On May 28, President Bush signed a new tax law. Two provisions in the new law directly affect whether you should or should not be a C corporation (as opposed to an S corporation):
1. The new maximum tax rate on ordinary income is now 35% (down from 38.6%), and 2. dividends paid by C corporations are now taxed at the same rates as long-term capital gains (maximum 15%, down from 20%). Both provisions are retroactive to Jan. 1. The 35% is scheduled to return (sunset) to 38.6% in 2011, while the dividend break will end Dec. 31, 2008.
OK, you C corporation guys and gals, listen up. The following is a list of the pros and cons of remaining as a C corporation or electing S corporation status. (Hint: nine out of 10 corporations enjoy tax advantages by being an S corporation.)
First, here are the cons of being an S corporation.
- You will probably 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 the first “pro” that follows. And consider the top individual rate and the C corporation rate are the same 35%.
- Health insurance premiums for shareholder/employees and their families are not fully deductible.
- Long-term care premiums for shareholder/employees, including their spouses, are not fully deductible.
- Any assets owned as of the date of the S election are subject to the “Built-in-Gain Tax” if sold within 10 years after the election. This tax is easy to avoid.
- Use of a fiscal year is either not available or is impractical. This usually forces a Dec. 31 year-end.
- The accumulated C corporation earnings would be permanently frozen at the date of S election. I don’t see this as a problem, because those earnings are frozen anyway.
- 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.)
Now, the pros of why you should elect S corporation status.
- Earnings, after making the S election, are not subject to double taxation and do not increase accumulated C corporation earnings. Over time this is reason enough for most C corporations to switch to S.
- It opens up significant tax-saving estate planning opportunities. The typical client saves more than $1 million in taxes, including income tax, capital gains tax and estate tax.
- Reasonable compensation becomes a non-issue with the IRS.
- Unreasonable surplus problems, often a big and expensive deal, disappear.
- An S corporation provides an opportunity to divide family income among family members. It saves huge amounts of income tax and estate tax. The trick is to give nonvoting stock to kids and grandkids, while the founder retains the voting stock.
- Dividends (automatic double taxation) are no longer required. Sure, only 15% for C corporation dividends is a low tax rate, but a rather high toll to pay when compared to zero for an S corporation.
- You enjoy low capital gains tax rates instead of high ordinary income tax rates on sales of assets acquired by the corporation after the S election or after the 10-year built-in-gains period.
- The tax basis of your stock is increased dollar-for-dollar for un-drawn profits. For example, if profits of the S corporation over a period of years were $900,000 and you only took $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, an S corporation is a must.
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, less than about $125,000, and you also 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 get the benefit of deducting your health insurance and/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.
And finally, if you are a C corporation-decision maker, here are two choices for you to get more info. Contact the book division of Blackman Kallick Bartelstein at the address below. We have an S Corporation report, Special Report No. 17, for sale for $27.
Or you can send the following four items to “S Corporation Test” at the same address: 1. A copy of your last C corporation tax return; 2. A personal financial statement; 3. a family tree — name and birthday for you, your spouse, your kids and grandkids; and 4. your phone numbers. I will call you and review the pros and cons as applied to your exact circumstances.
Irving Blackman is a partner in Blackman Kallick Bartelstein, 10 S. Riverside Plaza, Suite 900, Chicago, IL 60606; tel. 312/207-1040, or via e-mail at [email protected].