To Be On Not To Be ... an S corporation

A reader, Joe, who had a mammoth tax problem (both income tax and estate tax) called me. I listened. Both problems would be solved easily by electing S corporation status. Joe agreed. On the other hand, his accountant, a fine CPA, was a bit hesitant, but sent a wonderful 15-item list of and Following are the important items on the list, plus a few of my own. My comments are shown in italics. First,

A reader, Joe, who had a mammoth tax problem (both income tax and estate tax) called me. I listened. Both problems would be solved easily by electing S corporation status. Joe agreed.

On the other hand, his accountant, a fine CPA, was a bit hesitant, but sent a wonderful 15-item list of “Pros” and “Cons.” Following are the important items on the list, plus a few of my own. My comments are shown in italics.

First, the cons

  • Probably would pay more income tax in the current year. Make the computation. But, remember, when you want to get those after-tax dollars out of your C corporation someday, you will be double taxed. Also, see Pros No. 1.
  • Health insurance premiums for shareholders and their families are not fully deductible. Long-term care premiums for related employees — including their spouses — not fully deductible.
  • Any assets owned as of the date of the S corporation election are subject to the “Built-in Gains Tax” if sold within 10 years after the election. Never had a client hit with this tax. You must know what to do and when to do it.
  • Use of a fiscal year is not available or is impractical. Usually forces a Dec. 31 year-end. Rarely a consideration.
  • The accumulated C corporation earnings would be permanently frozen at the date of election. No problem, those earnings are frozen anyway.
  • Life insurance proceeds can’t be distributed from S corporation until all S and C corporation earnings have been paid. A corporation, C or S, should not own life insurance in the first place.

Now, the pros

  • Earnings after making the S election are not subject to double taxation and don’t increase accumulated C corporation earnings. This is reason enough for most C corporations to switch to S.
  • Opens up new estate planning opportunities. In Joe’s case it will save him a total of $35 million in taxes: income tax, capital gains tax and estate tax.
  • Reasonable compensation becomes a non-issue with the IRS. Unreasonable surplus problem (often a big and expensive deal) disappears. Also, an opportunity to divide family income with family members. Saves huge amounts of income tax and estate tax. Trick is to give nonvoting stock to kids and grandkids.
  • Dividends (automatic double taxation) no longer required although that’s changed with the latest tax law.
  • You enjoy capital gain tax rates instead of income tax rates on sales of assets acquired after electing S or after the 10-year built-in gains period.

There are only three good reasons to be a C corporation: 1) Your taxable profits are, and are likely to remain, less than $125,000 and you need the after-tax dollars in the corporation to retain growth or pay down debt; 2) You use the C corporation as a vehicle to get the benefit of deducting your health insurance and/or long-term care premiums; and 3) You have carry-forward losses or other tax credits that would be lost if you make an S election.

You say you are a C corporation and don’t have at least one of the above three reasons to stay that way. Then, it’s time for you to elect S status. Do it!!

A final note: After Joe’s accountant reviewed my written comments, he called me with a hearty endorsement of making the S election.

Irving Blackman is a partner in Blackman Kallick Bartelstein, 300 S. Riverside Plaza, Chicago, IL 60606; tel. 312/207-1040 or via e-mail at [email protected].