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An S Corporation
Isn’t Always Best

See also:
Is There an LLC in Your Future? 

onventional wisdom says that smaller firms should incorporate as S corporations [formerly Subchapter (s) in the Internal Revenue Code]. While an S corporation enjoys many corporate attributes, it is treated like a proprietorship or partnership for purposes of determining its Federal income tax liability. Quite simply, at the end of each fiscal year, its total net earnings (or losses) are prorated to each shareholder on the basis of their equity interests, and these earnings (or losses) are incorporated into their individual income tax returns.

          Among the advantages of the S corporation for smaller business is no "double taxation" — i.e., paying an income tax on corporate net income, and then paying an individual income tax on the dividend income subsequently distributed by the corporation. The S corporation also offers the advantage of the frequently wealthy shareholders being able to immediately offset corporate losses against their personal taxable income.

          Thus, an S corporation "generally will not be liable for federal income tax." If losses are incurred during the startup period (or any other period), these losses can be deducted each year from the shareholders' individual tax returns. All income, losses, credits and deductions are "washed through" the S corporation at the end of each fiscal year, and carried directly to the individual tax return for each shareholder via the Schedule K-1 (Form 1120S). Being emptied out at the end of each fiscal year, the S corporation has no retained earnings account.

          For most smaller businesses, the S corporation has long been the preferred corporate structure. The operational accounting is simpler, and accounting, legal and administrative expenses are minimized. Shareholders' receive the immediate benefits of earnings without "double taxation," and the shelter of tax deductible losses (should they be incurred) on their individual tax returns. There are sound reasons this is generally the most popular corporate structure.

          However, for smaller businesses that are growing rapidly, consideration of converting to the conventional C corporation status may be warranted. The primary motivation for such a change would be the ability to retain and reinvest earnings in the expanding business.

          The maximum Federal income tax rate for C corporations is 34 percent for taxable income up to $10.0 million, whereas the maximum tax rate on S corporation income is now the maximum individual rate of 39.6 percent. At the other end of the range, the Federal tax on corporate income of $100,000 is $22,250 for a C corporation, whereas the incremental tax on this income added to other income of the shareholders in an S corporation could be as high as $39,600 if the shareholders are already in the maximum tax bracket. If the business is striving to retain and reinvest all possible cash during a period of strong growth, it will obviously forgo distributing cash dividends thereby avoiding the problem of "double taxation."

          The maximum tax rate will be effectively reduced by more than 16 percent, and substantial funds will then be retained to meet the voracious capital needs of the expanding enterprise. Discounting the effects of depreciation charges, this shift ofcorporate structure and tax strategy yields an almost 10 percent increase in net cash flow; one wag has suggested that the IRS has become one of his venture capital partners.

          Of course, such a fundamental change in corporate status calls for a careful understanding of the longer-range goals of the principals. If the sale of the corporation is contemplated in the near future, the capital gain from the sale of the corporation will be taxed at the corporate level and again on the individuals' tax returns when the former owners receive their gain — i.e., there will then be a "double taxation" on the capital gain from the sale. With the sale of an S corporation, the capital gains are simply incorporated into the former owners' personal income and taxed only once. Also, once an election is made to adopt C corporation status, this corporate status cannot be changed during the next five years.

          For the principals in a smaller business that is enjoying rapid growth, the conventional wisdom may not be correct. A thorough financial and legal examination of a possible conversion to C corporation status may indeed be warranted.

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Thomas A. Faulhaber, Editor

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