Tax differences between C corporations and S corporations are complicated enough to require the help of a qualified accountant. An S corporation uses the tax rules of a partnership, even though it's still legally a corporation. Technically, an S corp with a cash-basis accounting system shouldn't have retained earnings in the traditional sense that the term is used under corporate tax rules if you made the Subchapter S election in the corporation's first taxable year.

Double Taxation

A regular C corporation is considered a taxpayer under Subchapter C of the federal tax code. It must pay taxes on net income at its corporate tax rate. Anything left over after taxes are paid is the company's profits. The corporation can keep these profits in a "retained earnings" account to use for business purposes, or it can distribute all or a portion of the profits to shareholders as dividends. Dividends get taxed again when received by shareholders, resulting in double taxation of corporate profits.

Pass-Through Taxation

Making a Subchapter S election for a qualified corporation avoids double taxation. Once the election is approved, the corporation is no longer required to pay entity-level taxes as a taxpayer. Instead, profits and losses pass through to shareholders in proportion to their ownership interest. Profits are reported on each shareholder's personal return and taxed only once at the individual tax rate under this scheme.

Retained Earnings

Under C corporation tax rules, retained earnings are profits that the corporation holds that have already been taxed at the entity level. Technically a cash-basis S corporation doesn't have this type of retained earnings, because the entity doesn't pay taxes on its profits. Every year, an S corporation must allocate all of its pre-tax profits to shareholders so they can pay the taxes on the amounts. Although profits must be allocated to shareholders every year, they don't have to be distributed. The board of directors can decide to allocate profits but not distribute all of the money. Whatever gets held by the S corporation is sometimes generically called "retained earnings," but the account the money is credited to has different tax rules.

C Corporation Conversions

If a corporation makes a Subchapter S election after it has been in business for a while, it's possible that it will have a traditional retained earnings account that gets carried over into the new partnership tax system. Distributions from this account are still taxable as dividends when the shareholders receive the money. Meanwhile, the S corporation may have a separate account that tracks the profits that were allocated to shareholders under pass-through taxation but not distributed to them. The shareholders paid taxes on this amount when their share was allocated, so distributions from this "retained earnings" account can be made tax-free. The technical label for this account in a typical cash-basis accounting system for an S corporation is the accumulated adjustments account, though some businesses may simply call it a retained earnings account.