How Are Retained Earnings Taxed in an S Corp?

Retained earnings in an S corporation are taxed to the shareholders in the year the company earns the profit, not when the cash is eventually paid out. Each shareholder reports their pro-rata share of income on their personal return and pays federal income tax at individual rates from 10% to 37%, whether or not the business distributes a single dollar.¹ Money left in the business after that tax has been paid becomes post-tax capital and does not face a second layer of federal income tax when it later comes out, provided the shareholder has enough stock basis to absorb the distribution.

Pass-Through Taxation in the Year Earned

An S corporation doesn’t pay federal income tax at the entity level. It files Form 1120-S and issues each shareholder a Schedule K-1 reporting their share of income, losses, deductions, and credits, which the shareholder then carries onto their Form 1040.²

The tax attaches to the profit, not to any cash movement. If the corporation earns $200,000 and distributes nothing, each shareholder still owes tax on their proportional slice.³ That’s the part that catches new S corp owners off guard: you can owe tax on money you never held.

The rate that applies is your individual rate. For 2026 that runs from 10% on the first $12,400 of taxable income for single filers up to 37% above $640,600.⁴ Compare that to a C corporation, which pays a flat 21% at the entity level and then triggers a second tax when the money reaches shareholders as a dividend.⁵ The S corp avoids that second layer. The tradeoff is that shareholders pay tax up front on everything the business earned, including whatever the company kept.

Estimated Tax Payments on Money You Haven’t Received

Because the income is taxed as it’s earned rather than as it’s paid out, wage withholding rarely covers what shareholders owe. If you expect to owe at least $1,000 for 2026 after withholding and refundable credits, quarterly estimated payments on Form 1040-ES are generally required.⁶

The 2026 due dates are April 15, June 15, September 15, and January 15, 2027. You avoid an underpayment penalty by paying the lesser of 90% of the current year’s tax or 100% of the prior year’s tax. If your 2025 adjusted gross income was above $150,000 ($75,000 for married filing separately), that prior-year safe harbor rises to 110%.⁶ Many S corporations solve the cash-flow problem by making a “tax distribution” each quarter so shareholders have the funds to cover their estimates.

Retained Earnings Increase Your Stock Basis

Every shareholder tracks an “adjusted basis” in their stock, which is essentially a running record of after-tax investment in the company. The shareholder is responsible for keeping this tally, not the corporation.⁷

Basis starts with what you paid for the shares (or the value of property you contributed). Each year it goes up by your share of company income and down by distributions, your share of losses, and certain nondeductible expenses.⁸

When the company retains earnings, your basis rises by the income allocated to you on the K-1, reflecting the fact that you already paid tax on those dollars. If you begin the year with $50,000 in basis and the company allocates $20,000 of income to you, basis climbs to $70,000. That increase is what prevents you from being taxed twice on the same income when the money eventually comes out or when you sell your stock.

Taking the Retained Money Out Later

When the company later distributes cash that was previously retained, the payment is tax-free to the extent of your stock basis, because the underlying income was already taxed the year it was earned.⁹ Every dollar distributed reduces your basis by a dollar.

Take a shareholder with $100,000 of basis. A $30,000 distribution brings basis down to $70,000 and produces no additional tax. A $120,000 distribution against that same $100,000 of basis is tax-free for the first $100,000, and the remaining $20,000 is treated as a capital gain. Long-term capital gains rates for 2026 are 0%, 15%, or 20%, depending on total taxable income and filing status.¹⁰

Companies With C Corporation History

If the S corporation carries accumulated earnings and profits from years when it was a C corporation, distributions follow a three-tier hierarchy. They come first out of the accumulated adjustments account (AAA) as tax-free returns of previously taxed S corporation income; next out of the leftover C corp earnings and profits as taxable dividends; and finally under the standard basis-reduction rules.⁹ Losses and nondeductible expenses can drive the AAA below zero, but distributions cannot.¹¹ A company that has been an S corporation since inception has no C corp earnings to worry about, and distributions default to the simpler basis-reduction rule.

The QBI Deduction Reduces the Effective Rate

Shareholders can shave the effective tax rate on their pass-through income using the qualified business income (QBI) deduction under Section 199A. Eligible owners deduct up to 20% of qualified business income from the S corporation. The One Big Beautiful Bill Act made the deduction permanent and expanded its availability starting in 2026.

