tax at the corporate level. Instead, the profits (or losses) are passed through directly to the owners or shareholders, who then report that income (or loss) on their personal tax returns.
Here’s a breakdown of what this means:
1. *Avoidance of Double Taxation*: Unlike C corporations, which are taxed at both the corporate level and the shareholder level when dividends are distributed, pass-through entities avoid this double taxation.
2. *Taxation at Individual Level*: Shareholders or owners are taxed on their share of the profits based on their individual tax rates. This can be beneficial, especially if the individual tax rates are lower than corporate tax rates.
3. *Allocation of Income and Losses*: The profits and losses are allocated among the shareholders or partners according to their ownership percentages or agreed-upon terms. Each shareholder reports their share of the income or loss on their personal tax returns.
4. *Self-Employment Taxes*: In the case of partnerships and LLCs, members may also be subject to self-employment taxes on their share of the profits.
This structure is commonly used because it can result in tax savings and simplified tax reporting for businesses and their owners.