1. Comparing an S Corporation and C Corporation.
  1. Introduction.
  1. Deciding whether to have a corporation make the S corporation election primarily involves weighing the tax advantages and nontax disadvantages of the S corporation election. Whether the advantages will outweigh the disadvantages depends on several factors, including whether the corporation will operate at a profit or loss in the first years for which the election is to be effective, the amount, if any, of estimated corporate income, the amount of salaries to be paid to shareholder employees, the percentage of income to be retained in the corporation's business, tax brackets of the shareholders, and limitations on fringe benefits paid on behalf of shareholder-employees.
  1. Deciding whether a corporation and its shareholders will benefit if the corporation makes the election requires a careful weighing of all the factors. In most situations, no single factor will be decisive.
  1. Deciding whether to make the election also involves projecting what the income of the corporation and its shareholders will be over a period of years. Care must be taken to make sure that projections are as accurate as is reasonably possible.
  1. The TRA 1986 repealed the General Utilities doctrine and implemented a new tax upon certain built-in gains of former C corporations which have appreciated assets on the effective date of their post-TRA 1986 S corporation elections. These changes require great deliberation in deciding whether to operate in the corporate form since once chosen, it is now much more costly to change again to a non-corporate form of doing business.
  1. The Revenue Reconciliation Act of 1993 once again changed the rate for individuals and corporations. The maximum marginal rates for corporations are once again lower than the maximum marginal rate for individuals.
  1. Major Benefits vs. C Corporation.
  1. Ordinary Losses - A C corporation may deduct net operating loss only to the extent of its taxable income during three-year carryback period and the fifteen year carryforward period. In contrast, losses of an S corporation pass through to its shareholders and generally are deductible by them to the extent of their basis in stock and debt of the corporation.
  1. Capital Losses - A C corporation may deduct capital losses only to the extent of its capital gains. Excess losses are subject to a three-year carryback and a five-year carryforward.
  1. If a C corporation incurs a significant capital loss that it cannot deduct either currently or as a carryback, an S election resulting in a pass through of the loss to shareholders may provide them with the following benefits:
  1. Use of the loss to offset capital gains otherwise taxable;
  1. Use of the loss to offset up to an additional $3,000 of ordinary income;
  1. An indefinite carryover of the loss.
  1. Credits - Because credits reduce tax liability rather than taxable income, they ordinarily result in the same tax savings whether utilized at the corporate or shareholder level. Moreover, the applicable tax liability limitation and carryover period for the general business credit are generally the same for both corporate and non-corporate taxpayers.
    1. Nevertheless, an S election may be desirable if it accelerates the utilization of the credit. This may occur, for example, if the corporation has insufficient current tax liability to obtain a current tax benefit from the credit, whereas the shareholder has enough tax liability to use the credit more quickly.
  1. If the shareholder is subject to the AMT, current use of the credit by the shareholder may be restricted even if the shareholder has a substantial regular tax liability.
  1. Income Tax Savings.
  1. A major disadvantage of a C corporation is the potential for double taxation of its earnings: once through the corporation and again when distributed to shareholders as dividends. This double taxation problem can result in an effective tax rate of up to 60.74% on corporate income.
  1. An S corporation eliminates this double taxation problem (except on recognized built-in gains and certain excess passive income) by taxing the corporate income only once at the shareholder level, thus limiting the maximum effective tax rate on corporate income to the shareholder's marginal rate (38.6% beginning in 2002). Thus, if distributions represent a relatively large percentage of earnings, then an S election can result in a large overall tax savings.
  1. Accumulated Earnings Tax.
  1. A C corporation may be subject to a penalty tax if it accumulates earnings beyond its reasonable business needs. If applicable, the tax is 38.6% on accumulated taxable income.
  1. An S corporation, in contrast, is not subject to the accumulated earnings tax. Thus, an S election may be desirable, for example, if a corporation plans to retain its earnings beyond the minimum accumulated earnings credit ($250,000 for most corporations) or its reasonable business needs.
  1. Tax Exempt Income - Tax exempt interest is not taxable to a C corporation but nevertheless increases its earnings and profits. Thus, upon distribution, the interest may be taxed to the distributee shareholder as a dividend.
  1. In contrast, if an S election is made, the interest retains its tax exempt status when passed through to the corporation's shareholders and generally may be distributed tax-free to them.
  1. Note, however, that if the corporation has sub-C earnings and profits, the tax-exempt interest may effectively be taxed to the S corporation under § 1375 or taxed as a dividend to the shareholders upon distribution.
