Personal liability protection: One advantage of forming an S corporation is the shield from personal liability offered to its shareholders. As opposed to entities like sole a proprietorship or general partnerships, the S corporation limits an individual’s personal liability with respect to the business. Similar to LLCs and LLPs, an S corporation’s shareholders are generally not liable for the corporation’s debts merely because of their ownership interest in the corporation.
Simplified tax accounting: Another advantage of forming an S corporation in lieu of a partnership or an LLC electing to be treated as a partnership is that the tax accounting is generally easier for an S corporation. Partnerships require that a separate set of bookkeeping records be kept in addition to the regular books kept for tax accounting, while S corporations do not require such additional records.
Pass-through entity status: The Tax Reform Act of 1986 (Publication 99-514) made the S corporation an appealing option for doing business. The 1986 Tax Reform Act limited the ability of C corporations to escape from double taxation. Further, individual income tax rates became lower than corporate income tax rates, thus making the S corporation’s status as a pass-through entity more appealing. While legislative changes since 1986 have affected some of the benefits of forming and operating an S corporation (for instance, the top marginal tax rates for individuals have risen since then), the S corporation is still an attractive entity choice for closely held businesses.
A major benefit of forming an S corporation is its pass through entity status. The most important benefit of pass through entity status is the ability to avoid double taxation (i.e., income tax imposed on both corporate profits at the corporate level and again at the individual shareholder level on the distribution of profits as dividends) (Code Section 301(c)(1)). If a valid S corporation election is in effect for an entire year, the S corporation is generally not subject to income taxes (Code Section 1363).
As a pass-through entity, all profits and losses of the business pass to the corporation’s shareholders (Code Section 1366(a)(1)(A), (B)). All undistributed income increases the shareholder’s basis in the shareholder’s interest in the corporation (Code Section 1367(a)(1)(A), (B), (C)). This increase in basis decreases future gains when the shareholder sells stock. A shareholder’s basis in stock is decreased by losses, deductions and non-deductible expenses which do not constitute distributions (Code Section 1367(a)(2)). There is a special rule under Code Section 1367(a)(2)(B) for charitable stock donations. Income, losses, deductions and gains are allocated to shareholders on a per day basis proportionate to the number of shares owned by each shareholder (Code Section 1377(a)(1)(A)).
S corporations with no accumulated earnings and profits can make tax-free distributions to shareholders to the extent that the distributions do not exceed the shareholder’s basis in their stock (Code Section 1368(b)(1)). If the distribution exceeds the shareholder’s stock basis, it is considered a gain from the sale of the asset (Code Section 1368(b)(2)). If the S corporation has accumulated earnings and profits and makes distributions to its shareholders, such distributions are treated as dividends, and any amounts over the accumulated earnings and profits are treated as a recovery of basis and then as gain from the sale of property (Code Section 1368(c)(2), (3)).
Tax Tip Example:
To illustrate the tax benefit offered by an S corporation as opposed to a C corporation, assume the combined federal and state corporate income tax rate is 40% and the federal and state individual income tax rate is 38% and pre-tax income is $1,000,000. In the case of a C corporation, the corporation pays $400,000 in corporate federal and state income tax which leaves it $600,000 to distribute to shareholders who then pay $228,000 ($600,000 x 38%) in federal and state income taxes. The net amount available after tax is $372,000. With the S corporation, there is no federal and state (generally) income tax on the $1,000,000. The shareholders pay $380,000 in federal and state income tax. The net amount available after tax is $620,000 compared to the $372,000 that is available for the C corporation. While this example is simple, it illustrates the substantial tax savings that could result from avoiding double taxation.
There are three situations where an S corporation could pay federal tax:
- One occasion occurs when the S corporation has earnings and profits from a pre-S election year and also has excess passive investment income (Code Section 1375).
- An S corporation is also subject to double taxation if it has net recognized built-in gains within a specified number of years of making the election to be an S corporation after previously being a C corporation (Code. Section 1374(a)). Note, however, that Code Section 1374(c)(1) limits this general rule by providing that Code Section 1374(a) does not apply when the corporation has always held S corporation status.
