Rethinking the S Corporation

William J. Killory, CPA, Partner (Mar, 2014)

Since at least 1986 the preferred form of entity has been a flow through, either an S Corporation or a partnership vehicle.  The main reason for this was that there is no corporate tax on these organizations as the incidence of tax is determined at the individual owners’ level.  Individual tax rates since 1986 have been lower than corporate rates so the math clearly favored these entities.

Come April 15, 2014, many high income taxpayers are going to find that individual rates are much higher than the top corporate rates.  The top personal rate is a nominal 39.6%, not including the loss of personal exemptions and the add-back of itemized deductions.  The tax on net investment income adds another 3.8% for high income taxpayers and the additional Medicare levy tacks on an additional 0.9% on wages above $250,000. When you add in the impact of New York States highest rates the top marginal rate for individuals can exceed 50%.

The C Corporation tax starts at 15%, rises to 34% at $75,000, climbs to 39% above $100,000 and settles at 34% after $335,000 of taxable income.  The top rate climbs again at $10 million to 35% and personal service corporations pay at a flat 35% from dollar one. The rate on C-Corps in New York is currently 7.1% and with a single allocation factor those who sell to customers outside of New York face an even low rate. We generally balance the corporate tax burden with the individual tax rates through wages to the owners, treating the corporation like a poor man’s S-Corp.  In the normal operation of a business there is not a lot of difference in the rate of taxation and currently it tips a bit in favor of the corporation at the highest marginal rates.  One caveat is that the top federal income tax bracket for married individuals starts at $450,000.  The federal average tax rate getting to that level is 28%, still much lower than the corporate rate.

The big difference, and it has always been the key consideration in choosing the type of entity, is the exit plan.  In the S-Corp the built up profits generally are distributed tax free as they have already been taxed at the individual level.  Distribution of profits from the C-Corp will create dividend income to the shareholders.  There is no corporate deduction for the dividend and the individual rate of tax is either 15% or 23.8% plus the state tax obligation.  Doing the math, you can have a net corporate rate of 39% and a combined personal rate of 28% to get to a 67% rate on those earnings.

If and when it comes time to sell the company the S-Corp has clear advantages.  Most purchasers are looking at buying assets both from a tax and liability perspective.  The sale of the assets in the S-Corp mirrors the effect on the owners’ personal return.  The nature and type of income is determined at the entity level, ordinary income or capital gain and the tax will be determined at the shareholder level after subtracting the shareholders’ basis in the S-Corp.  For those actively involved in the business the 3.8% tax on net investment income does not apply on the proceeds of the sale of the business.  To the extent that the S-Corp is sold on an installment basis, the capital gain related to that can be deferred until the note is collected.

The sale and liquidation of the C-Corp gain is determined at the entity level.  Capital gain is taxed at the same rate as other income so there is no advantage there.  The liquidation of the company will generate capital gain on the owners’ personal return with the amount paid for the stock as the basis against the proceeds.  While the gain will be treated as capital gain, it will also be subject to the net investment income tax as well.  If there is an installment note, keep it in the corporation as the distribution of the note will trigger immediate corporate tax and individual capital gain.  Again, the combined corporate and personal rate could be 67% on the sale and liquidation of the company assets.

It is possible for a C-Corp to convert to an S-Corp, but there is currently a ten year period where any built-in gains will be taxed as a C-Corporation.  You can convert from an S-Corp to a C-Corp, however, you are prevented from reconverting back to an S –Corp for five years.

Determining the form of entity has become more complicated because of the increase in individual tax rates.  Each circumstance will depend on both the company and individual variables.  What may be good in the short term could be quite expensive in the long run. Your Dermody, Burke & Brown tax professional can walk you through the process and determine your best course of action.

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