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.
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.
Despite enhancements to manufacturing technology, there are still issues today that can cause programs to fail. These failures can cause lost time, scrapped parts, damaged machines and even injured operators.
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