Does an S Corporation Pay Taxes for Retained Earnings?

Setting up your business as a Subchapter S corporation has distinct tax advantages, including that you don't have to pay corporate income taxes on your profits. But the profits of an "S corp" are still taxed, including those that become retained earnings. If your company has significant retained earnings, that could actually make S corporation status less desirable.

S Corp Basics

When a regular corporation makes a profit in a year, it pays corporate income taxes on that profit. After-tax profit can then be paid out to the shareholders as dividends or reinvested in the company as retained earnings. A company that has been granted S corp status by the Internal Revenue Service doesn't have to pay corporate income taxes. Instead, the profit "flows through" the company to its shareholders. The shareholders report that profit as personal income on their tax returns. If you hold, say, 60 percent of the stock in an S corp, and the company has a profit of $50,000, you are responsible for reporting $30,000 of that as income -- and paying taxes on it.

Retained Earnings

Just like regular corporations, S corps can distribute profits to their shareholders, keep them as retained earnings or do a little of both. The difference is that the regular corporation makes this decision after it pays corporate income taxes. An S corp doesn't pay taxes. The shareholders pay all the taxes on the company's profit, no matter what the company does with that profit. If the company then distributes profits to the shareholders, the distribution isn't taxable income to the shareholders because they are already paying income taxes on the money. But if it chooses to keep profit as retained earnings, the shareholders still pay income taxes on the money.


This is where retained earnings can become a problem for an S corporation. Shareholders get taxed on their percentage of the profits regardless of whether they actually receive any of those profits as a cash distribution from the company. Reinvesting profits is how companies grow, so every dollar of retained earnings is a dollar going toward the future of the company. But it's also a dollar that the shareholders are paying taxes on. If you're the only shareholder, or if the company has only a handful of shareholders, all actively involved in the business, this may not cause trouble. But if you have a minority, "silent partner"-type investor, that person may not be thrilled at the idea of paying taxes on money he won't receive, especially if he doesn't have a say in what the company does with its profits.


Whether S corporation status is right for any business depends on your particular circumstances. Paying taxes on profit not received should be weighed against the tax benefits of S corp status: Individual income tax rates are generally lower than corporate rates, which reduces the overall tax burden on the company and its shareholders. Also, profit distributions are untaxed. Dividends from a regular corporation, by contrast, are taxable income to shareholders -- meaning that corporate profits are effectively taxed twice. If the shareholders of a company and their tax advisers conclude that S corp status isn't worth the hassle, a company can terminate the status on its own. Be forewarned, though, that if you give up S corp status, you can't reapply for it for five years.