Rethinking the S election: disadvantages of S status may outweigh benefits.

Although the tax benefits of S corporations have existed in some form since 1958, tax practitioners seldom found the S election advantageous for their clients until the early 1980s. First, the Economic Recovery Tax Act of 1981 reduced the highest individual tax rate from 70% to 50%, while retaining a 46% top corporate tax rate. This 4% spread contrasted sharply with the 24% (and higher) historic spread. Second, the Tax Equity and Fiscal Responsibility Act of 1982 created parity for retirement plans of S and C corporations. Finally, the Subchapter S Revision Act of 1982 removed much of the complexity of the S corporation provisions and made them more workable. The result of these three acts was to significantly broaden the appeal of subchapter S and to give tax practitioners more opportunities to decide whether an S election should be made.

The Tax Reform Act of 1986 (TRA) significantly added to these benefits to make the S corporation the entity of choice. The top individual tax rate was lowered below the top corporate rate. In addition, the repeal of the General Utilities doctrine(1) by the TRA meant that, generally, the S election would result in lower taxes over the life of the entity.

However, the Revenue Reconciliation Act of 1993 (RRA) reversed the favorable legislative trend, by raising the top individual rate above the top corporate rate, and adding an exclusion under certain circumstances for 50% of the gain from the sale of certain small business C corporation stock.(2) Although some S corporation advantages remain (such as the increase in a shareholder's basis for income retained in the business, and the absence of the corporate alternative minimum tax (AMT), personal holding company (PHC) tax and accumulated earnings tax (AET)), the S corporation should not always be the entity of choice. Entities contemplating electing or maintaining S status should examine the reasons not to make or continue an S election. This article will explore these reasons.

Tax Rates

One of the most common reasons for not electing S status is the belief that income retained in the business will be taxed at a lower rate if the entity is a C corporation. This occurs when the corporate tax rates of 15 of the first $50,000 and 25% of the next $25,000 of taxable income are lower than the shareholder's individual marginal rate on the same income. However, this apparent disadvantage must be analyzed further.

While the total Federal tax on the first $75,000 of income can be less at C corporate rates, the total tax on income can be greater, depending on the amount of corporate income and the shareholder's marginal rate. For example, if corporate income is effectively taxed at 28% at the shareholder level, the break-even point (above which total C corporate tax is greater than total S corporate tax) is $152,272 (0.28x = $22,250 + 0.39 (X - $100,000)).(3) Thus, if an entity's taxable income will exceed $152,272, S status may be preferable.

This break-even point increases substantially at higher marginal shareholder rates. In fact, if calculated at the highest individual rates, the tax on C corporate earnings, whether retained or not, would seldom be less than the tax as an S corporation. Current tax savings should not be the only consideration, however, since they can be outweighed by the tax incurred on eventual liquidation or sale of stock. The undistributed earnings of a C corporation do not increase a shareholder's stock basis, but the undistributed earnings of an S corporation do. By operating as an S corporation, the corporate-level tax imposed on a liquidation or sale of assets of a C corporation could also be avoided.

Indirect Tax Increases

Tax on income from operations as an S corporation can be greater than that of a C corporation for other reasons.

* Fringe benefits 

Employee fringe benefits paid on behalf of 2%-or-more shareholder-employees do not receive the favorable tax treatment they would if paid by a C corporation.(4) Due to the 35-shareholder limit, most S corporations have at least one 2%-or-more shareholder-employee. This is why most personal service corporations (PSCs), which typically pay out all corporate earnings as compensation, do not find an S corporation to be advantageous.

While Sec. 1372 does not specify which fringe benefits, if paid to 2%-or-more shareholder-employees, are neither deductible by the S corporation nor excludible from the recipient's income, the following fringe benefits (except the last) are discussed in the Senate Report to the Subchapter S Revision Act:(5)

* The cost of up to $50,000 of group-term life insurance.(6)

* The $5,000 death benefit.(7)

* Meals and lodging furnished for the convenience of the employer.(8)

* Employer payments under accident and health plans.(9)

* Cafeteria plans.(10)

* Dividends received deduction

Sec. 1371(a)(2) disallows an S corporation the dividends received deduction (DRD). For a C corporation that is a shareholder, Sec. 243 provides a 70% exclusion of qualifying dividends from income (80% if the investor corporation holds 20% or more of the stock). The deduction results in less of the dividend being taxed.(11)

This disadvantage to S corporations and their shareholders can be significant in the case of entities exporting U.S. goods, because the primary tax incentive for most U.S. exporters--foreign sales corporation status--is useless unless the dividend can be excluded.

