Certified Financial Management Specialist Practice Exam

What does an S Corporation primarily allow regarding income distribution?

1. Income is taxed at corporate rates

2. Income passes through to owners

3. Income is exempt from taxation

4. Income is allocated based on shareholding percentage

The correct answer is: Income passes through to owners

An S Corporation primarily allows income to pass through to the owners, which means that the income earned by the corporation is not subject to federal corporate income tax. Instead, the income, deductions, and credits are passed directly to the shareholders, who then report this income on their personal tax returns. This pass-through taxation feature is a significant advantage of operating as an S Corporation, as it helps to eliminate the double taxation that can occur with a traditional C Corporation, where the corporation pays taxes on its profits, and shareholders then pay taxes again on dividends they receive. This organizational structure benefits the shareholders by allowing them to be taxed on the corporate income at their individual tax rates, which may be lower than the corporate tax rate, depending on their overall income. Additionally, this setup enables the S Corporation to retain its profits within the company for reinvestment without triggering immediate tax implications at the corporate level.