S Corporation Overview
This article is overview of how S corporations and their shareholders are taxed.
The 2017 tax act has changed the economics of choosing a business form. As a result, many S corporations will want to consider revoking their status and became C corporations. This is a complicated decision driven by the lower 21% corporate income tax rate, the 20% rate on dividends, the 37% individual maximum marginal income tax rate, and the §199A deduction amount, as well as other factors.
Each taxpayer is unique and will want to prepare a comprehensive analysis before deciding whether a revocation of S corporation status makes sense.
The discussion below provides an overview of some of the tax advantages and disadvantages of using the S corporation form.
To decide whether to elect (or revoke) S corporation status, you should undertake a comprehensive modeling exercise to see which of the business forms makes the most sense for you. We can help you with the modeling based on assumptions you give us.
While S corporations are corporations for purposes of state law, they are taxed as a pass-through entity like a partnership for federal (and, in many cases, state) income tax purposes. There are several major federal income tax advantages of operating as an S corporation instead of as a regular C corporation. These advantages include:
• A single level of tax. The income of an S corporation is generally subject to just one level of tax, at the shareholder level. In other words, the income generally is taxed only to the corporation’s shareholders. In contrast, a C corporation pays tax on its earnings, and its shareholders pay a second tax when corporate earnings are distributed to them in the form of dividends.
• Pass-through deduction. Shareholders of an S corporation may deduct their allocable share of 20% of the qualified business income of the S corporation, subject to limitations based on the shareholder’s taxable income and allocable share of W-2 wages paid by the S corporation and allocable share of unadjusted basis of qualified property owned by the S corporation. Shareholders claiming this deduction are subject to a special rule for determining a substantial understatement of tax, and the penalty may be assessed if the understatement exceeds 5% rather than 10% of the tax required to be shown on the return for the taxable year.
• The availability of losses. Shareholders of an S corporation generally may deduct their share of the corporation’s net operating loss, up to 80% of the shareholder’s taxable income, on their individual tax returns in the year the loss occurs. Losses of a C corporation, however, may offset only the corporation’s earnings. This pass-through of an S corporation’s losses to its shareholders makes the S corporation form particularly suitable for start-up businesses that are expected to generate losses during their initial stages.
• Income splitting. S corporations can serve as excellent vehicles for splitting income among family members through gifts or sales of stock.
Although operating as an S corporation offers many significant tax benefits, there are also some significant disadvantages associated with electing S status. The primary disadvantages are:
• Excess business loss limitation. Shareholders are not permitted to deduct excess business losses which are generally the amount of aggregate deductions attributable to the business plus $250,000 ($500,000 if filing jointly.) Any excess business loss which is disallowed in the current year becomes part of the shareholders net operating loss carryforward in future years. C corporations are not subject to an excess business loss limitation.
• Special exclusions. The exclusion of up to 100% of the gain on the sale of “qualified small business stock” does not apply to the sale of stock in an S corporation.
• Fringe benefits. Fewer tax-free fringe benefits may be provided to shareholder-employees of S corporations than to shareholder-employees of C corporations.
• Limitations on ownership. Stock in an S corporation can only be transferred to eligible shareholders — individuals, estates, certain trusts, and certain pension plans and charitable organizations. An S corporation cannot have more than 100 shareholders, but married couples and other family members count as one shareholder. A nonresident alien may not be a shareholder (but may be a potential current beneficiary of an ESBT). These limitations restrict the sources and amount of equity capital.
• Classes of stock. An S corporation may not issue preferred stock, since such stock will constitute a prohibited second class of stock. This limitation also may restrict the sources and amount of equity capital.
• Lower corporate tax rate. As mentioned at the outset, tax rates applicable to individuals may be higher than the rates that would apply to a C corporation at the same income level, although the effective rate of the double tax on a C corporation still makes the S corporation attractive.
• ESOPs. Since 1997, employee stock ownership plans can be used, but some of their tax advantages are not available to S corporations.
• Estate Planning. Estate planning for shareholders is generally more complicated when an S corporation is involved.
Not all corporations may elect S status. The election is available only to qualifying “small business corporations.” A corporation must formally elect to be taxed as an S corporation by filing Form 2553, Election by a Small Business Corporation, with the IRS.
An S corporation’s taxable income must be computed in order to determine the items of income or loss to pass through to the shareholders. An S corporation’s taxable income generally is computed similar to that of a partnership. Thus, items of income, gain, loss, deduction and credit, the separate treatment of which could affect the tax liability of a shareholder, must be passed through separately to each shareholder. The tax character of these items is determined at the corporate level, and they retain their character when passed through to the shareholders.
An S corporation that was once a C corporation may be subject to one or more of three separate taxes at the corporate level (e.g., the “built-in gains” tax). This rule is an exception to the general rule that S corporations are not subject to tax.
Items of income, gain, loss or deduction that pass through to a shareholder are reflected in the basis in his or her stock (and, in some cases, in debt, if any, that the corporation owes to the shareholder). Increased stock or debt basis helps utilize S corporation losses at the shareholder level.
Once an S election is made, it applies for all succeeding years unless the election is terminated. If the election is terminated, S status generally cannot be re-elected for five years. An election can be terminated either intentionally or unintentionally. The election may terminate by revocation, by the corporation’s ceasing to satisfy the eligibility requirements for S status, or by the corporation’s failing a passive investment income test. For example, the election terminates if the S corporation’s stock is acquired by a nonqualified shareholder (e.g., a corporation) or if the number of shareholders exceeds the maximum permitted. The election terminates on the day the eligibility requirement is violated. If the termination is inadvertent, the IRS may allow the corporation to continue as an S corporation if the terminating event is corrected within a reasonable period of time.