If a closely held corporation involuntarily becomes an S corporation, how are the shareholders taxed?

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The key idea is pass-through taxation. When a closely held corporation becomes an S corporation, the tax burden shifts from the entity to its owners. An S corporation is treated as a pass-through for tax purposes, so the corporation itself generally pays no income tax. Instead, all the income, deductions, credits, and losses flow through to the shareholders in proportion to their ownership, and each shareholder reports their share on their personal tax return and pays taxes at their individual rates. This is why the shareholders are taxed as S corporation shareholders rather than as C corporation taxpayers. It’s a different structure from a regular C corporation (which faces corporate-level tax) and from a partnership (which also passes through items but is not a corporate entity).