Taking The S-corporation Route To Tax Savings

Changes in the tax laws make S corporations an attractive alternative to other forms of organization.

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Subchapter-S corporations aren't what they used to be. In the past two years, congress has substantially changed the laws governing this type of organization. It even renamed them -- "Subchapter S" or "Small Business Corporations" are now officially called S corporations.

The changes in the tax laws make this a good time to reconsider the S corporation as a form of organization. But there is a reason for urgency: 1984's deadline for electing S-corporation status is March 15.

S corporations provide business owners with the same protection as regular corporations, but income is not subject to the corporate tax. The two exceptions to this rule are the tax on passive income and the tax on capital gains. The capital-gains tax applies only to S corporations that haven't been S corporations for the previous three years, unless the S election was made at the company's inception. With S corporations, income flows through the individual's personal tax return -- just as it would if the business were a sole proprietorship or partnership.

For example, suppose a corporation generates taxable income of $500,000 for taxable 1983. The corporate tax on that amount would be $209,750. The tax to an individual in the 50% bracket would total $145,125. That leaves the business owner with $145,125 in profits to pocket. With an S corporation, there is no corporate income tax. The business owner pays the maximum individual income tax -- in this case, $250,000 -- and retains the other $250,000. By operating the company as an S corporation, the business owner takes home $104,875 more than he or she would otherwise.

In this respect, an S corporation is the same as the old Sub S. The absence of a corporate income tax on earnings continues to be its primary selling point. So what is new about it? Losses, capital gains, and credits are treated differently, and there is a hike in the amount of passive income (interest, rents, royalties) an S corporation may receive. There is also an increase in the number of shareholders this type of corporation may have.

Most of these changes came with the passage of the Subchapter S Revision Act of 1982, which simplified the tax treatment for S corporations and eliminated, or considerably relaxed, many of the disadvantages, such as the 20% cap on passive income. The Economic Recovery Tax Act of 1981 (ERTA) and the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) brought changes in S-corporation rules as well. For example, TEFRA increased the amount of money a business owner can plow back in for retirement.

Historically, the owners of Sub-S corporations were treated like sole proprietors and members of partnerships when it came to retirement plans. They could deposit a certain dollar amount in a Keogh or H.R. 10 plan, but that figure was below the amount owners of a regular corporation could set aside in a qualified plan. TEFRA virtually equalized that disparity. Starting January 1, 1984, owners of S corporations may contribute the lesser of 15% of earned income or $30,000 to a qualified profit-sharing plan (twice last year's levels). What is more, that amount will be adjusted for cost-of-living increases beginning in 1986.

Passive-income limits have also been raised or, in some cases, eliminated. That means that more companies can take advantage of this form of organization. Previously, a Sub-S corporation could collect no more than 20% of its annual gross receipts in interest, rents, and royalties. Now, there is no limit on passive income for corporations that had S-corporation status since their inception. There is a limit, however, for companies that have not been S corporations since their formation and that had retained earnings at the time of their election: The Internal Revenue Service can terminate an S corporation's status if passive income exceeds 25% of gross receipts each year for three consecutive years. (Such companies are liable for a tax on the excess amount.) Still, the passive-income limitation is now a minor concern, and few corporations will be ensnared by this trap.

As for the number of shareholders an S corporation is permitted to have, the new ceiling is 35, as opposed to the previous cap of 25. The eligibility rules for shareholders has also been expanded to include certain trusts, although nonresident aliens are still ineligible, as are foreign trusts and other corporations.

The new rules governing the treatment of losses and capital gains are complicated, but not as difficult to follow as they were before passage of the 1982 Act. Traditionally, new businesses likely to realize losses during their early years chose to operate as Sub-S corporations, since the Sub-S form permitted shareholders to deduct such losses currently against their personal incomes. Regular corporations, though, could carry those losses forward to offset income later when the business became profitable. If an S corporation reported a $5,000 loss, the business owner could subtract that amount on his or her individual income tax return.

