For many corporations, the most important tax decision hinges on whether or not to elect to be treated under the provisions of sub-chapter S of the Internal Revenue Code. The choice concerning S-Corporations (S-Corp. status is often a complex one that is fraught with significant tax implications. As with many tax decisions, there are both potential advantages and disadvantages in choosing to be treated as an S-Corp. Some of these factors are general in nature, while other are somewhat unique to government contractors. In determining whether to elect S-Corp status, these advantages and disadvantages must be carefully analyzed and weighed based on a company’s specific situation.
Unless an S-Corp election is made when a business incorporates a cooperation is automatically a “regular” corporation (C Corp.). In order to elect treatment as an S-Corp., there are certain eligibility requirements which much be met. (Please refer to table on page 3 for requirements).
Tax Advantages of S-Corp Election
There are three primary tax advantages to be gained form becoming an S-Corp. All three derive fromm the fact that an S-Corp is throated as “pass-through” entity: i.e., items of income or loss, deductions, and credits are passed through directly to a corporation’s shareholders on a pro-rata basis commensurate with their ownership percentages. The most important benefit of this pass-through approach is the ability to avoid double taxation: i.e., taxed imposed on corporate profits at the corporate level and tax imposed at the individual shareholders level on the distribution of those profits as dividends. A simple comparison using an estimated combined Federal and state corporate rate of 40% and an individual rate of 38% may help to illustrate this benefit:
|Corporate taxes at 40%||400,000||None|
|Corporate net income distributed||600,000||1,000,000|
|Individual taxes at 36%||216,000||360,000|
|Net funds available||384,000||640,000|
While somewhat oversimplified, the foregoing example demonstrates the substantial tax savings that potentially can result form the ability to avoid the corporate level income tax. Although some might argue that the double tax can just as easily be avoided by not paying current dividends, this argument ignore two factors. The first is that a C-Corp. is subject to a potential accumulated earnings tax if it amasses more than $250,000 of retained earnings ($150,000) for personal service corporations). The second is that virtually every corporate owner will eventually look to receive his share of a corporation’s retained earnings. Often this occurs when the owners decide to “cash in” by selling or merging the corporation. Since buyers generally prefer to purchase assets rather than stock, the proceeds of such transactions usually flow through the corporation, where they are taxed prior to being distributed as dividends subject to a second. tax.
Two other rather obvious benefits of S-Corp. status can be observed in the above example. The first has to do with differences between corporate versus individual income tax rates. currently, the top Federal individual rate is 31% as compared with respect to state tax rates (although not all states recognized S-Corp. concept). Thus, election of S-Corp. status for profitable companies can mean an immediate tax savings in may cases. In addition, the pass-through of corporate income or loss directly to the corporation’s owners provides each shareholder with a wide range of planning opportunities in minimizing the tax bite on corporate earnings. For example, a shareholder may be able to reduce the overall tax burden on S-Corp earnings by shifting income to family members. This can be accomplished by transferring stock to minor children over the age of 13. Typically, such minor children will be in a lower tax bracket and will thus pay a lesser amount of tax than would the parent.
Yet another advantages of S-Corp. treatment relates to the utilization of corporate net operating losses. Subject to certain relatively complex requirements, a shareholder may be able to offset S-Corp. losses against personal taxable income from other sources. Thus, the shareholder may be able to capitalize on the time value of money by utilizing such losses sooner than might be possible if the company were a C-Corp.. Generally speaking a shareholder mush have sufficient “basis” in the S-Corp to enable the use of losses to offset other income. Basis is obtained through by the corporation. The guarantee by shareholders of corporate debt does not create basis for loss utilization by shareholders.
Requirements for S-Corporation Eligibility
The corporation must be a domestic, small business corporation
- No more than 35 shareholders
- Only natural persons can be shareholders, including qualified trust and estates
- No nonresidents alien shareholders
- Only one class of stock; voting rights do not create second class of stock
The corporate must be an eligible corporation
- Cannot be member of an affiliated group
- Financial institution, foreign corporations, insurance companies and domestic international sales corporations (DISC) or former DISC are not eligible.
The corporation must make a proper and timely-filed S-Corporation election
- All shareholders must consent to the election to be treated as an S-Corporation
- Form 2533 must be completed and filed with the Internal Revenue Service within 2 1/2 months after the beginning of the year in which the election is to be effective.
Disadvantages to Electing S-Corp. Status
Despite the very substantial benefits associated with S-Corp status, the treatment is not without its share of potential disadvantages. One of these is that S-Corp. are limited in choosing a “permitted tax year”. Normally an S-Corp. must use a calendar year in filing its tax returns. This may present a dilemma for government contractors who have historically chosen to use a fiscal year end, such as September 30. The election of S-Corp. status usually means that the corporation will have to either:
- Change its year end for both tax and financial reporting purposes (if it wants to minimize accounting complex), or;
- Use different year-ends for tax and financial reporting purposes (which may be impermissible, and in any event can make for some very cumbersome accounting problems), or;
- Seek to use one of the permitted alternative year-ends (which are generally limited to September, October, or November and which require a tax prepayment equal to the estimated tax deferral which results form suing a tax year-end different form that of the corporation’s shareholders).
A potential disadvantage peculiar to government contractors concerns loss of the ability to recover state taxes as part of a company’s indirect cost. Normally, state taxes actually paid a accrued are recoverable as par to the G&A cost pool. The adoption of S-Corp. status transfers responsibility for such state taxes to the individual shareholders and thus removes them form the G&A pool.
Another disadvantage often encountered by government contractors who elect S-Corp. treatment relates to multistage tax filing. Because contract operations may be relatively far-flung, even small government contractors are often required to file in as many as five or more states. Since some states do not recognize S-Corp. status, the process of complying with the various state filing requirements for both the corporation and its shareholder can become unwieldy and expensive.
Two common misconceptions exists with respect to the effect of adopting S-Corp. status. The first is that the election somehow alters the legal status of the corporation to that of a partnership, wherein each shareholder has unlimited liability for the acts of the corporation. In fact, the election of S-Corp. treatment does not change the legal structure or standing of the corporation; it is merely a tax option. The second misunderstanding is that the transfer of responsibility for the payment of taxes on corporation income to the individual shareholders somehow creates a cash need that would not otherwise have existed. A look at our original comparative example above should quickly dispel this notion. It can easily be seen that the cash required to pay just the corporate portion of the total obligation as C-Corp is $400,000, compared to the total S-Corp obligation of $360,000. Accordingly, the S-Corp. could distribute the necessary $360,000 to the shareholder(s) on a tax-free basis and would still be better off by $40,000 than if it had to pay its own tax of $400,000 at the corporate level.
Most of the advantages and disadvantages of S-Corp status have been described briefly. It is important to not that the rules and regulations governing subchapter S corporations, as well as recent decisions and current issues presently before the various courts today, would require a discussion of S-Corp status beyond the scope of this article. The information contained in this article is presented to provide a general understanding of the benefits and cautions in electing S-Corp status.
Please note: tax rates noted in this article may be outdated. Please consult with your accountant for updated information.
Copyright © 1992 Friedman & Fuller, P.C.