S corporations are a type of business structure that offers the same limited liability as regular corporations, known as C corporations, but have different tax implications. In addition, only certain corporations are eligible to make the S corporation election. To qualify, the company must have fewer than 100 shareholders, be a domestic corporation, not have more than one class of stock and only have certain types of shareholders.
S corporations are a pass-through entity, which means that all of the income flows through the company to the individual owners. This avoids the double taxation that hits C corporations -- the corporation pays taxes on all of the profits and then the individual owners pay taxes a second time when those same profits are distributed to investors. However, the S corporation must still file an informational tax return, which tells the Internal Revenue Service the income and expenses for the company during the year.
The S corporation income is taxable (or the losses are deductible) to the S corporation owners in the year it's earned, regardless of whether the company actually distributes the income or not. As a result, the owners' basis in the company increases based on the amount of income reported or decreases by the losses deducted each year. For example, say you contributed $100,000 to the S corporation. If your share of the company's income is $10,000, you include that $10,000 in your taxable income for the year even if you don't receive any payments from the S corp. But, your basis for your ownership goes up to $110,000.
The type of income that flows through to the owners can have a significant effect on how the income is taxed. Generally, the officers and employees of the S corp are paid a reasonable salary, which counts as earned income and has Social Security and Medicare taxes -- payroll taxes -- withheld from it. Any additional distributions to employees who are also owners are considered profits of the company, so it counts as investment income, which isn't subject to payroll taxes or self-employment taxes.
When the S corporation makes distributions to the owners, those distributions aren't taxable to the extent that they don't exceed the owners' basis for the company. Instead, they reduce your basis. For example, if your basis for your share of the S corporation is $110,000 and you receive a $10,000 distribution, you don't report that $10,000 as taxable income. Instead, it just reduces your basis for the S corporation to $100,000.