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Tax Reductions and Control Objectives
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The S Corporation has attributes that make it a viable alternative for any closely held corporation.
Electing S corporation treatment for a corporation is usually most favorable in these types of situations:
Where it is expected that the corporation will experience losses for the initial year or years of doing business and where the shareholders will
have income from other sources that the "passed through" losses can shelter from tax. If S Corporation losses are passive losses — such as losses from real estate investments — they can only be used to offset other passive activity income, except for certain shareholders who are real estate professionals.Where, because of the low tax brackets the shareholders are in, there
will be tax savings if the anticipated profits of the corporation are passed through to them rather than being taxed at corporate tax rates.Where the nature of the corporation’s business is such that the corpora
tion does not need to retain a major portion of profits in the business. In this case, all or most of the profits can be distributed as dividends without the double taxation that would occur if no S corporation election were in effect.Where a corporation is in danger of incurring an accumulated earnings penalty tax for failure to pay out its profits as dividends.
It will often be advantageous for your corporation to operate as an S corporation in its early years, when losses can be passed through to shareholders, or when income is not so great as to push the shareholders into higher tax brackets. Also, the nontax advantage of being incorporated and protected from personal liability if the business fails is generally most important during the early years of operation, when the risk of failure is highest.
Many businesses initially start as S Corporation, obtaining the advantage of limited liability while being taxed much like an unincorporated business. Later, when or if the profit from the business becomes very substantial, the S Corporation election can be terminated, and the C Corporation can be used to split income between the corporation and its stockholder/employees.
While there
are some significant advantages to operating as an S corporation, the S Corporation election is frequently not advisable under some circumstances. Some of the possible disadvantages of operating your business in the form of an S corporation are:The change to S Corporation status may eventually result in a large corporate-level tax on built-in gains or an immediate last in, first out (LIFO) recapture tax.
The tax law regarding S corporations is very complex and you should expect to pay substantial additional legal or accounting fees to your tax adviser, compared to what would be necessary with a regular corporation.
S corporations are now treated almost exactly like regular corporations with respect to pension and profit-sharing plans. One important difference remains; any employee who owns 5% or more of the stock and participates in the S Corporation's pension or profit sharing plan is prohibited from borrowing from the plan, unlike a participant in a regular corporation's retirement plan.
Certain built in gains of an S Corporation (which is converted from a C Corporation) may be taxed to the corporation and the shareholder for federal tax purposes.
Fringe benefit payments for medical, disability, and group term life insurance for 2% shareholders are deductible, to the corporation, but are taxable to the shareholder/employee.
Unlike many regular corporations, very few newly electing S Corporations may now have a fiscal year that ends earlier than September.
The dividends a shareholder receives are exempt from the FICA, SECA and other payroll tax computations. This will give a benefit by reducing payroll taxes for non-wage payments to shareholders. It is emphasized that to forego all salary when a person is performing services will make the Internal Revenue Service question and challenge the treatment and place you in a vulnerable tax position.
Dangers of C Corporation can come from the fact that dividend paid or deemed as paid are not tax deductible. There may be times when the Internal Revenue Service challenges a payment to a shareholder. The payment may have been treated on the corporate books as an ordinary business expense. The Internal Revenue Service may challenge the business purpose test and take a contrary position that it was an expense of the shareholder not the corporation. The worst case scenario would be that in a C Corporation the Internal Revenue Service challenge being successful would deem the payment to the shareholder as a dividend. None of the payment(s) would be deductible, nor the deemed dividend deductible and the shareholder would face the expenses as income on his or personal tax return.
Rules and regulations for maintaining the S Corporation election are complex. The Internal Revenue Service may challenge the election at any time. In addition, any action, lack of action, or event can occur which might terminate the S election. Terminations can be caused inadvertently or intentionally. Terminations are not always controllable by all parties involved. A challenge by the Internal Revenue Service to disallow the S Corporation election, if successful, will impact both the corporation's tax position and the investors' and shareholders tax positions and related tax returns for both federal and state purposes. The result of such a change cannot be projected and is not determinable.