The Trouble With S Corporations
In the mad rush to switch to S-corporation status, a lot of company owners overlooked the pitfalls. Fortunately, it's not too late to switch back
In their effort to help businesses uncover loopholes in the Tax Reform Act of 1986, financial journalists, accountants, and attorneys have been touting the S corporation as a place to start, based on a single aspect of the tax law, the differential between individual and corporate tax rates. At first blush, it seems smart to pursue any trick that promises to cut taxes. And the highest individual rate of 28%, effective for taxable years after 1987 and applicable to S-corporation stockholders, is lower than the highest rate of 34% for regular corporate taxable income. (For 1987, transitional rules are in effect, with the highest individual rate set at 38.5% and the highest blended corporate rate at 40% for corporations reporting on a calendar-year basis.) The problem is that an S corporation is not necessarily taxed at a lower rate than a conventional corporation. And where the S corporation would indeed produce lower taxes, the same savings can often be achieved by other means and without sacrificing the other advantages of the C corporation.
My own belief is that the S corporation is not the answer for a vast majority of companies, and that a switch could have serious consequences for an established corporation. Let me explain.
* The value of the S corporation as a tax-sheltering device has been diminished by the Tax Reform Act of 1986. And, depending upon how corporate profits are to be used, S-corporation taxes may be higher than they would be for the same company taxed as a C corporation.
The S corporation differs from the C corporation in only two material respects. With an S corporation, profits, whether paid out or retained, are allocated to the owners in relationship to their stock holdings and are taxed at the personal rate. With a C corporation, double taxation occurs when profits are taxed at the corporate level and then again at the personal level when distributed as dividends. Unlike the C corporation, which can use its losses only to offset corporate profits, S-corporation losses flow through to the owners and can offset personal income from other sources.
But because of the change in the personal tax rate, losses are worth a maximum of only 28? on the dollar (38.5? in 1987), compared with 70? a decade ago and 50? last year. Then, too, deductible losses are limited to what you have at risk. What the Internal Revenue Service considers to be at risk is only what you've invested plus any corporate debts you've personally guaranteed. As a result, some of the benefit can be lost forever. That's because S-corporation lossesd can be used only in the year incurred, while C corporations carry losses backward or forward to affect corporate profits.
Perhaps more important for those considering a switch to S-corporation status is the fact that corporate taxes are lower than individual taxes on the first $200,000 of taxable income. While the individual rates, in contrast, begin at 15% and jump to 28% at $29,750 on a joint return ($17,850 for unmarried taxpayers), corporate tax rates are a flat 15% on the first $50,000 of taxable income and only 25% on the next $25,000. The maximum rate of 34% does not take effect until net profits exceed $75,000.
If we assume that profits are going to be retained in the company to finance growth -- and not passed on to shareholders, which could result in double taxation -- then a case must be made for the conventional corporation, at least for taxable income up to the $200,000 threshold. (Even with income up to $1 million, the S advantage may not be significant since in practice, conventional-corporation managers could decide that some portion of the profits should be retained for working capital, which would eliminate the double tax on that portion. Then they would likely pay out much of the balance as compensation -- in bonuses, pensions, or additional benefits. Only the remainder would be paid as dividends and be subject to the double tax.) Under the transitional rules in effect for 1987, the threshold is even higher, about $500,000. And when state taxes are taken into account -- several states do not recognize S-corporation status for tax purposes -- the threshold could be higher still.
* An S corporation is limited as a vehicle through which owners can enjoy tax-favored benefits.
The only retirement plans available to most S-corporation shareholders are the popular Individual Retirement Account, the low-cost Simplified Employee Pension Plan, and the Keogh Plan. In contrast, owners of conventional corporations have a wide range of choices, including pension and profit-sharing plans and employee stock ownership plans. Further, many group benefits, such as medical-expense reimbursement, group medical, group life insurance, and the $5,000 death-benefit exclusion are generally not available to S-corporation shareholders.
And, finally, the S-corporation shareholder is denied such other important benefits as the use of company stock for charitable purposes, deferred taxes on business income, and the use of deferred compensation, except for the 401(k) plan made available by the 1986 tax act.
* An S corporation is limited as a tax-planning device.
The S corporation exposes all company profits to current taxation, even if no cash is paid out. In contrast, the C corporation is one of the best devices for deferring taxes and sheltering personal income. As noted above, the S corporation offers shareholders a limited number of retirement benefits; the C corporation offers a plethora, from income-deferral plans to the deduction for closely held shares donated to qualified charities.
In addition, the S corporation must use the calendar year, except under special circumstances and with IRS approval; the C corporation usually has a choice of taxable years. This fact in itself makes the C corporation a tool for shifting income between periods and between the company and its owners. Take a C corporation with a fiscal year ending October 31 and pretax profits of $50,000. By declaring a bonus this year that is payable, say, on January 7, 1988, the corporation can claim a deduction for the payment in this fiscal year while the benefit will not be taxed to the owners until they file their 1988 income tax returns, due on April 15, 1989. In the S corporation, this sum would be taxable to the owners for 1987 and as such would be included in their 1987 returns.
