Pass Through Status
When a corporation elects to be treated as an S corporation by the IRS, the shareholders are choosing not to be taxed at the corporate level. Instead, the corporation passes its respective profits and losses through to its shareholders. This has net economic advantages of avoiding double taxation of earnings and profits, and in the case of losses, allows owners to shelter other sources of income from taxation.
Corporate Tax Return
An S corporation files an information return using IRS Form 1120S, on which it calculates profits or net operating loss on its business activities. The corporate tax return includes standard tax deductions for ordinary and necessary business expenses. However, since an S corp is a pass through entity for tax purposes, it does not pay any taxes on its profits or make use of losses directly. These are instead ratably allocated among the various corporate shareholders and disclosed to each on IRS Schedule K-1, so that each individual taxpayer may include the corporate profit or loss on their individual tax return.
S Corporation Shareholders
Each individual shareholder in an S Corporation receives an IRS Schedule K-1, which indicates the shareholder's percentage allocation of business profits and losses. Income allocated on the K-1 is combined with other sources of income on the shareholder's individual tax return. Any losses from the K-1 can then be applied against these multiple sources of income, potentially lowering the shareholder's overall tax obligation.
Carry Forward and Carry Back Losses
A valuable characteristic of pass though losses is that, according to the IRS carry forward and carry back rules, an S corporation shareholder may apply excess losses from the current year against previous or future years of taxable income. This advantageous tax treatment has the effect of increasing the value of deductions and losses since they can have significant tax effects outside of the current tax year.