* Other disadvantages

When operations are conducted through multiple corporations, an S corporation's inability to file consolidated returns can prove to be disadvantageous. A consolidated return would allow the income of one corporate entity to be sheltered by the loss of another member of the controlled group. Losses-of one S corporation may not offset the income of a related entity because of the basis, at-risk and passive loss limitations imposed at the shareholder level. Intercompany transactions are also less likely to be challenged under Sec. 482 when a consolidated return is filed.

The income of an S corporation can be greater than that of a C corporation, because Sec. 267(a)(2) requires the matching of deductions and income for expenses paid by an accrual-method corporation to a cash-method shareholder. The deduction is deferred until the income is includible in the shareholder's income for expenses accruing to any S corporation shareholder, but only to a greater-than-50% C corporation shareholder. This creates a disadvantage, at least currently, when the S corporation and its shareholders have different yearends.

It is also possible for S corporation income to be taxed twice at the state level. This situation can occur, for example, when the company is taxed in a state that is not the residence of a shareholder, and neither the company's state nor the shareholder's state of residence recognizes S corporations.

The Sec. 1371(b) prohibition on the carryover of tax attributes (e.g., losses and credits) from a C corporation to an S corporation year can create another disadvantage to former C corporations, although net operating losses, capital losses, and business and AMT credits can be used to reduce the built-in gains tax. Also, an S election by a former C corporation is treated by Sec. 1373(b) as a disposition for purposes of the recapture of foreign losses, which may result in immediate income recognition.

Choice of Fiscal Year

In the use of a corporate fiscal year, S corporations are at a significant disadvantage when compared with nonpersonal service C corporations. Most S corporations (as well as partnerships and PSCs) are limited in the use of a fiscal year-end and may have to pay to choose one.(12)

Generally, to use a noncalendar year-end, an S corporation must establish a satisfactory business purpose under Sec. 1378(b) or make an election under Sec. 444. Unless at least 25% of the S corporation's annual gross receipts are to be received during a two-month period for three consecutive years or the desired year-end is the same fiscal year as that of a majority of the S corporation's owners, a satisfactory business purpose will exist in only very limited circumstances.(13)

When the Sec. 444 election is made, the corporation's choice is limited to a fiscal year-end in which the deferral period does not exceed three months.(14) For most entities, the S corporation's choice is limited to September 30, October 31 or November 30. In addition, Sec. 7519 provides that the company must make a "required payment" for each year the Sec. 444 election is in effect, a refundable noninterest-bearing deposit designed to approximate the value of the tax deferral resulting from the fiscal year-end.

Additional Taxes

Former C corporations may be at an additional disadvantage in having to pay a second tax at the corporate level after making the S election.

* Built-in gains tax

The built-in gains tax may be the single most important reason why an otherwise eligible entity would not make an S election. This tax ensures that certain economic gains that arose before S corporation status do not escape tax at the C corporation level.(15) It is generally applicable only to former C corporations(16) that file an S election after 1986 (1988 in the case of certain qualified corporations).(17)

Under Sec. 1374, the tax is computed at the highest corporate rate currently in effect on gains accruing during the period the entity operated as a

C corporation but recognized during the first 10 years as an S corporation.(18) It is imposed on the lower of the (1) built-in gains recognized during the tax year or (2) taxable income as if the entity were not an S corporation. For elections filed after Mar. 31, 1988, recognized built-in gains not currently taxed because of the taxable income limitation are carried forward and will be taxed if the corporation subsequently has taxable income in the remainder of the 10-year recognition period. The built-in gain for a specific asset is the excess of each asset's fair market value (FMV) over its adjusted basis on the date the S election was first effective. Maximum built-in gains for all assets owned on such date are limited to the excess of the total FMV of all such assets over their adjusted bases. Built-in losses reduce gains for purposes of this limitation.

The built-in gains tax can be prohibitive--reason enough not to make an S election. This can be especially true for cash-basis taxpayers, since the tax is applied to income not only from sales or exchanges of assets, but also from such income recognition events as the collection of accounts receivable and the sale of inventory in the normal course of business. The built-in gains tax also applies to other taxable dispositions, such as a distribution of appreciated property to shareholders.

