Is it allowed that 1120S balance sheet with retained earnings? Or the retained earnings need to be distributed by K1 to business owners?

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@PC2025 wrote:

The net earnings from S Corp is supposed to be split into two parts: W2 income and distribution. 

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No, the individual taxpayer has earnings from W-2 income and pass-through income from the corporation (the corporation's profit after paying wages).  Distributions are separate.

In other words, the taxpayer will pay tax on the profit of the corporation (after W-2 wages), plus their W-2 wages, regardless of their distributions.

 S corporations are not permitted to have retained earnings in the technical sense. Instead, S corporations use an Accumulated Adjustments Account (AAA) to track profits that have not been distributed to shareholders. S corporations are pass-through entities, which means that profits flow directly to shareholders for tax purposes, regardless of whether the money remains in the business. This is different from regular corporations, which can retain and pay taxes on their earnings