  1. Alternative Minimum Tax - For tax years beginning after 1986, C corporations are subject to the alternative minimum tax and the environmental tax. In addition, a C corporation's alternative minimum taxable income is increased by 75% of the excess of adjusted current earnings over AMTI. The ACE adjustment also results in a C corporation paying a tax at the rate of 15% on its tax exempt income.
  1. In contrast, an S corporation is not subject to either the AMT or the environmental tax. Moreover, the S corporation does not compute the book income adjustment and therefore does not pass through this adjustment to shareholders in computing their individual AMT liabilities.
  2. Thus, if a C corporation is subject to the AMT, considerable tax savings are possible by electing S status even if the pass through of the corporation's preferences and adjustments subject the shareholders to the AMT.
  1. Other Factors.
  1. S corporations are not precluded from using the cash method of accounting. In contrast, most C corporations with three-year average annual gross receipts exceeding $5 million may not use the cash method, except for certain qualified personal service corporations.
  1. An S election may be desirable if the corporation can reasonably anticipate a future IRS audit regarding the reasonableness of compensation paid to one or more shareholders/employees. Reasonable compensation may still be an issue, however, if:
  1. The corporation has accumulated earnings and profits and the disallowance would result in the deemed distribution exceeding the accumulated adjustments account.
  1. The state does not recognize S status.
  1. The disallowance would increase taxable income, thus increasing the amount of excess net passive income subject to tax under § 1375.
  1. The disallowance would affect the amount of deductible contributions to a qualified retirement plan.
  1. An S election will exempt a corporation from the personal holding company tax.
  1. NOL and other carryovers from a C corporation year will be captured at the corporate level and may expire unused as long as the S election is in effect. The NOL and general business carryforwards from a C corporation may only be used to offset the built-in gains tax.
  1. Tax Factors Discouraging Election.
  1. Built-in Gains Tax - The built-in gains tax may be considered to exact a toll charge for electing S status.
  1. For example, most electing corporations will incur costs to obtain a qualified appraisal of their assets as of the conversion date to S status.
  1. Moreover, any recognized built-in gains taxed at the corporate level will immediately pass through (net of the corporate level tax) and be subject to tax again at the shareholder level. In contrast, such gain recognized by a C corporation would merely increase earnings and profits and would not be taxed again until such earnings and profits were distributed to the shareholders.
  1. In addition, a greater administrative burden will be placed on the S corporation which will have to maintain detailed records of asset dispositions for purposes of § 1374.
  1. Dividend Income - An S election may not be desirable if the corporation derives a substantial portion of its income from dividends received from domestic corporations.
  1. Under § 243(a)(1), a C corporation may deduct 70% of the dividends in computing taxable income. However, the corporation's earnings and profits are increased by the full amount of dividends and thus may be fully taxed when the income is distributed to shareholders.
  1. In contrast, since an S corporation's income is computed in the same manner as an individual, the dividends received deduction is not allowed. Thus, the dividends pass through to shareholders and are fully taxable on their individual returns.
  1. Section 1202 Exclusion - The disposition of stock in an S corporation does not qualify for the 50% exclusion under § 1202. Section 1202 excludes from gross income 50% of the gain (up to certain limits) from the sale or exchange of qualified business stock held for more than five years by taxpayers other than C corporations. Qualified business stock is defined in § 1202(c)(1) as stock in a C corporation originally issued after August 10, 1993, if the corporation is a qualified small business as of the date of issuance, and the stock is acquired by the taxpayer at original issue (with certain exceptions) for money, property, or as compensation for services (except for services as an underwriter). In addition, § 1202(c)(2) provides that the corporation must meet the active business requirements of § 1202(e) during substantially all of the taxpayer's holding period of the stock.
  1. In general, a qualified small business is a domestic C corporation whose aggregate gross assets at all times on or after August 10, 1993, and before the stock issuance did not exceed $50,000,000, and whose aggregate gross assets immediately after the stock issuance did not exceed that amount (§ 1202(d)(1)).
