Pass Through Taxation
A C-corp is taxed at the entity level while an S-corp is taxed at the individual level. Pass through taxation means that the income and losses from an entity is not taxable to the entity, but rather is reported on the tax returns of the owners of the entity. With a C-corp, the company's income or losses are reported on the corporate income tax return. Only when the company pays out its earnings to the shareholders do the shareholders report any income on their tax returns. When you convert a C-corp to an S-corp, the business income no longer gets taxed to the corporation. Instead, the income passes through to the shareholders of the S-corp and gets included on the shareholders' personal returns. This also allows shareholders to take corporate losses on their personal tax return.
Because an S-corp is a pass through entity, it avoids double taxation. When a C-corp has profits, the corporation is taxed on those profits at corporate rates. Then, when the corporation makes distributions to the shareholders, the money is taxed a second time as a dividend on the shareholders' returns. After converting to an S-corp the company is no longer subject to the corporate income tax. Instead, shareholders report the income or losses on their own tax return so the money isn't taxed twice.
A C-corp must report all of its income or losses each year on the corporate income tax return. However, a C-corp does not have to pay out any of its earnings to the shareholders, so if the company doesn't make any distributions, shareholders don't have any income to report on their income taxes. With an S-corp, the income or losses pass through to the shareholders every year whether or not the company actually makes distributions. For example, if the company earns $10,000, the shareholders must report that income even if the S-corp doesn't distribute any of the income.
The corporate income tax rates are different than the personal income tax rates. A C-corp is taxed at the corporate tax rate while S-corp income is taxed at the individual tax rate. If the individual tax rate is lower than the corporate tax rate, this results in tax savings the business income. For example, if the applicable corporate tax rate is 35 percent and the applicable individual rate is only 28 percent, the business income would be taxed at a lower rate after converting from a C-corp to an S-corp.