C corps vs. S corps: how tax law changes may prompt switching.

For private companies formed before the limited liability company (LLC), the corporation was typically the business entity of choice. Some elected to be taxed as small business corporations or "S corporations" to gain tax advantages over regular "C corporations."

However, many privately held corporations decided to be taxed as C corps. One reason was that C corp owners believed they would pay less in overall tax versus their S corp peers. Also, many privately held corporations were not eligible under prior Internal Revenue Service (IRS) rules to undertake a small business election.

With the enactment of the 2003 and 2004 Tax Acts, owners of closely held C corporations may want to reevaluate conversion to an S corporation.

Congress made the C corp vs. S corp conversion decision more interesting when it lowered the maximum individual income tax rate from 39.6 percent to 35 percent--matching the maximum corporate income tax rate. Fully phased in during 2003, this tax rate reduction dispels the argument that a private company owner would pay less tax as a C corp. In contrast, if the entity's income had "passed-through" to the S corp owner, it would have been taxed at the higher individual tax rate (39.6 percent).

Prior tax rules limited S corps to having no more than 75 shareholders--forcing some privately held corporations into C corp status. However, the 2004 Tax Act increased the limit to 100 shareholders for tax years beginning after 2004. And, since many private companies are family-owned, the new legislation also allows up to six generations of a family to elect to be treated as a single shareholder with respect to the 100-shareholder limit. These provisions will enhance the ability of larger closely held C corps to elect S corp status.

S Corporation Tax Advantages

S corps enjoy many significant tax advantages, including:

* Single level of tax. Income earned by an S corp is generally only taxed once, at the shareholder level. Income earned by a C corp is ultimately taxed twice--once at the corporate level, and again as dividend income to shareholders upon distribution.

* Exit strategy. An S corp's taxable income flows directly through to its shareholders, increasing their tax bases in the corporation's stock. This increased tax basis will ultimately reduce the gain on any future stock sale, generating more after-tax cash to the owner. A C corp owner is not entitled to an increase in the stock basis for his or her share of the corporation's earnings.

Similarly, an S corporation is also a desirable target in a tax-advantaged acquisition strategy known as a Section 338(h)(10) transaction. Such an acquisition gives an S corp purchaser significant tax benefits, usually without a corresponding tax increase on the selling shareholders. As a result, this structure can often justify a purchase premium for the selling S corp shareholders. A stand-alone C corp cannot be sold using this type of transaction.

* Preferential capital gains tax rates. With an S corp, gain from the sale of a capital asset held for at least one year will retain its "tax character" upon flow through to its shareholders and could be taxed at preferential capital gains rates of 15 percent. Regular C corps are not eligible for preferential rates, meaning capital gains can be taxed up to the maximum corporate rate of 35 percent.

S Corporation Tax Disadvantages

There are three significant tax disadvantages to keep in mind:

1. Eligibility requirements. Two eligibility restrictions that were not changed in the 2004 Tax Act can limit S corp owners in raising capital and estate planning. These include the single class of stock requirement and the prohibition on certain types of share-holders. With S corps, only one class of stock can be outstanding at any time. Moreover, other corporations and LLCs are not permitted as shareholders.

2. Shareholder tax compliance. S corporation's shareholders' tax compliance burden can increase significantly if the entity operates in multiple states. If an S corporation operated in three different states, its shareholders may be required to file annual individual income tax returns in each of those states.

3. Conversion costs. C corps with assets that are significantly appreciated (especially last-in, first-out, or LIFO, inventory), and those with significant passive income can trigger special S corporation-level taxes upon S corp conversion or immediately thereafter (such as LIFO recapture, built-in gains and excess passive income taxes). In these situations, conversion may be cost-prohibitive.

Is It Time to Switch?

The new tax legislation has changed the choice of business entity environment for private companies, and privately held C corps might benefit from electing S corp status. But, before making the switch, the owners of private companies currently operating as C corporations should consult with their advisors to determine whether they are eligible for a small business corporation election--and, if so, whether the tax benefits would outweigh any disadvantages.

Greg W. Smith ([e-mail]) is a Senior Tax Manager with PricewaterhouseCoopers' Private Company Services practice in Washington, DC.