  1. The active business requirements of § 1202(e) are met if the corporation uses at least 80% of the value of its assets in the active conduct of at least one qualified trade or business and the corporation is an eligible corporation (§ 1202(e)(1)). The term "qualified trade or business" is defined negatively in § 1202(e)(3) as any trade or business other than: (1) a trade or business involving the performance of services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services; (2) any banking, insurance, financing, or investing business; (3) any farming business; (4) any business involving the production or extraction of oil, gas, and other natural deposits; and (5) any business of operating a hotel, motel, or restaurant. Under § 1202(e)(5), however, a corporation generally does not meet the active business requirement for any period during which more than 10% of the value of its assets (in excess of liabilities) consists of stock or securities in other corporations (unless they are more than 50% owned subsidiaries). Further, under § 1202(e)(7), the active business requirement is not met for any period during which more than 10% of the total value of its assets consists of real property that is not used in the active conduct of a qualified trade or business; owning, dealing in, or renting real property is not treated as the active conduct of a qualified trade or business. A corporation is an eligible corporation if it is a domestic corporation and is not: (1) a DISC or former DISC; (2) a corporation with respect to which a § 936 election is not in effect for the corporation or its subsidiaries; or a RIC, REIT or REMIC; or (3) a cooperative (§ 1202(e)(4)).
  1. The active business requirements are automatically satisfied if the corporation qualifies as a small business investment company, i.e., it is an eligible corporation, as defined in § 1202(e)(4), and is licensed to operate under § 301(d) of the Small Business Investment Act of 1958 (as in effect on May 13, 1993) (§ 1202(c)(2)(B)).
  1. The amount of a taxpayer's gain eligible for the exclusion is limited by § 1202(b), which provides in part that the aggregate amount of the gain from the disposition of stock of one corporation that may be taken into account under § 1202(a) is limited to the greater of: (1) $10,000,000 reduced by the aggregate amount of eligible gain taken into account by the taxpayer in earlier years and attributable to dispositions of stock issued by the same corporation; or (2) ten times the aggregate adjusted basis (without regard to any additions after the date of issuance) of qualified business stock issued by that corporation and disposed of by the taxpayer during that taxable year.
  1. Rollover of Gain Under § 1044 and § 1045 - A shareholder of an S corporation will normally not be eligible to use § 1044 and § 1045 to avoid the gain on disposition of its shares of stock.
  1. Section 1044 allows any individual or C corporation to elect to avoid current recognition of capital gain on the sale of publicly traded securities by rolling over the proceeds into common stock of, or a partnership interest in, a specialized small business investment company within sixty days of the sale. Separate limitations on the amount of capital gain eligible for nonrecognition apply to individuals and C corporations. In the case of an individual, the amount of gain which may be excluded cannot exceed the lesser of (1) $50,000 or (2) $500,000, reduced by the amount of gain previously excluded for all preceding taxable years (§ 1044(b)(1)). In the case of a C corporation, the amount of gain which may be excluded for any taxable year cannot exceed the lesser of (1) $250,000 or (2) $1,000,000, reduced by the amount of gain previously excluded for all preceding taxable years (§ 1044(b)(2)).
  1. Under § 1045, an individual is allowed to rollover tax free gain from the sale or exchange of qualified small business stock (as defined in § 1202) held for more than six months where the taxpayer uses the proceeds to purchase other qualified small business stock within 60 days of the sale (§ 1045(a)). For purposes of the rollover provisions, the replacement stock must meet the active business requirement for the six-month period following the purchase (§ 1045(a)(4)(B)). Generally, the holding period of the stock purchased will include the holding period of the stock sold, except for purposes of determining whether the six-month holding period is met.
  1. If gain from any sale is not recognized because of the rollover election, that gain is applied (in the order acquired) against the basis for determining gain or loss on any qualified business stock which is purchased by the taxpayer during the 60-day period beginning on the date of the sale (§ 1045(b)(3)).
  1. Section 1045 is effective for sales or exchanges occurring after August 5, 1997.
  1. Since the definition of qualified small business stock for purposes of § 1045 has the same definition as provided in § 1202, stock in an S corporation is not eligible for the elective rollover provisions of § 1045.
  1. Other Factors.
  1. An S corporation may not provide tax-free fringe benefits to shareholders owning more than 2% of the corporation stock (See Rev. Rul. 91-26, 1991-1 C.B. 184, which provides that fringe benefits paid on behalf of a shareholder-employee of an S corporation are treated as additional compensation).
  1. The corporation's choice of taxable years may be restricted.
  1. The shareholders' estate planning opportunities may be limited.
  1. Since not all states recognize an S election for state tax purposes, the corporation may continue to be subject to state taxes.
  1. Given the various eligibility requirements, the corporation's S status will require continuous attention to ensure the election is not unintentionally lost.
  1. The ability of some corporations to use passive losses and credits to offset active business income will be lost.