An S corporation is a "pass-through entity" for purposes of federal taxes. This means that the Internal Revenue Service allows the S corporation to treat its profits and losses the way a partnership does, passing the amounts onto shareholders who pay taxes, based on their share on their individual tax returns. Because profits and losses pass through to individual shareholders, the way those amounts are allocated is an important business matter.
Ownership of a corporation is indicated by holding shares of stock. A regular corporation can have multiple classes of stock, such as preferred stock and common stock--where some shareholders are entitled to preferential treatment. For example, owners of preferred stock in a regular corporation are entitled to have their dividends paid first; then, if there is anything left over, owners of common stock are paid. The Internal Revenue Code restricts an S corporation to one class of stock. Every shareholder of an S corporation must have equal entitlement to profit distributions. Profits in an S corporation are distributed equitably, without preference to any shareholder over another.
Profits and losses in an S corporation are allocated amongst shareholders in proportion to each shareholder's percentage of ownership interest. Percentage of ownership interest is determined by dividing the number of shares the shareholder owns by the total number of outstanding shares.
An S corporation doesn't pay taxes. It files a tax return that indicates its profits and losses, but passes those amounts through to its shareholders in proportion to the shareholder's percentage of ownership interest. The shareholders record the amount on their personal income tax return and pay taxes on it at the individual tax rate.
A regular corporation distributes profits as dividends, which may or may not reflect the shareholder's percentage of ownership. This type of corporation can choose to distribute all of its profits or only some of its profits. It can distribute its dividend as a flat amount to all shareholders, per share, or distribute a dividend preferentially based on classes of stock. The S corporation, conversely, must allocate all of its profits every year to its shareholders so taxes can be paid on the amounts. As in a partnership, after which it is modeled, shareholders in an S corporation receive a "distributive share" of all profits and losses for the year--equal to their proportionate ownership share.
A shareholder of an S corporation receives notice of his share of profit and losses through a Schedule K-1, which is provided to him at the end of the tax year by the corporation. This schedule reflects the shareholder's current percentage of ownership interest, as well as the percentage of profit (or loss) that the corporation made during the year the shareholder will include on his personal income tax return.