Planning before and after the S election may minimize the effect of the tax. FMV appraisals should be obtained for all assets owned on the date the election is first effective, because all gains (but no losses) will be presumed to be built in, unless the taxpayer can prove otherwise. When practical, asset dispositions planned after the election should either be accelerated to the last C corporation year or deferred beyond the 10-year recognition period. Built-in losses should be recognized in a year a built-in gain is recognized. Planning to minimize taxable income through the payment of compensation to owner-employees or the acceleration of other deductible expenses is particularly important in a year in which a built-in gain is recognized.

* LIFO recapture

A C corporation using the LIFO inventory method and making an S election after Dec. 17, 1987 is required under Sec. 1363(d) to pay a corporate-level tax on the "LIFO recapture amount."(19) This rule is designed to complement the built-in gains tax on the sale of inventory and requires the newly electing S corporation to recognize the excess of the inventory's FIFO value over its LIFO value in its last C corporation return. The increase in tax as a result of this inclusion in income is payable in four equal annual installments, beginning with the due date of the last C return. The remaining three installments are payable with the next three S corporation returns. This rule does not prohibit the use of LIFO, but requires only that the tax benefits of the LIFO method enjoyed in C corporation years be recognized as C income.

* Tax on excess passive income

Former C corporations that generate significant passive income also may not find the S election to be advantageous. Sec. 1375(a) imposes an additional tax at the highest corporate rate currently in effect if passive income exceeds 25% of the corporation's gross receipts and the S corporation has accumulated earnings and profits (AE&P) at the end of the year.(20) The S election will be involuntarily terminated if passive income exceeds 25% of gross receipts for three consecutive years and the company has AE&P at the end of the third year. For this purpose, passive income is income from dividends, interest, annuities, certain rents, royalties, and gains from the sale or exchange of stock or securities.

Proper planning can minimize or eliminate this tax. If possible, controlling the year in which passive income is recognized may result in the 25% threshold not being met. Since the amount of excess passive income is limited to the corporation's taxable income for the year, the year in which other items of income or expense are recognized can also affect the amount of tax. It may also be advisable to distribute the AE&P before year-end, especially if inadvertent termination is imminent.(21) Sec. 1375(d) grants authority to the IRS to waive this tax (unlike the built-in gains tax) if the company believed in good faith that it had no AE&P.

Other Burdens

* Eligibility requirements

The requirements to elect and maintain S status make the structure of an S corporation much less flexible than that of a C corporation. These requirements can be complex and can have an adverse effect on raising capital and transferring equity interests.

Sec. 1361 provides that only a small business corporation can make an S election. Under Sec. 1361(b), a small business corporation is a domestic corporation that does not have more than 35 shareholders;(22) each shareholder must be either an individual U.S. citizen or resident, an estate or a permitted trust; and the corporation must have only one class of stock. These restrictions on the number and kind of shareholders and stock place the S corporation at a disadvantage when seeking equity investments, especially venture capital funds and foreign investors. Also, the benefits of an employee stock ownership plan or a stock bonus plan are not available, since the resulting trusts would not be permitted shareholders under Sec. 1361(c)(2). An S corporation cannot be a member of an affiliated group.(23) Not being able to create a subsidiary(24) can adversely affect the company's ability to properly structure its operations.

The eligibility rules must be met continually throughout the S corporation's existence. This will result in an additional burden on management and, ultimately, additional costs to the shareholders. For example, while many inadvertent or unplanned terminations can be avoided by shareholder agreements restricting transferability of stock, these agreements will require time to negotiate and additional professional fees.

Inadvertent termination can be more costly to the corporation and its shareholders than if the S election were never made. The mistaken belief that an S corporation election is in effect will prevent the proper planning necessary to mitigate the PHC tax, AET and AMT. In many cases, double taxation could have been avoided if it were known in advance that a distribution would not be tax free.

The corporation and its shareholders may also be subject to underpayment penalties if an inadvertent termination is not discovered in time to make quarterly estimates based on current income. Estimates for the resulting C corporation's income probably cannot be based on the prior-year's tax, because the prior year would be the last S corporation year, which, in most cases, shows no tax liability.(25) Unexpected termination may also require shareholders to report greater taxable income than estimated if their estimates were based on the passthrough of losses and credits or the receipt of tax-free S distributions.

* Succession planning 

The use of an S corporation in estate and family income tax planning requires careful consideration, since the consequences can affect not only the estate, but also the family and other shareholders.

