Blackman on Taxes


 

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To Be or Not to Be an S CorporationThat is the Question

Thursday, September 01, 2011
 

Are you a closely held business that operates as a C corporation? If so, this is must reading. If you are an S corporation, chances are you will learn one or more tax tricks here to enrich you or your family, rather than the IRS.

To start, burn this into your mind. There are only three good reasons to be a C corporation:

1) Your taxable profits are, and are likely to remain, under about $125,000, and you need the after-tax dollars in the corporation to maintain growth or pay down debt;

2) You use the C corporation as a vehicle to gain the benefit of deducting your health insurance or long-term care premiums;

3) You have carry-forward losses or other tax credits that would be lost if you make an S election.

Here’s a list of the pros and cons of staying a C corporation or electing S corporation status (Note: nine of 10 corporations enjoy tax advantages by being an S corporation.)

Why you may not want to be an S corporation:

1) Probably would pay more income tax in current year as an S corporation. C corporations only pay 15 percent in income tax on the first $50,000 of net profit, and 25 percent on the next $25,000. But remember, when you’re ready to retrieve those after-tax dollars out of your C corporation, you will be double-taxed. And, consider the top individual rate and the C corporation rate are currently the same—35 percent.

2) Health-insurance premiums for shareholder/employees and their families are not fully deductible.

3) Long-term care premiums for shareholder/employees and their families are not fully deductible.

4) Any assets owned as of the date of the S election are subject to the Built-in-Gains Tax (a whopping 35 percent) if sold within 5 yr. after the election. (This tax is easy to avoid.)

5) Use of a fiscal year is either not available or impractical. Usually forces a December 31 year-end (rarely a consideration).

6) The accumulated C corporation earnings would be permanently frozen at the date of the S election. Not a real problem, since those earnings are typically frozen.

7) Life-insurance proceeds cannot be distributed from an S corporation until all S corporation and prior C corporation earnings have been paid out. (A corporation–C or S–should not own life insurance in the first place.)

Why you want to be an S corporation:

1) Earnings, after making the S election, are not subject to double taxation and do not increase accumulated C corporation earnings. For example, suppose your new S corporation earns a total of $1.2 million in profits during its first 3 yr. You pay tax on the profits each year as-earned. Those profits are like a piggy bank—you can take any amount at any time, tax-free, as a dividend. Just don’t exceed the accumulated S corporation profits. Over time, this is reason enough for most C corporations to switch to S.

2) Opens up significant tax-saving estate-planning opportunities. For example, it opens the door for using an intentionally defective trust, which allows you to sell your business tax-free to your children or key employees. Our typical client saves more than $1 million in taxes, including income tax, capital gains tax and estate tax.

3) Reasonable compensation (a corporate plague) becomes a nonissue with the IRS.

4) Unreasonable surplus problems—often a big and expensive C corporation deal—disappear.

5) An opportunity to divide family income among family members. This saves huge amounts of income and estate tax. The trick is to give nonvoting stock to kids and grandkids, while the founder keeps control by retaining the voting stock.

6) Dividends (automatic double taxation for a C corporation) no longer are required. Sure, only 15 percent for C corporation dividends is a low tax rate, but it’s a rather high toll to pay when compared to zero for an S corporation.

7) You enjoy low capital-gains tax rates (only 15 percent) as an S, instead of high ordinary income-tax rates (35 percent) on sale of capital assets by a C corporation.

8) The tax basis of your stock increases dollar-for-dollar for undrawn profits. For example, if a year’s profits for the S corporation total $900,000 and you only take $400,000 as tax-free dividends, the basis of your stock would increase by $500,000. If you sold your stock, that $500,000 would be tax-free. If you are thinking of selling down the road, an S corporation is a must.

The Best of Both Worlds

Often, a family business receives the best tax results by having one or more S corporations and a separate C corporation—typically a management company. The new C corporation and old operating S corporations(s) are structured to take advantage of the tax law for the family business owner to enjoy the tax advantages available to both a C corporation and an S corporation. MF

 


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