Should You Make an S-Election?

By Thomas Tartaglia, CPA (Nov, 2009)

One of the first decisions faced by a business owner is choosing the optimal type of legal entity to conduct the business operations. This is commonly referred to as the choice of entity decision. For most businesses, the entity options typically include the corporation ("C" or "S"), the sole proprietorship, the single-member LLC, the partnership, and the multi-member LLC.

We will be discussing corporations currently operating as C-corporations and the advantages and disadvantages of electing S-corporation status.

In order to qualify as an S-corporation the following criteria must be met

  • The entity must be a domestic corporation
  • It cannot have more than 100 shareholders
  • Shareholders must be individuals who are U.S. citizens or residents - estates and certain trusts also qualify as shareholders
  • There can only be one class of stock
  • The corporation cannot be an ineligible corporation (a corporation with a C-corp. shareholder, certain insurance companies and financial institutions and Domestic International Sales Corp.)

The deadline for filing the Form 2553 (Election by a Small Business Corporation) differs depending on whether the corporation is already in existence or newly formed. For an existing C-corporation electing S-status, the election must be filed:

  1. during the tax year preceding the first tax year the S-election is to be effective,

    or

  2. on or before the 15th day of the third month of the initial "S" year.

S-status begins on the day following the last day of the C-corporation's tax year.

For a newly formed corporation, the election must be filed on or before the 15th day of the third month following the "activation date" of the corporation. The regulations indicate that the activation date is the earliest date that the corporation has shareholders, acquires assets, or begins conducting business. Case law has also interpreted the activation date to be the incorporation date.

The most common reason for electing "S" is the elimination of double taxation. Generally, S-corporations are not taxpaying entities, items of income and deduction flow through to its shareholders and are taxed at the individual level only. Entity level losses can be deducted (subject to certain limitations) from other personal ordinary income. C-corporation earnings are first taxed at the corporate entity level at rates ranging from 15% to 34% and then again at the individual level upon distribution of assets (including cash). However C-corporate tax rates are currently lower than personal tax rates on the first $50,000 of corporate taxable income (15%). Therefore a corporation with taxable income of $50,000 or less will mitigate some of the adverse effects of double taxation.

Another potential benefit of operating as an S-corporation is that long term capital gains generated within the corporate entity flow through to the individual shareholders and are taxed at the individual maximum rate of 15%, as opposed to a C-corporation where gains remain within the entity and are taxed at the regular corporate rate. For this reason appreciating property, such as investments and Real Estate, should not be held in a C-corporation.

Additionally, S-corporation shareholders can withdraw their equity tax free, to the extent they have basis. Distributions from a C-corporation (in the form of dividends) are non-deductible expenses by the corporation and includable in income of the shareholder, although the current low individual tax rates on dividends will mitigate some of the adverse effects of double taxation. It is anticipated that the lower tax rates on capital gains and dividends will increase in the near future therefore creating a higher double taxation threat in the coming years. Also S-corporations are not subject to certain "penalty taxes", for example "personal holding company tax" and "accumulated earnings tax." 

Flow through income and distributions from the S-corporation are not subject to self employment tax. Compensation for services provided by an officer-shareholder are wages, not "SE" income, and therefore the amount of wages can be balanced with the amount of flow through income effectively limiting payroll tax expenses. The caveat is that officer-shareholder wages must be paid at a reasonable rate, although the IRS does not define "reasonable compensation" within the code. Reasonable compensation can be determined by looking at the role of the officer within the corporation, their qualifications, hours worked, salary history and wages paid in similar companies. Conversely, certain fringe benefits are treated as taxable income to employee-owners owning directly or indirectly more than 2% of the stock of an S-corporation. Accident and health insurance premiums paid and the cost of up to $50,000 of group-term life insurance are taxable to the shareholder and are required to be reported on the shareholders W-2. Health insurance premiums are deducted on the shareholders' personal return. The following are some of the disadvantages to converting your corporation from a "C" to an "S":

  • S-corporations must generally operate on a calendar year basis for tax purposes. The S-corporation may elect a fiscal year but will be required to make an annual prepaid tax deposit that approximates the amount of tax deferral benefit of using a fiscal year end.
  • Converted S-corporations do not escape corporate level taxes entirely. The "built-in gains tax" is potentially assessed when the C-corporation owns assets with a fair market value in excess of tax basis at the time of the S-conversion and those assets are sold for a profit generally within 10 years of the corporation's S-election. The tax is assessed at a rate of 35% on the gain.
  • A converted C-corporation with undistributed accumulated earnings and profits that generates passive investment income exceeding 25% of their total gross receipts for the year will be taxed at 35%. If this occurs for three consecutive years the corporation's S-election will be terminated.

These are a few of the many items to consider when making a decision whether or not to elect S-status. We encourage you to contact your tax professional here at DB&B to help guide you in your decision making process.

 

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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