Weighing tax benefits of S corporations

Factors to consider in deciding which type of incorporation is best for you

AS TAX LAWS continue to evolve, so do choices of entity. Being mindful of the alternatives is critical to achieving tax benefits. Both S corporations and Limited Liability Companies (LLC's) are flow-throughs, which have long been a desirable alternative to regular C corporations.

Unlike in C corporations, the incomes of flow-throughs are taxed directly to their individual owners, largely independent of distributions. C corporations, on the other hand, are double-taxed, incurring their own tax first, without any long-term capital gains break. Then, as money is distributed to owners, it is taxed again at the individual level, without a deduction to the corporation. The law enforces the double tax by limiting owner salaries to reasonable levels, and by preventing corporations from accumulating excess earnings.

However, S corporations have a newly enhanced tax advantage over LLC's. Only active shareholders of S corporations are exempt from the Affordable Care Act's new 3.8% tax on unearned investment income of joint filers making over $250,000. While inactive owners of both entities incur the new tax, highincome active members in LLC's do also, in that a 3.8% Medicare tax applies to their flow-through income.

There are several benefits and risks of becoming and operating as an S corporation. LLC's, on the other hand, feature absence of corporate formalities, unrestricted owner types, flexibility of income allocation and distributions, ability to distribute appreciated assets, and more immediate tax benefits of losses if incurred.

Ultimately, the choice of entity depends heavily on the direction of future tax legislation. The year 2013 saw increases in maximum tax rates for individuals to 43.4% for ordinary income and 23.8% for long-term capital gains and qualifying dividends. Meanwhile, maximum rates for C corporations held firm at 35% on all income. If C corporation rates decline to be more competitive globally, as many in the federal government advocate, flowthrough entities may lose their current appeal. Companies must work with their tax advisors to assure adequate consideration of the unique facts of their situations.

Election and ownership

Switching from a regular C corporation to an S involves a special election, which may have tax costs. Electing S status causes the loss of any credits or carryovers from previous years, and subjects the corporation to "built-in gains" tax at the time of the election, which includes adjustments of property to market value. If sold within a period of ten years after the election, S corporations may be open to double taxation.

The advantages of S corporations in taxes come with many restrictions, violation of which can result in termination of S status and loss of its tax benefits. The number of shareholders is limited to 100. Ownership is restricted to individuals, estates, certain trusts, and certain exempt organizations.

Corporations, partnerships, and nonresident aliens are ineligible. An S corporation cannot be an owned subsidiary of a C corporation or a multiple member LLC, but can be a 100%-owned subsidiary of another S corporation.

Transfer or sale of stock can have severe consequences. If a shareholder is an LLC with more than a single member, the S election terminates. It is advisable to have a shareholder agreement in place to provide a right of first refusal, in the event that stock is offered for sale to nonqualifying shareholders.

Moreover, only a single class of stock is allowed. For example, preferred shares may not be issued. A potential problem arises with undocumented shareholder debt. If upon audit, the Internal Revenue Service interprets the debt as a second class of stock, the S election terminates. On another note, voting right differences do not constitute separate classes of stock.

Choice of tax year-end is restricted. The concern is that shareholders could otherwise benefit from cash-basis timing differences. Selecting a year-end other than Dec. 31 requires that sufficient funds be kept on deposit with the U.S. Treasury to offset any timing benefit.

Taxation and compliance

Once operating as an S corporation, taxation takes place at the owner level from amounts reported on the schedule K-l from the form 1120-S. Unlike C corporations, dividend distributions are not taxed unless they exceed the shareholder's cumulative basis. The basis is the amount paid for the stock plus amounts lent to the company plus the pro rata share of the accumulated adjustments account, which is basically the equivalent of retained earnings while the entity is an S corporation. A shareholder's guarantee of debt does not constitute basis.

Additionally, unlike C corporations, losses may provide tax benefits for owners. The deductibility of losses for active shareholders, however, is limited to the basis in the stock. Losses in excess of basis must be carried forward.

Compensation of stockholders who are active in the business must not be unreasonably low or distributions unreasonably high. The reason is that these shareholders might evade payroll taxes by making non-taxable distributions instead. Some tax practitioners advise clients to apply a minimum benchmark of the FICA base, which is $117,000 in 2014.

Distributions are heavily restricted. In accordance with the formalities of having a single class of stock, distributions must be paid in proportion to ownership. Also, distributions must be made to the actual shareholders. For example, if a trust owns the stock and distributions are paid directly to beneficiaries, it might cause the Internal Revenue Service not to respect the existence of the trusts.

Moreover, distributions in excess of basis are taxed as capital gains. S corporations having C corporation earnings and profits face additional potential taxes. If paid out of C corporation earnings and profits, excess distributions are taxed at ordinary dividend rates. Passive investment income in excess of 25% of gross receipts is taxed at the highest C corporation tax rate. Continuing the excess for three years can cause the S election to terminate.

Fringe benefits

While shareholders of regular C corporations participate in tax-favored fringe benefits alongside their employees, their counterparts in S corporations are limited. Shareholders owning more than two percent of an S corporation are considered to be self-employed for purposes of many of the rules. They may not participate in certain programs, including cafeteria plans and flexible spending accounts. Other financial benefits, such as medical or education, are deducted by the company and taxed to the shareholder in year-end payroll reporting. The medical insurance portion of compensation is exempt from social security, Medicare, or unemployment taxes. Medical insurance premiums are deductible by shareholders as selfemployed medical expense on their personal income tax returns.

On the other hand, life insurance premiums are fully taxable to shareholders, without a personal tax deduction. There may be good reasons to carry life insurance outside of the business. If it is used to fund corporate buy-sell agreements among shareholders, proceeds from policies that are normally exempt from taxes for beneficiaries may be taxed at maximum rates under transfer of value rules. A separate partnership might be preferred to avoid the issue, while also retaining the benefit of increased equity interest basis brought about by individual surviving owners doing a cross-purchase.

S corporation considerations

Summarized here are the critical aspects of S corporations. Failure to comply with restrictions on ownership, distributions, or passive investment income could result in termination of S status. This means the S corporation reverts to a C corporation, and the benefits, including the single level of taxation, are immediately lost.

Election and ownership

* Electing S status may cause loss of certain tax benefits, including credits and carryovers from previous years.

* A sale may be double-taxed within ten years of making the S election.

* Number of shareholders may not exceed 100.

* Shareholders must be individuals, estates, certain trusts, or certain exempt organizations.

* Shareholders may not be corporations, partnerships, or non-resident aliens. The only exception is 100% ownership by another S corporation.

* Only a single class of stock is allowed, although voting right differences do not constitute separate classes of stock.

Taxation and compliance

* S corporation income flows through to its shareholders, who report their share on their individual income tax returns.

* S corporation losses are deductible only up to the basis in the stock.

* Distributions up to basis are not taxed.

* Shareholder compensation must not be unreasonably low, or distributions unreasonably high.

* Distributions must be proportioned to ownership.

* If entities are shareholders, distributions must be to those entities, not direct to beneficiaries.

* Distributions become taxable if paid in excess of cumulative undistributed income or out of prior C corporation accumulated earnings.

* Passive income must be within limits or risk termination.

2% shareholder fringe benefits

* Shareholders may not participate in certain programs, such as cafeteria plans and flexible spending accounts.

* Medical insurance and most other benefits are deducted by the S corporation as compensation and taxed to shareholders.

* Life insurance premiums are taxed to shareholders without an S corporation deduction.

* Life insurance proceeds from policies held within the S corporation risk taxation at maximum rates under transfer of value rules.

By William H. Wiersema, CPA, EA Contributing Editor