In certain business and tax scenarios, electing S corporation status for your business can be advantageous. In other scenarios it may not be beneficial. We discuss below some of the more common scenarios taxpayers may encounter in making their decision to elect S corporation status or use another entity structure for their business.
Taxpayers should recognize the general situations that lend themselves to electing S status. A frequent scenario involves a new business that is expected to incur losses during the initial start-up period. Assuming sufficient basis (e.g., stock investment) exists, the losses passed through to the shareholders can be deducted on their personal returns. S corporation stock is eligible for Section 1244 treatment, so if the venture is unsuccessful and the stock is later sold or exchanged at a loss, ordinary loss treatment is possible versus less favorable capital loss treatment.
A profitable, cash-rich closely held corporation is a likely candidate for an S election, particularly a personal service corporation (e.g., physician or lawyer). An accumulation of cash enables the corporation to make distributions to the shareholders to pay the income tax generated by the pass-through income from the S corporation. Personal service corporations are not eligible for the graduated corporate tax rates, and electing S status will minimize exposure to an unreasonable compensation issue.
An established corporation in a mature industry may want to consider electing S status. As earnings growth slows and reinvestment in plant and equipment falls, the corporation may accumulate earnings even if substantial dividends are paid. S status enables the corporation to avoid double taxation on the distributions to shareholders and eliminates exposure to the corporate-level accumulated earnings tax.
Taxpayers should also recognize the general situations that lend themselves to forgoing the S election. A rapidly growing corporation in a competitive, expanding market may not benefit from the S election. The profits earned by the corporation will be passed through to the shareholders and may be taxed at a higher rate than if taxed at the corporate rates. However, the corporation may not have the cash to pay the resulting shareholder income tax liability, because of heavy research and development costs or reinvestment in plant and equipment.
If most of a corporation’s shareholders are employees, it may want to remain a C corporation. Common fringe benefits provided to the shareholder/employees will be taxable if the corporation elects S status.
An S corporation may be severely limited in its ability to raise outside capital because of the 100-shareholder limitation and restrictions on eligible shareholders. Furthermore, the one-class-of-stock limitation prevents an S corporation from issuing preferred stock to outside investors (or to the older generation in a family-controlled corporation). The corporation’s existing shareholders may not want outside investors to participate in the future growth of the corporation, while the outside investors may want the steady income stream generated by preferred stock or may be unwilling to invest unless the stock is convertible or participating preferred.
Obviously, this article is technical in nature, but making an S election requires a thorough analysis of all pertinent facts. Please contact us if you have questions on whether to elect S status or to discuss any other tax compliance or planning issue.