An S election can complicate some traditional planning techniques, such as shifting income to lower-bracket family members. Sec. 1366(e) provides the Service with the authority to make adjustments when there is a failure to pay reasonable compensation for services or for the use of capital. Unlike the C corporation requirement of reasonable compensation, Sec. 1366(e) focuses on too little, rather than too much, compensation, and applies even if the recipient is only a family member of a shareholder. Planning to minimize both income and estate taxes by giving stock may not be available to an S shareholder, due to restrictions on the number of shareholders.

The restrictions on the type of shareholders can frustrate sophisticated income and estate planning, because only certain trusts are permitted as shareholders. The estate freeze, a traditional estate tax planning technique, is also limited by the S corporation eligibility rules. Since an S corporation can only have one class of stock, the classic preferred stock recapitalization is not available, although a less dramatic freeze is available to an S corporation, using voting and nonvoting common stock.(26)

The death of a shareholder can lead to unforeseen consequences unique to S corporations and their shareholders. Most testamentary trusts will qualify under Sec. 1361(c)(2) as S shareholders only for 60 days from the date of transfer. This may result in an unexpected termination of S status. The liquidity of an estate is usually of prime importance and can be adversely affected if distributions are not available to pay income tax on undistributed S corporation earnings. The executor may find that the basis of S stock is much less than what the decedent had invested in such stock and undistributed earnings, due to a stepdown to FMV mandated by Sec. 1014.

Shareholder Concerns

The S election can have an adverse effect on individual shareholders as well. Shareholders can be allocated taxable income from undistributed S earnings without a corresponding distribution to pay the tax. While this possibility can and should be addressed in supplemental shareholder agreements, cash flow requirements and agreements with third parties may restrict the ability to make such distributions.

Losses, expenses and credits of an S corporation may not receive the same tax treatment as in a C corporation, due to the basis, at-risk and passive activity loss limitations imposed at the shareholder level. The basis limitation rules of Sec. 1366(d)(1) generally do not affect C corporations. Sec. 465(a)(1)(B) limits the at-risk rules to C corporations that meet the ownership requirements for PHCs. The passive activity loss restrictions apply to closely held C corporations and certain PSCs, but only to a limited extent for nonpersonal service C corporations.(27)

Shareholders with substantial investment income who finance their stock acquisitions may find their interest deduction reduced if the corporation makes an S election. Interest on debt used to acquire C stock would generally be investment interest expense and deductible to the extent of the shareholder's investment income. Interest on debt incurred to acquire S stock is investment interest only to the extent allocated to the portion of the corporate assets comprised of portfolio or other investment assets.(28) If the shareholder does not materially participate in the S corporation's activities, the interest expense is reported as a passive activity and either decreases passive activity income or increases passive activity loss on the shareholder's return.(29) Even if the shareholder materially participates, if the entity owns nonoperating assets, such as a rental property, a portion of the interest expense will have to be allocated to passive activities.

When an S election is contemplated, there may be a problem if shareholders have borrowed from the corporation's qualified retirement plan. The prohibited transaction rules of Sec. 4975 apply to loans to 5%-or-more S owner-employees, but not to C owner-employees. Beyond prohibiting loans made while an S corporation, any existing loans become prohibited transactions on conversion to S status.

Third-Party Concerns

Another disadvantage of S status concerns the expectations of third parties who have reason to rely on the financial statements of the entity. For example, lenders and bonding companies may not look favorably on distributions to shareholders to pay tax on undistributed earnings. Financing agreements may even restrict the payment of dividends. This issue might be resolved through education of and communication with the third parties.

The LLC Alternative

A limited liability company (LLC), if available, can sometimes be a better alternative than an S corporation. This entity has been hailed as the best of both worlds, providing the flexibility offered by partnership taxation principles combined with a limit on the owner's liability. Taxation as a partnership can be more favorable due to the lack of the strict S corporation eligibility rules and the ability under certain circumstances to specifically allocate passthrough items. In addition, unlike S shareholders, owners of entities taxed as partnerships can use their proportionate share of entity-level debt in calculating basis.

Although at least 46 states have already adopted LLC legislation, practitioners must proceed with caution before this type of entity is chosen. Uncertainties will arise as to the extent limitations on liability will be recognized in other states. There are also uncertain tax consequences due to the newness of the LLC concept. Finally, the LLC's lack of continuity of life and transferability of interests may make the S corporation the better alternative.

