Protecting Subchapter S Status
Back in 1990 Dallas-based Hatfield & Co., a wholesale distributor of industrial valves, decided to reorganize itself from standard C-corporation status into a Subchapter S corporation. It's a decision that makes sense for many closely held businesses, since their profits are taxed twice when they're organized as C corporations: first at the corporate level and then when distributed at the individual level. As an S corporation, a company avoids having to pay corporate tax.
Unfortunately, George Boles, Hatfield's chief financial officer, soon realized the switch had left him to cope with one of the murkiest and most volatile aspects of the tax code. "I'm a CPA, but I've got to admit that just staying in compliance with all the tax changes that have taken place since the 1980s has been a real nightmare," he says. "The Subchapter S rules have got to be some of the toughest of all."
The challenge with Subchapter S is to make sure your company doesn't engage in financial behavior that disqualifies it from S-corporation, or single-taxation, status. As Boles explains, "There are all kinds of regulations I've got to stay on top of. For example, S corporations cannot expense health insurance the way C corporations can -- and if we did it by mistake, the IRS could argue we'd made an unauthorized distribution to our shareholders. We'd lose our Subchapter S status and be liable to tax assessments and maybe some penalties as well."
Another rule to beware of: when corporations switch status, as Hatfield & Co. did, their assets must be assessed at fair market value. "If your corporation then disposes of what the IRS considers to be too many of those original assets over the next 10-year period, you run the risk of being taxed like a C corporation on the proceeds of the sales."
Perhaps worst of all, over the last year CFOs and CEOs of S corporations have been forced to grapple with tremendous uncertainty as the IRS and the accounting profession have debated proposals to make regulations even tighter. Boles reports, "There's been a proposal out that anytime a shareholder receives any income distribution larger than other shareholders' -- perhaps even in the form of minor differences in fringe benefits -- the IRS could disqualify the company from Subchapter S status because it would argue the firm really had two classes of shareholders" -- another no-no under existing rules.
How does Boles navigate the company's course through this mine field? Besides taking 40 hours of continuing education -- something he's required to do as a CPA -- he also subscribes to the "Commerce Clearing House Weekly Tax Alert" newsletter (202-626-2200; $60 annually) to stay abreast of even the slightest hint of change. He recommends both to internal staffers of any Subchapter S corporation. "You can't depend upon your outside CPA to watch everything you do," says Boles.
"The tax benefits to our company from having made this switch certainly outweigh the regulatory problems that have resulted," he says. "The drawback is, I do have to spend a fair amount of time now monitoring the tax implications of all our financial decisions." -- Jill Andresky Fraser* * *