The deduction is straightforward for shareholders whose total taxable income falls below $201,750 (or $403,500 for joint filers in 2026). Above those thresholds a phase-in range applies, and the deduction is gradually reduced for service-based businesses like law firms, medical practices, and consulting companies. That phase-in range was widened to $75,000 for most filers and $150,000 for joint filers beginning in 2026. A new minimum deduction of $400 applies for taxpayers with at least $1,000 in QBI from a business in which they actively participate.

The impact on retained earnings is real. If the corporation earns $300,000 and you qualify for the full 20% deduction, the taxable pass-through income drops by $60,000. That saving applies whether the earnings are kept in the business or paid out.

Reasonable Compensation Comes First

Before an S corporation can meaningfully retain earnings, shareholder-employees have to receive a reasonable salary for the work they perform. This is the most heavily audited area of S corporation compliance, and it directly controls how much of the company’s income can end up as retained earnings rather than payroll.

Salary is subject to Social Security and Medicare taxes (FICA), split between employee and employer. Distributions and retained earnings are not. That gap creates an obvious pull toward paying a low salary and keeping the rest inside the business or taking it as a distribution. The IRS is aware of the incentive, and courts have consistently held that the label a shareholder puts on a payment doesn’t control whether it counts as wages.¹²

If the IRS finds the salary unreasonably low, it can reclassify distributions as wages and assess back employment taxes, penalties, and interest. The test looks at what someone doing comparable work would earn in a similar business, factoring in the shareholder’s training, experience, and time devoted to the company. Setting a low salary deliberately to reduce payroll taxes is not a defense.¹² Getting this number right is the prerequisite to retaining earnings in a way that survives an audit.

Additional Taxes That Can Layer On

The pass-through framework covers most of the tax picture on retained earnings, but a few additional taxes can apply in specific circumstances.

Net Investment Income Tax

Shareholders who don’t materially participate in operations may owe a 3.8% net investment income tax (NIIT) on their share of company income. It kicks in when modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly), and those thresholds are not adjusted for inflation.¹³ Owners who actively run the business generally aren’t subject to NIIT on operating income. Passive investors should factor it in.

Entity-Level Taxes for Former C Corporations

The rule that S corporations owe no federal income tax has two exceptions tied to C corporation history. An S corporation converted from C corp status can owe built-in gains tax on appreciated assets sold within five years of the conversion, calculated at the 21% corporate rate on the net built-in gain during the recognition period.¹⁴ And an S corporation carrying C corp earnings and profits that receives more than 25% of its gross receipts as passive investment income (interest, dividends, rents, royalties, and similar) owes an entity-level tax at 21% on the excess net passive income.¹⁵ If that situation persists for three consecutive years, the corporation can lose its S election.

State Taxes

Some states impose their own entity-level tax on S corporations regardless of the federal pass-through treatment. These vary and can include franchise taxes, minimum annual fees, or composite income taxes. The federal treatment described here doesn’t override state obligations.

If S Corporation Status Ends

If a company loses or revokes its S election, retained earnings built up during the S years do not automatically become taxable, but the window to withdraw them tax-free is limited. During the post-termination transition period, shareholders can still receive cash distributions applied against stock basis, tax-free, to the extent of the remaining AAA balance.¹⁶ Once that period closes, the corporation is a C corporation for all purposes, and future distributions of those same retained earnings are taxed as dividends.¹⁷

1
Internal Revenue Service. S Corporations
2
Internal Revenue Service. 2025 Instructions for Form 1120-S
3
Office of the Law Revision Counsel. 26 USC 1366 – Pass-Thru of Items to Shareholders
4
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
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Office of the Law Revision Counsel. 26 USC 11 – Tax Imposed
6
Internal Revenue Service. 2026 Form 1040-ES, Estimated Tax for Individuals
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Internal Revenue Service. S Corporation Stock and Debt Basis
8
Office of the Law Revision Counsel. 26 USC 1367 – Adjustments to Basis of Stock of Shareholders
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Office of the Law Revision Counsel. 26 USC 1368 – Distributions
10
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
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eCFR. 26 CFR 1.1368-2 – Accumulated Adjustments Account
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Internal Revenue Service. S Corporation Employees, Shareholders and Corporate Officers
13
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
14
Office of the Law Revision Counsel. 26 USC 1374 – Tax Imposed on Certain Built-In Gains
15
Office of the Law Revision Counsel. 26 USC 1375 – Tax Imposed When Passive Investment Income of Corporation Having Accumulated Earnings and Profits Exceeds 25 Percent of Gross Receipts
16
Office of the Law Revision Counsel. 26 USC 1371 – Coordination With Subchapter C
17
eCFR. 26 CFR 1.1377-2 – Post-Termination Transition Period