Whether to S-elect or Not to S-elect, That is the Question

Patricia Greenhouse, CPA (Aug, 2015)

We are often asked by our corporate shareholders whether it is beneficial to file an election to become an S Corporation. Our first inclination is to shout a resounding “yes”; however we need to take a deep breath and respond that it depends on many factors. This conversation typically continues with the following questions:

What about double taxation?

How does the 3.8% tax on net investment income impact my choice?

What about the appreciated assets in my corporation?

Double taxation?

A C Corporation is taxed at the corporate level imposing the corporate tax rates and its distributions of the corporation’s earnings to its shareholder are also taxed at an individual level. An S Corporation generally is not taxed at the corporate level; its items of income, deduction, credits, etc. are passed to its shareholders who compute and pay only taxes on one (individual) level.  Accordingly, a C Corporation is viewed as tax inefficient as a result of the double taxation of the corporate earnings.  However, as the tax rate on most distributions to C Corporation shareholders is the same rate as long term capital gains (15% - 20%), the negative effects of double taxation at the C corporation level is reduced.  Businesses with $50,000 or less of taxable income would pay tax at the 15% C Corporation rate and typically these businesses would retain this income to fund growth. The S Corporation shareholder would pay taxes on the $50,000 at a potentially much higher personal tax rate.  Reasonable compensation to the shareholder/employee can be used as a deduction to lower taxable income of the C Corporation. The impact of double taxation has been reduced because of the changes in the individual rates.  The marginal rates of both the corporation and the shareholders need to be considered before deciding if double taxation is a problem. Double taxation is not necessarily the deal breaker.

3.8% tax on net investment income?

Effective for tax years beginning on or after January 1, 2013, a 3.8% tax is imposed on the lesser of an individual’s net investment income or the excess on the taxpayers modified adjusted gross income over certain thresholds. Net investment income (NII) is defined as the sum of the following, reduced by allowable deductions that are properly allocable to them:

1) Taxable interest

2) Ordinary dividends

3) Annuities from nonqualified plans

4) Royalties

5) Rents and income from partnerships and S corporations, unless derived in the ordinary course of a trade or business that is not a passive activity with respect to the taxpayer (the ordinary course of a trade or business exception)

6) Net gain attributable to the disposition of property other than property held in a nonpassive trade or business

For S Corporation shareholders the differentiation between materially participating shareholders and passive shareholders are significant to the imposition of the 3.8% NII tax. These factors need to be considered in determining the pros and cons of an S election. If an S Corporation shareholder materially participates in the business, the shareholder’s share of the trade or business income is not treated as net investment income. It is important to note that only items produced by pass-through entities retain their character of material participation. If a trade or business is held through a C Corporation, the corporate earnings are not subject to NII tax at the corporate level, but dividends and capital gains generated by the C Corporation are generally included in net investment income.

Appreciated assets in the corporation?

When a C Corporation elects S Corporation status there is a net unrealized built-in gain if the combined fair market value of the assets exceed the combined basis of the assets.  Built-in Gains (BIG) tax are triggered by property dispositions; however these rules affect property dispositions only during the recognition period. Congress has shortened the recognition period from 10 years to 5 years, but has not yet made this permanent. When considering an S election the potential tax liability of BIG tax must be evaluated. However, there are potential fact patterns where an S election immediately prior to a planned C Corporation asset sale could prove advantageous. Please refer to the example in the following paragraphs.  This illustrates a scenario in which the S election even considering the potential BIG tax liability on the appreciated assets made sense and demonstrates the interplay of the net investment income tax. The future of the business and the possibility of property dispositions need to be considered in an S election decision.  The timing of the property dispositions is also an important factor especially in light of the reduced recognition period of 5 years.

Example

For example, consider a C Corporation in which the value of its assets exceed the asset basis by $6,500,000, and the basis/net book value is $2,000,000. The owner have been offered $8,500,000 by an unrelated buyer for the business assets and then plans to liquidate.  As a C Corporation the corporate level tax on the gain on the asset sale would be $6,500,000 ($8,500,000 less $2,000,000) and the tax (34% rate applied to the $6,500,000 gain on sale) would be $2,210,000.  The remaining proceeds paid to the owner upon liquidation would be $6,290,000 ($8,500,000 selling price less $2,210,000 tax on gain). On an individual/shareholder level the liquidating proceeds would be subject to 20% (maximum capital gains rate) plus the 3.8% tax on net investment income.  The net investment income tax applies because the corporate liquidation is viewed as a deemed sale of the shareholders stock. Thus an individual tax liability of $1,497,020 (23.8 tax rate applied to $6,290,000 liquidating proceeds) is also generated. At the end of the day our C Corporation owner has $4,792,980 ($6,290,000 less $1,497,020) in his pocket and has avoided the BIG tax. 

What would happen if an S election was made immediately prior to the asset sale?  The only corporate level tax for the new S Corporation is BIG tax which would be $2,275,000 (Built in gain of $6,500,000 times the 35% tax rate). In this case, the liquidating proceeds would be $6,225,000 ($8,500,000 selling price less $2,275,000 BIG tax). On the individual/shareholder level the shareholder would be subject to tax on pass through capital gains of $4,225,000 ($6,500,000 built in gain less $2,275,000 BIG tax). At the maximum capital gain rate of 20% the tax would be $845,000 ($4,225,000 times 20%). In this case, the 3.8% net investment income tax would not apply because we are assuming that the owner actively participates in the business.  Additionally, the gain on liquidation would be calculated on the individual/shareholder level as follows: $6,225,000 liquidating proceeds less basis in stock of $4,225,000 resulting in a gain on liquidation of $2,000,000. This gain is also subject to 20% capital gain and results in an additional tax of $400,000 ($2,000,000 times 20%).  Thus the total tax on an individual level is $1,245,000. ($845,000 plus $400,000).  Under this scenario our new S Corporation shareholder is left with $4,980,000 ($6,225,000 liquidating proceeds less $1,245,000 individual taxes) in his pocket (even after paying the BIG tax).  This is compared to our C corporation shareholder from the above paragraph who is left with $4,792,980.

Why is there a difference of $187,020 in after tax proceeds?  This is primarily the result of the fact that the owner is not subject to net investment income tax that he would have if the asset sale were within the C corporation.  This is offset by the one percent difference in the BIG tax rate of 35% and the C corporation tax rate of 34%.  If we multiply the C corporation liquidating distribution of $6,290,000 by 3.8 % the tax savings is $239,020.  The offset of $52,000 is the 1% difference on the gain on the sale of assets of $6,500,000 tax effected by the 20% capital gain rate.

As you can see a thorough examination of all the current and future facts is needed to answer the question of whether to S-elect or not to S-elect. There is no one answer to address the many issues involved with this decision. Please consult your advisors at Dermody Burke and Brown CPA’s LLC for guidance.  

 

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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