If you own a closely held business that operates as a C corporation, you might want to reconsider and elect S corporation status. Electing to be an S corporation enables you to enrich you and your family instead of the IRS.
Modern Machine Shop,
Burn this into your mind—there are only three good reasons to be C corporation:
1. Your taxable profits are less than $125,000, and you need the after-tax dollars in the corporation to maintain growth or pay down debt.
2. You use the C corporation as a vehicle to get the benefit of deducting your health insurance and/or long-term care premiums.
3. You have carry-forward losses or other tax credits that would be lost if you make an S election.
With that said, C corporations should listen. The following is a list of the “pros” and “cons” of electing S corporation status.
S Corporation Cons
1. As an S corporation, you will probably pay more income tax in the current year. C corporations pay only 15 percent in income tax on the first $50,000 of net profit and 25 percent on the next $25,000.
2. Health insurance premiums for the shareholders/employees and their families are not fully deductible.
3. Long-term care premiums for the shareholders/employees and their families are not fully deductible.
4. Any assets owned as of the date of the S election are subject to the “Built-in-Gain Tax” (a whopping 35 percent) if sold within five years after the election. However, this tax is easy to avoid.
5. An S corporation election usually forces a December 31 year end as opposed to a fiscal year.
6. The accumulated C corporation earnings are permanently frozen at the date of the S election. This is only a mild problem, because those earnings are generally frozen anyway.
7. Life insurance proceeds cannot be distributed from an S corporation until all S corporation and prior C corporation earnings have been paid out. (Any corporation, C or S, should not own life insurance in the first place.)
S Corporation Pros
1. After making the S election, earnings are not subject to double taxation and do not increase accumulated C corporation earnings. For example, suppose your new S corporation makes a total of $1.2 million in profits during the first three years ($300,000, $400,000 and $500,000 each year, respectively). You pay tax on the profits each year as earned. Those profits are like a piggy bank. You can take any amount at any time—tax-free—as a dividend. Just don’t exceed the accumulated S corporation profits. (Over time, this is reason enough for most C corporations to switch to S corporation status.)
2. Electing to be an S corporation opens significant tax-saving and estate planning opportunities. For example, it opens the door for using an intentionally defective trust, which enables you to sell your business, tax-free, to your children or key employees. The typical client saves more than $1 million in taxes, including income tax, capital gains tax and estate tax.
3. Reasonable compensation becomes a non-issue with the IRS.
4. Unreasonable surplus “problems” (often a big, expensive C corporation deal) disappear.
5. Becoming an S corporation provides an opportunity to divide family income among family members. This saves large amounts of income tax and estate tax. The trick is to give non-voting stock to children and grandchildren, while the founder keeps control by retaining the voting stock.
6. Dividends (automatic double taxation for a C corporation) are no longer required. Sure, only 15 percent for C corporation dividends is a low tax rate, but it’s a rather high toll to pay compared with zero for an S corporation.
7. You enjoy low capital gains tax rates (only 15 percent) as an S corporation, instead of high ordinary income tax rates (35 percent) on sale of capital assets by a C corporation.
8. The tax basis of your stock is increased dollar-for-dollar for undrawn profits. For example, if your S corporation makes $900,000 in profit over a period of a year, and you took only $400,000 as tax-free dividends, the basis of your stock would increase by $500,000. If you sold your stock, that $500,000 would be tax-free. If you are thinking of selling down the road, an S corporation is a must.
The Best of Both Worlds
Often, a family business gets the best tax results by having one (or more) S corporations and a separate C corporation (typically a management company). The new C corporation and old operating S corporation(s) are structured so that the family business owner can enjoy the tax advantages available to both a C corporation and an S corporation.
Choosing whether to be an S corporation is one of the most important tax decisions a business owner ever makes.
Comments are reviewed by moderators before they appear to ensure they meet Modern Machine Shop’s submission guidelines.