The catch was that a shareholder couldn't deduct an amount that was greater than his or her "basis in stock and debt," which is figured, basically, by adding the original cost of the stock plus direct loans, plus or minus the earnings or losses of the corporation. Moreover, a deduction not taken in a current year was lost forever. Under the Subchapter S Revision Act, the basis limitation remains for any one taxable year, but there is an unlimited carryover for losses in excess of basis. An excess loss can be deducted in future years when basis exists.

This benefit is more than simply the difference between the top tax rates for individuals (50%) and for corporations (46%). For example, a corporation generates a net operating loss of $100,000 in 1984, and becomes profitable in 1986, with $200,000 in taxable income. Under S-corporation rules, the shareholders can realize an immediate benefit of $50,000 cash; the $46,000 tax benefit to the regular corporation in 1986, discounted at 8%, has a comparable present value of only $39,500. The $50,000 is available to the shareholders now, either to keep or, if necessary, to reinvest in the business.

Other changes in S-corporation rules are geared toward making administratior easier. Before the Subchapter S Revision Act was passed, complicated rules determined at what point the shareholder would be taxed. This created many problems in determining when and how distributions should be made. Keeping track of the layers as they pertained to each shareholder was often an administrative nightmare. To make matters worse, there were different rules for cash and property distributions.

The act eliminated the layering system. Timing no longer determines when a distribution is taxable, unless amounts are distributed in excess of basis. The gain realized on the excess distribution is taxed at capital-gain rates. No differentiation is made between cash and property; however, if appreciated property is distributed, the S corporation recognizes gain as if the property has been sold.

On the negative side, fringe rules have changed, too. Newly electing S corporations are now treated like partnerships and sole proprietorships, meaning that health insurance, disability insurance, and group life insurance are not deductible by the corporation.

Under the old law, many chief executive officers believed they were properly operating as Sub-S corporations, only to be informed by the IRS that their Sub-S status had terminated during the year, due to a technical violation of the Subchapter-S rules. The old law allowed no relief to taxpayers in such cases. If your corporation technically failed to qualify as an S corporation, regardless of intent of the shareholders, it lost its S-corporation status for the entire year in which the termination took place, as well as for five subsequent years.

Under the 1982 act, S-corporation status can still be terminated when a corporation ceases to qualify, but the penalties are less severe. If the S corporation corrects the problem that caused the disqualification within a reasonable time, and both the corporation and all share-holders agree, then the S corporation can continue after the IRS has decided that the termination was inadvertent.

As in the past, an S corporation may not own 80% or more of the stock of any other corporation. What is more, the new rules still permit only one class of stock, but the rule has been liberalized in that neither common stock with different voting rights nor straight debt are considered to constitute a second class of stock.

To elect S-corporation status, an eligible corporation must file Form 2553 with the IRS. On that form, shareholders unanimously consent to the election during the first two months and 15 days of the taxable year, since, in most circumstances, an S corporation is restricted to the use of a calendar year. Any shareholder owning stock during the year prior to the date of the election must also consent to this form of organization.

If you previously terminated a Sub-chapter-S corporation, you can still elect S-corporation status. Under the old law, a five-year waiting period was required. The new law also imposes a five-year waiting period, except where termination occurred under the old law. If you qualify, you can elect S-corporation status for 1984, even if Sub-S status was terminated as late as 1982.

To revoke an S-corporation election, shareholders holding more than half the company's equity must consent. The revocation must be made within the first two months and 15 days of the year to be effective for that year. Otherwise, it will generally be effective for the following tax year. Disqualifications, such as issuing stock to an ineligible shareholder, can effectively terminate the election by splitting the year in two parts: For half the year the company is treated as an S corporation, for the other half it is treated as a regular corporation.

Before deciding to choose an S corporation as your form of business, consult a tax attorney or accountant. In particular, ask if your state recognizes S corporations. Some states treat S corporations like regular corporations, which means that your company would be exempt from the federal corporate income tax but not the state income tax.