16 Dec S-Corporation: Tax Implications
S Corporations and their shareholders are taxed very differently than C Corporations, but not every corporation is eligible to elect S status. If a corporation has a shareholder that is a corporation, a partnership, a non-resident alien or an ineligible trust, S status just is not available. Banks and insurance companies cannot elect S status. Also, the election cannot be made if the corporation has more than 100 shareholders or has more than one class of stock.
For purposes of the 100 limitation, a husband and wife are counted as only one shareholder. And all the members of a family, six generations deep may elect to be treated as a single shareholder.
The one class of stock requirement is not violated if the corporation has both voting and non-voting common stock and the only difference between the two stocks is voting rights. But all preferred stock is out. Also, there’s a great, a really huge safe harbor provision that easily can be satisfied to protect against the threat of an S selection being jeopardized by a shareholder debt obligation being characterized as a second class of stock.
In defining the S-status eligibility rules, Congress has expanded the rules for trusts overtime. Many commonly used trusts are now eligible to be S Corporation shareholders including a voting trust, a revocable living trust, select trust that receives S Corporation stock via will or a living trust when somebody dies, a QTIP trust and a special trust called an “electing small business trust”.
But this eligible trust list is still very limited and many trusts used in estate planning will not qualify as S Corporation shareholders. So whenever an S selection is part of a plan that involves trusts as many do, great care must be taken to ensure that the S status is not inadvertently lost because an ineligible trust ends up owning some of the stock of the S Corporation.
Electing in and out of S status can present some planning challenges. An election to S status requires the consent of all shareholders. A single dissenter can hold up the show. For this reason, often it is advisable to include in the organizational agreement among the owners, typically a shareholder’s agreement, a provision that requires all owners to consent to an S selection, if a designated percentage of the owners at any time approves the making of the election. Exiting out of the status is easier than electing in. A revocation is valid if approved by shareholders owning more than half of the outstanding voting and non-voting stock.
The income of an S Corporation is passed through and taxed to its shareholders. The corporate entity itself reports the income but generally pays no taxes plus the corporate entity must report to the shareholders specific items that a shareholder will report differently on a personal income tax return. Items such as capital gains or interest expense, charitable contributions and similar items — these are referred to as separately stated items.
The advantage of course of this pass thru structure is that there is no threat of a double tax. There is only one tax at the owner level. Since there is no double tax threat, all of the C Corporation traps tied to that menacing double tax structure are no longer needed — things such as disguised dividend trap or the accumulated earnings trap or the personal holding income trap and the alternative minimum tax trap.
S Corporation losses also are passed thru to the shareholders. Unlike a C Corporation, the losses are not trapped inside the entity. Does this mean the shareholders can use the losses to reduce the tax bite on their other income? Maybe. There are various hurdles that must be overcome at the individual shareholder level and they can be difficult in many situations.
An S Corporation shareholder, for example, cannot benefit from any loss to the extent it exceeds the shareholder’s out-of-pocket investment in the stock of the company or loans made by the shareholder to the company.
Perhaps the toughest hurdle is the passive loss rule, an 80s brainchild that is designed to prevent a tax payer from using losses from a passive business venture to offset active business income or portfolio income, portfolio income being interest dividends, that type of thing.
It was created to stop doctors and others from using losses from real estate and other tax shelters to reduce or eliminate the tax on their professional or investment income. Losses passed thru from a passive venture can only be offset against passive income from another source. If there’s not sufficient passive income to cover the passive losses, the excess passive losses are carried forward until sufficient passive income is generated or the owner disposes of his or her interest in the passive activity that produced the unused losses.
Whether a particular business activity is deemed passive or active with respect to a specific S Corporation shareholder is based on the shareholder’s level of participation in the entity. That is whether the shareholder is a material participant in the activity. Generally speaking, and I do mean generally, the material participation standard will be met if the shareholder works more the 500 hours in the business during a given year or spends more time working in the business than any other person. Given this hurdle, in any planning analysis, it is never safe to assume the use of the S Corporation will convert start up losses into slam dunk tax benefits for the shareholders.
As a passed thru entity, an S Corporation has the potential to generate passive income for its shareholders. That’s a very good thing. Generally, taxable income is classified as portfolio income which is dividends, interests, royalties, that type of thing.
Active income which is income from activities in which a tax payer materially participates or passive income, income from passive business ventures operated through an S Corporation or a partnership tax entity. Passive Income is the only type of income that can be sheltered by either an active Loss or a passive Loss. So the passive loss rule by limiting the use of passive losses exalts the value of passive income.
An S Corporation that generates passive income can breathe tax life into passive losses from passive activities. A C Corporation has no capacity to produce passive income. It pays dividends or interests, both classified as portfolio income or compensation income which is classified as active income.
In contrast, an S Corporation may pass thru valuable passive income to those do not work for the company. An S Corporation’s shareholder basis in his or her stock fluctuates. Unlike stock in a C Corporation, there is no locked-in basis. When income is allocated to the shareholder, the stock basis goes up. When losses are allocated and cash or property is distributed, the stock basis goes down.
This basis booster can be a valuable perk to the owner of thriving businesses that is retaining income to increase growth and expansion. In the case of Jane previously discussed, the $2,000,000 of retained earnings in an S Corporation would’ve increased the basis of her stock by that $2,000,000.
An S Corporation offers a few of the same perks as a C Corporation. An S Corporation may enjoy all the benefits of the tax free reorganization provisions of the code. And the sale of the S Corporation stock will trigger capital gains treatment. An S Corporation may even have a multi-entity holding company structure by an S-Corporation creating qualified subchapter S subsidiaries.
Transfers of appreciated property between an S Corporation and its shareholders might trigger unpleasant tax consequences, so they need to be carefully analyzed. If for example, appreciated property is exchanged for stock, the same 80% stock control requirement previously mentioned for C Corporations will need to be satisfied to avoid a tax hit for the shareholder.
And if an S Corporation transfers appreciated property to its shareholders, a tax hit will be triggered but not the painful double tax of a C Corporation tax structure. Also, any liquidating distributions or redemptions may trigger tax liabilities with an S-Corporation.
An S Corporation like a partnership tax entity is subject to severe limitations in selecting a fiscal year. Hence, nearly all S Corporation are calendar year tax payers. As compared to a C Corporation, there is much less flexibility on this one. A C Corporation’s conversion to an S-Corporation is far easier from a tax perspective than a conversion to an entity that is taxed as a partnership.
Usually, such a conversion is the only viable option for a C Corporation that wants to shed its C Status and become a passed thru entity. But there are some traps in an S Conversion for built-in gains, prior accumulated C Corporation earnings, LIFO inventory reserves, and excessive S Corporation investment income. But usually these traps can be mitigated or eliminated completely with smart planning.
That completes our discussion. We hope that the presentation has been informative and that it has been helpful to you. Thanks for your time!