Does an S Corp Still Make Sense?
Should you convert from an S corporation to a C corporation or vice versa?
January 28, 2010
With all the talk of impending individual and corporate tax rate changes, existing corporate entity structures should be carefully re-evaluated. During uncertain times like the present, the future treatment of corporate structures might deviate greatly from past results. S corporations served a great purpose with individual tax rates being lower than corporate tax rates. This tax situation may soon change. Without a crystal ball, however, it’s impossible to accurately predict where future legislation will bring us.
Convert C to S?
An important consideration in this decision revolves around the individual income tax rates. President Obama has frequently discussed increasing the highest individual tax rate to 39.6 percent as well as increasing the tax rate on qualified dividends to 20 percent. These changes would certainly make the S corporation less attractive, as long as corporate tax rates did not increase. As a C corporation, taxable income of $100,000 generates an entity level tax of $22,250. This same income passed through to an S corporation shareholder in the highest tax bracket incurs a tax of $39,600. As long as the C corporation does not pay dividends or liquidate, no double taxation occurs. Even with taxable income of up to $10 million, the average corporate tax rate is a “reasonable” 34 percent. A five-percent savings at that level could be a strong influence in the decision, if all other factors are equal.
S corporation status imposes many restrictions and limitations. A domestic corporation can have no more than 100 shareholders, who must be U.S. citizens, resident aliens, estates or certain types of trusts and tax-exempt entities. Noncompliance with these restrictions could invalidate the S election.
Some of the negatives of S corporations may remain, regardless of the direction of corporate and individual tax rates. As the law stands now, the built in gains tax alone could be enough of a deterrent to making the switch to S corporation status. A former C corporation may incur a corporate level tax after electing S status by disposing of appreciated assets consisting of gain attributable to the period after the S election is made. At a 35-percent tax rate, this built-in gain obstacle may be hard to counteract.
When Would The Switch From C to S Make Sense?
Clearly, in the case of anticipated losses for an extended period of time, an S corporation provides an advantage. If there were no built-in gains looming ahead, the future benefits of an S corporation should be carefully considered. With so many unknowns, this analysis may prove to be too difficult to finalize with any degree of certainty. If a C corporation intends to pay significant dividends or liquidate in the immediate future, a switch may make sense.
What About S to C?
With all the potentially negative reasons cited above for S corporations, you might think this is a good time to revoke the S election. However, the threat of double taxation of distributions from the C corporation, regardless of the tax rates, still imposes sufficient hesitation to change status. This double taxation can occur if the corporation sells appreciate assets and then distributes the proceeds to the shareholder as a dividend. The dividend is taxable income to the shareholder and is not a deduction to the corporation. Double taxation could also occur if the corporation retains too much of its profits and becomes subject to the accumulated earnings tax, which is imposed on top of the corporate income tax, adding an additional 15 percent tax to the corporate tax burden.
Not being able to pass losses through to the shareholder is also a negative aspect of the C corporation. The losses remain with the corporation, if and until, the corporation has profits against which the losses may be used.
If an S election is revoked, the new C corporation cannot switch back to an S corporation for five years. This restriction emphasizes the importance of careful deliberation prior to making a change in corporate structure.
When all factors are considered, it appears that there are not strong enough reasons to support a switch in either direction at this time. In unusual circumstances, the decision to change status under the right terms can be justified, but with the direction of tax rates still unknown, a switch could carry serious tax implications. Without a compelling reason to change, the best course may be status quo.
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Mary F. Bernard, CPA, is a tax principal and director of state and local tax services at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI.