The Business Advisor S CORPORATIONS: What you need to know about electing S corporation status. by Mary Hanson

Over the years I have become more of an advocate of S corporation status. I have encountered a number of business situations (primarily corporate dissolutions and business sales) in which corporate shareholders were disadvantaged by not having elected S corporation status at the time the entity was created.  I have encountered situations with LLCs which would have been avoided if an S corporation had been used instead of a limited liability company.

Circumstances can change. But the choices you make now need to fit most of your business circumstances. There are negative tax consequences in converting from a C corporation to an S corporation. The tax burden resulting from changing from a C corporation to an S corporation can be so great that the change should not be made. You have only one chance to be an S corporation "from the beginning," and this option should not be overlooked.

While the S corporation is not the right choice for every situation, it is important that the pros and cons of of using an S corporation be considered at the time an entity is formed.  This article examines the reasons the reasons a new corporation should often elect S corporation status.

S Corporation Characteristics and Benefits

The key characteristic of S corporation status is the "flow-through" of profits and losses, income, capital gains, and capital losses to the shareholders of the corporation in proportion to their ownership interests for tax purposes.  The idea (but watch out for the reality) is that taxes are not paid at the corporate level, but only at the shareholder level.

This "flow-through" characteristic avoids the double taxation of C corporations, where profits and appreciation are taxed as income and capital gains of the corporation and then taxed again when distributed to shareholders. This is a significant tax burden for a C corporation and its shareholders when cash or assets are distributed to shareholders as a result of a sale or dissolution of the business.

The two levels of tax involved in the sale or dissolution of a C corporation are the tax that the C corporation pays when the assets are sold at a gain to the corporation, and then the tax that the shareholders pay when the cash in the corporation is distributed to the shareholders.

Since, over time, the tax basis of assets is reduced as depreciation is taken, corporations often have such a low tax basis in assets that much of the sale price received by the corporation is subject to significant tax at the corporate level. At the shareholder level, since many owner-operated corporations are started with minimal capital, the shareholder may have significant capital gain (the difference between the price originally paid for the stock and the value distributed to the shareholder upon dissolution of the corporation) when the money is distributed from the corporation to the shareholder.

Electing S corporation status and maintaining the corporation as an S corporation from the beginning solves most of the double taxation problem.

Another benefit of the flow-through characteristic of S corporation status is that business losses are passed through to shareholders. For shareholders of new startup companies which anticipate losses, the S status allows the write off of corporate losses on personal tax returns. Often the losses can be used to offset other gains or income of the shareholders, reducing personal taxes.

S corporations also avoid the risk of the IRS challenging distributions to shareholders as excessive compensation or as dividends subject to tax at the corporate level.

A related advantage is that investors who are not active in the business and cannot be paid a salary or other compensation can receive distributions of S corporation profits. Without S corporation distributions, it can be difficult to provide investors with a return on their investment, except by distributing dividends which are subject to tax at both the corporate and shareholder levels.

Limitations

The major limitation on the use of S corporation status is that only "eligible" corporations may elect S corporation status. To be eligible, a corporation must meet a number of requirements, including:

* It cannot have more than 100 shareholders;

* It can have only one class of stock;

* All shareholders must be individuals or estates or certain types of trusts;

* It cannot have a shareholder who is a nonresident alien; and

* It cannot have a corporate shareholder.

If the corporation fails to meet the above requirements, the S status automatically terminates. S corporation status can be undone, for example, by one shareholder's transfer of stock to a non-eligible shareholder.

Other Disadvantages

There are a number of disadvantages in electing S corporation status. While some are minor, some can be significant.

One disadvantage is that IRS rules make the calendar year end the only easy fiscal year end for S corporations for tax reporting purposes.

Another one is that shareholders holding an interest of 2% or more in an S corporation cannot take full advantage of tax-favored employment benefits. Life insurance, health insurance, medical expense reimbursement, death benefits and other employment fringe benefits which are tax deductible for other employees (and for C corporation shareholders) are taxable as income to shareholders holding an interest of 2% or more in an S corporation.