- A third instance of double taxation occurs if the S corporation was previously a C corporation and inventoried goods under the LIFO method for its last C corporation year (Code Section 1363(d)).
Self-employment tax savings: One characteristic that makes the S corporation a very popular entity among investors is that S corporation allocations of income are not subject to self-employment taxes. Self-employment tax is imposed on every individual’s self-employment income at certain prescribed rates (Code Section 1401(a)).
Individual general partners in a partnership must pay self-employment tax on their distributive share of partnership income (Code Section 1402(a)). An S corporation and its shareholders are not subject to self-employment taxes even though the S corporation is a pass-through entity. Similarly, dividends on S stock are also excluded from self-employment tax (Code Section 1402(a)(2)). However, on the flip side, the IRS requires S shareholders to take a reasonable salary from the S corporation. These amounts are subject to employment taxes on both the corporation and the individual.
Disadvantages of S Corporations: Income tax return filing: Filing the S corporation income tax return is more complicated than that of a sole proprietorship or C corporation. Further, the corporation’s income or losses are divided among and passed through to its shareholders, who must then report the income or loss on the shareholder’s own tax return.
Ownership restrictions: Another disadvantage of an S corporation is that ownership restrictions apply. In an S corporation, all shareholders must be U.S. citizens or permanent residents. All shareholders must be individuals (though certain trusts and estates and charitable organizations may qualify as shareholders of an S corporation. Further, in an S corporation the number of owners is limited to 100 persons. Note that families can often be counted as a single shareholder for purposes of the 100 shareholder limit. (Code Section 1361(a)(1)(A); Code Section 1361(c)). In comparison, there is no restriction on the number of partners or nationality of the partners in a partnership or members in an LLC. A sole proprietor need not be a U.S. citizen or permanent resident.
More complicated election and revocation: Electing S corporation status is a little more complicated than organizing an entity as a partnership, corporation, or sole proprietorship. In order for an S election to be effective, certain formalities must be followed. The date the S election is made affects the tax year for which the election is effective. A corporation may subsequently revoke an S election if certain conditions are met. Similar to the election of S status, the timing of a revocation and the rescission of a revocation determines when the revocation is effective.
Corporate reorganization: S corporations are subject to the rules of subchapter C upon the reorganization of the entity (Code Section 368). If the S corporation survives reorganization in a Type A reorganization, all income, losses, deductions or credits are allocated on a per-share, per-day basis to shareholders (Code Secs. 368(a)(1)(A), 1377(a)(1)). If involved in a Type B reorganization, once the S corporation stock is traded solely for C corporation stock, the S corporation loses its S corporation status (Code 368(a)(1)(B)). In a Type C reorganization, S corporation status is lost upon the acquisition of the entity’s assets in exchange for C corporation voting stock (Code Section 368(a)(1)(C)).
Costly termination when appreciated property is involved
An S corporation may terminate in three situations:
(1) The S election is voluntarily revoked;
(2) S status terminates through failure to meet the eligibility requirements; or
(3) The corporation has passive investment income in excess of 25 percent of gross receipts for three consecutive tax years and has subchapter C earnings and profits.
Upon the liquidation of an S corporation, gain or loss is recognized at the corporate level on appreciated property, as if such property were sold at its fair market value (Code Section 336(a)). If the property distributed is subject to liability, the fair market value of that property is treated as not less than the amount of the liability (Code Section 336(b)). Thus, when an S corporation liquidates, the corporation distributes property to its shareholders. If a particular item of property has a fair market value in excess of its depreciated cost, the difference between the fair market value and the depreciated cost is recognized as either a gain or loss.
Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.
DON FITCH, CPA
74478 Highway 111 #3
Palm Desert, CA 92260
Toll Free: (877)CPA-Help or (877)272-4357
P.S. My firm is based upon referrals. Please feel free to refer my firm to anyone you know that is looking for a new CPA and/or tax preparer. Thank you in advance.
(Updated 03/03/2021 15:36)