The Trouble With S Corporations

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* 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.

S CORPORATIONS AND C CORPORATIONS

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

CORRECTION:

"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.

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