Perhaps the most significant pitfall is that shareholders pay taxes on all the taxable corporate income and gains, whether or not any funds are distributed to the shareholders. The board of directors may decide not to distribute profits. Or profits may be reinvested in the corporation's business activities so that there is no cash available for distribution to shareholders.

Even a sole shareholder can get hit with this burden of S corporation status. For example, if you are the sole owner of a corporation that has taxable income of $100,000, but the profits were spent on something that was not tax deductible and no cash was left at the end of the year, you will have to pay taxes on the $100,000.  The net taxable income is added to your personal income tax return, whether or not you received any distribution from the corporation.

Where there are two or more shareholders, the tax consequences will differ from one shareholder to another, due to different income levels, tax rates, and offsetting gains and losses from other sources for each person. Each shareholder needs to consider how the S corporation tax consequences will affect him or her.

The poorer shareholders need to be concerned about being dependent upon distributions. Wealthier shareholders may favor corporate reinvestment of profits, which reduce shareholder distributions and even put the shareholders in the taxes-to-pay-but-no-cash-distributions bind described above. The wealthier shareholders can withstand the tax problems created, and can even use these circumstances to pressure poorer shareholders to sell out.

Similarly, gains and losses generated by the corporation may be passive to an "investor" shareholder, while the same items are treated as active gains and losses to a shareholder actively involved in the business.

Where the gains and losses are passive, some shareholders may have no significant passive income against which to take a loss or no passive losses with which to offset a gain, while other shareholders have many other personal investment activities which generate offsetting losses and gains to get the best tax treatment. A corporate sale of assets which would produce a capital gain might have the best tax consequences in one year for one shareholder and in another year for another shareholder, depending on their income, offsetting capital losses, etc.

Another disadvantage is that the rules regarding S corporations can be quite technical, and the accounting can be complicated. Make sure you have considered all applicable tax and accounting consequences in your situation before deciding to elect S corporation status.

Converting to S status from C

Corporations cannot get the benefits of being a regular C corporation while the business is growing and then elect S corporation status just in time to take out profits and gains with only one level of tax. Federal tax treatment requires that retained earnings built up when a corporation is a C corporation be treated and taxed separately from the corporation's profits and other tax consequences after switching to S corporation status. These "built-in gains" must be separately taxed for 10 years after the conversion to S corporation status unless other tax treatment applies.

In addition, some items like accounts receivable may become immediately taxable upon conversion to S corporation status.

If the conversion to S corporation status is related to a sale of an active business and continuation of the corporation for other purposes, there are "passive income" rules that need to be considered.  If the corporation was going to be continued in order to hold promissory notes or rental real estate, this limitation is important. A C corporation that converts to an S corporation may not have significant passive income. A corporation that had earnings and profits as a C corporation and then converted to an S corporation will lose its eligibility to remain an S corporation if it has gross passive income (from rents, royalties, interest, dividends, etc.) in excess of 25% of total gross income for three consecutive years.

Established corporations, when considering electing S corporation status, must carefully consider the various tax burdens they would face by converting from a C corporation to an S corporation.  They must be aware that the benefits touted for S corporations may be seriously reduced by having been in business as a C corporation prior to any S election.

While established corporations should switch to S corporation status only with the advice and guidance of tax professionals, a new corporation should not fail to address the opportunity to select S corporation status

State Law

The pros and cons of electing S corporation status are not complete without a review of the state taxes that will apply to a corporation. Determine whether the states in which the corporation pays taxes allow the corporation to avoid taxes at the corporate level, as the IRS does, or if the state imposes taxes on the corporate level. Does the state have eligibility requirements that are the same as or different from the IRS?

In California state tax laws recognize S corporation, but impose a tax rate of 1 1/2% on taxable income at the corporate level, with a minimum tax of $800 which applies regardless of whether the corporation has a profit or a loss.

© Copyright 1998-2010  Mary Hanson. All rights reserved.