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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.

* An S corporation is limited as an estate-planning tool.

If you anticipate a taxable estate of $600,000 or less, you need not be concerned. But if you have a high net worth in which the value of your closely held business is significant, planning with an S corporation could be a severe handicap. Planners, for example, often use different classes of shares to "freeze" the value of a closely held business. Two common methods -- recapitalization and the use of a holding company -- involve the use of preferred stock, which is not available to the S corporation. Only one class of shares -- common stock -- is allowed.

Consider what that might mean for an S corporation earning $1 million a year, which is likely to be valued at no less than $10 million (using a capitalization factor of 10). Assume that adequate provisions for taxes are made at this value, but the owner dies when profits are $1.3 million. Since the business's value has not been frozen, it would now have to be valued at $13 million for estate purposes. Using an estate-tax rate of 50%, the surprise would be $1.5 million in unplanned taxes.

* An S corporation is limited in its ability to get financing.

While bankers and financiers have always treated the C corporation with admiration and respect, they have treated the S corporation with mild contempt, like an incorporated pocketbook. S corporations have generally found it harder to borrow funds than C corporations, and lenders will usually ask for the personal guarantee of principals.

As for outside financing, the pickings are likely to be equally slim. The principal deterrents to raising capital as an S corporation are rooted in the tax laws:

* Only 35 shareholders are allowed.

* There may be only one class of shares -- common stock.

* No foreign shareholders are allowed.

* No corporate shareholders are allowed.

* Generally, a trust cannot be a shareholder.

* An estate cannot be a shareholder.

* An S corporation cannot have subsidiaries or be a subsidiary of another company.

* S-corporation status is no guarantee that a company will not be taxed.

If you switch from a C corporation to an S corporation and carry over retained earnings, the S corporation will be taxed if it has passive income -- from dividends, rents, royalties, and so on -- in excess of 20% of total income. And if certain assets carried over from the old C corporation are sold prior to the end of the required holding period (five years on machinery, for example, and three years on autos), the investment tax credit claimed in earlier years will be "recaptured" and taxed. In addition, any amounts paid out of accumulated earnings will be treated as nondeductible dividends.

When all things are considered -- the S corporation's marginal level of tax savings (except in the most profitable companies), its limited value as a tax-planning tool, the difficulty of raising loan or equity capital, its diminished value as a tax shelter, and its uselessness as an estate-planning device -- the S corporation may be more of a stumbling block than a stepping stone on the road to wealth and prosperity. Even if yours is a very profitable company with net income in the millions, the potential for tax savings is likely to pale in comparison with the benefits you'll have to forgo. And a very profitable business would be deserving of a level of sophistication in estate planning that would not be possible with an S corporation.

So, if you haven't yet made the switch, but are considering it, think twice. And if you've already made the switch and now find it disadvantageous, consider switching back. You can do so with a minimum of red tape, and IRS approval is not required. But there is one catch: once you switch, you cannot make the change back to an S corporation for a period of five years.


A Comparison

S Corporations C Corporations

Number of shareholders

allowed 35 maximum Unlimited

Classes of shares One (common stock) Unlimited

Fiscal year end December 31 Any month's end

Personal liability Limited Limited

Group plans Severely restricted Unrestricted

Retirement plans Limited Unrestricted under law

Death-benefit exclusion None $5,000

Tax-planning tool Limited Wide range of options

Estate-planning tool Severely limited Excellent, flexible

Financing Very limited Excellent

Taxes Not taxed n1 Taxed n2

n1 Profits and losses are allocated to owners in relationship to their shareholdings.

n2 Transitional rates in effect through July 1, 1987. Afterward, 15% on first $50,000; 25% on next $25,000; 34% on excess over $75,000. Corporations with more than $335,000 in taxable income are taxed at 34% flat rate without the benefit of the lower brackets.

CORRECTION-DATE: September, 1987


"The Trouble with S Corporations" contained several inaccuracies. What follows is the correct information:

Both C corporations and S-corporation shareholders can carry losses backward and forward. Both types of corporations can have estates as shareholders. Both are eligible for the same retirement plans, and neither can sponsor a Keogh plan. A bonus that a C corporation declares to a more than 50% shareholder-employee, or an S corporation to any employee-shareholder, can be deducted only in the year in which the recipient includes the bonus in income. An S corporation can have a subsidiary if it owns less than 80% of the subsidiary's stock. An S-corporation shareholder can deduct losses up to the amount of his combined debt and equity in the company, but that total can't include debt of the corporation that the shareholder has merely guaranteed. When a company with retained earnings switches from C to S status, it will be subject to corporate taxation on passive income if that income exceeds 25% of gross receipts.

Last updated: May 1, 1987

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