Are you a closely held business that operates as a C corporation? If your answer is "Yes,"' then this article is a must to read. If you are already an S corporation, chances are you will learn one or more tax tricks, that most people don't know, that will enrich you or your family instead of the IRS.
To start, burn this into your mind. There are only three good reasons to be C corporation: (1) Your taxable profits are, and are likely to remain, under about $125,000, and also 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 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.
You C corporation guys and gals listen up! Following is a list of the "Pros" and "Cons" of staying a C corporation or electing S corporation status (Hint: nine out of 10 corporations enjoy tax advantages by being an S corporation.)
The cons of an S corporation
You probably would pay more income tax in the current year as an S corporation. (Hint: C corporations only pay 15% in income tax on the first $50,000 of net profit and 25% on the next $25,000.) But remember, when you want to get those after-tax dollars out of your C corporation someday, you will be double taxed. And consider the top individual rate and the C corporation rate are currently the same 35%. Other cons are:
- Health insurance premiums for shareholder/employees and their families are not fully deductible.
- Long-term care premiums for shareholder/employees and their families are not fully deductible.
- Any assets owned as of the date of the S election are subject to the "Built-in-Gain Tax" (a whopping 35%) if sold within five years after the election. (This tax is easy to avoid.)
- Use of a fiscal year is either not available or is impractical. Usually forces a December 31 year-end. (Rarely a consideration.)
- The accumulated C corporation earnings would be permanently frozen at the date of the S election. Not a real problem, generally 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.)
The pros of an S corporation
- 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 makes a total of $1.2 million in profits during the first three years. 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.
- Opens up significant tax-saving estate planning opportunities. For example, opens the door for using an intentionally defective trust, which allows you to sell your business tax-free to your children or key employees. (The typical client saves over $1 million in taxes including income tax, capital gains tax and estate tax.)
- Reasonable compensation (a corporate plague) becomes a nonissue with the IRS.
- Unreasonable surplus "problems" (often a big and expensive C corporation deal) disappear.
- An opportunity to divide family income among family members: Saves huge amounts of income tax and estate tax. Trick is to give non-voting stock to kids and grandkids while the founder keeps control by retaining the voting stock.
- Dividends (automatic double taxation for a C corporation) 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 (only 15%) as an S, instead of high ordinary income tax rates (35%) on sale of capital assets by a C corporation.
- The tax basis of your stock is increased dollar-for-dollar for undrawn profits. For example, if profits of the S corporation over a period of year was $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 down the road, an S corporation is a must.
The best of both worlds
Often, a family business gets 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. Neat!
Finally, it should be noted whether to be or not to be an S corporation is one of the most important tax decisions a business owner ever makes. If you are still a C corporation and have a taxable income of about $250,000 or more per year, I invite you to call me (Irv) at 847-674-5295 to review how to apply the information in this article to your exact facts and circumstances. \
If you are already an S corporation, make sure you are taking advantage of the many tax breaks available to an S corporation. Need help? Call me.
Irv Blackman, CPA and lawyer, is a retired founding partner of Blackman Kallick Bartelstein LLP and chairman emeritus of the New Century Bank, both in Chicago. He can be reached at 847-674-5295, e-mail [email protected], or on the Web at: WWW.TAXSECRETSOFTHEWEALTHY.COM.