However, with respect to taxes, the C corporation itself is
considered a taxable entity. That means that it files a tax return and
pays income taxes on its net income. If the corporation then
distributes income in the form of dividends to the shareholders, they
are taxed again on the income. This is often referred to as the
double tax of corporations. Most small businesses can avoid or
reduce this double tax by paying substantial compensation and
providing benefits to the shareholders who work in the business.
Compensation and benefits are generally tax deductible to the
corporation as a business expense. If a benefits plan is structured
properly, the value of the benefits may not be considered taxable
income to the employee. Compensation must be reasonable or there
is the possibility that the IRS could reclassify it as a dividend making
it subject to the double tax problem. The other method of avoiding
or reducing the double tax is to elect an S corporation status.

Unlike a C corporation, an S corporation itself is not a taxable entity.
The S corporation files an informational tax return on form 1120S,
but the corporation itself does not pay taxes on the net income of
the business. An S corporation is a pass -through entity which means
the profits or losses are reported by the owners (shareholders) on
their individual tax returns. An S corporation can also pay
compensation to shareholders who work in the business. If the S
corporation distributes income to the shareholders, there is no
double tax because the S corporation as an entity does not pay any
tax. Only the shareholders of the S corporation report and pay
income taxes on their prorata share of the business net income.