The Future

While it is difficult to predict future tax legislation, some degree of change is to be expected. For the long term, Congress has considered the integration of the individual and corporate tax structures,(30) as well as the repeal of subchapter S. While these proposals appear remote on the Federal level, as a result of budgetary constraints, several states have seriously considered the repeal of their S corporation legislation.

Congress is more likely to increase the benefits of S status when it considers several recently introduced proposals.(31) These proposals remove many of the restrictions on the number and kind of shareholders and stock, and eliminate other disadvantages, such as the nondeductibility of fringe benefits for 2%-or-greater S corporation shareholder-employees.

Conclusion

The many disadvantages and limitations of S corporations may make the decision to elect or maintain S status more difficult. See the checklist at left for issues to consider in making the decision. Small business owners needing some form of limited liability should scrutinize the rules regarding S elections before making or maintaining a choice-of-entity decision.

RELATED ARTICLE: Checklist: Issues to Consider in Making or Maintaining an S Election

* Top individual tax rate exceeds top C corporation tax rate

* Taxation of fringe benefits to 2%-or-greater shareholder-employees

* Ineligibility for DRD

* No consolidated return filing

* Relative inflexibility in choice of a fiscal year

* Potential for built-in gains tax

* Potential for LIFO recapture

* Tax on excess passive income

* One-class-of-stock requirement

* Can have no more than 35 shareholders

* Certain trusts are ineligible to hold S stock

* Possibility of inadvertent termination

* Estate planning more difficult for S shareholders

* More limited deductibility of investment interest

(1) The General Utilities doctrine was a provision of pre-TRA law that provided for nonrecognition of corporate gain or loss on (1) distributions of property to shareholders in complete liquidation or (2) sales of property pursuant to a 12-month liquidation. General Utilities and Operating Co., 296 US 200 (1935)(16-AFTR 1126, 36-1 USTC [paragraph] 9012), codified by now-repealed Sec. 333, and pre-TRA Secs. 336 and 337. (2) Sec. 1202(a), added by RRA Section 13113(a), provides for the exclusion of 50% of the gain from the sale or exchange of qualified small C corporation stock issued after Aug. 10, 1993 and held for more than five years. Sec. 1202 would not benefit most small business owners, because a prospective purchaser would rather purchase stock than assets. Even when stock is purchased, the increase in basis due to earnings retained by the S corporation may outweigh any Sec. 1202 benefit. (3) However, this break-even point can be significantly lower in states that recognize S corporations if at least part of taxable income qualifies as long-term capital gain. (4) Sec. 13 72(a) states that for employee fringe benefit purposes, an S corporation is treated like a partnership and a 2%-or-greater shareholder is treated like a partner. Rev. Rul. 91-26, 1991-1 CB 184, and Ann. 92-16, IRB 1992-5, 53, provide an S corporate-level deduction for accident and health insurance premiums if such premiums are reported as additional compensation. (5) S. Rep. No. 9 7-640, 97th Cong., 2d Sess. 22 (1982). (6) Sec. 79(a). (7) Sec. 101(b). (8) Sec. 119(a). (9) Secs. 105 and 106. (10) Sec. 125. (11) However, Sec. 535(b)(3) provides that the DRD is not allowed for purposes of the AET. For corporate AMT purposes, Sec. 56[g)(4)(c) provides that the DRD is not allowed in computing adjusted current earnings unless the dividend is from a 20%-or-more owned corporation, and then only to the extent that the payor is subject to Federal income tax on the earnings from which the dividend came. (12) While legislation as recent as the Revenue Bill of 1992 would have eliminated at least the restriction. on choice of year-end, the RRA contained no such provision. The AICPA Tax Division is working to reinstate the general availability of fiscal years for businesses in which such a year is appropriate. (13) Rev. Rul. 87-57, 1987-2 CB 117, illustrates when a business purpose is satisfactory. (14) See Rev. Proc. 87-32, 1987-2 CB 396. (15) Sec. 1374. Prior to its amendment by the TRA, Sec. 1374 imposed a corporate-level tax on long-term capital gains of a former C corporation recognized during the first three years as an S corporation. This provision does not apply for years beginning after 1991. (16) Sec. 1374(d)(8) provides that the built-in gains tax can apply to dispositions of property by an S corporation, the basis of which is carried over from property acquired from a C corporation. (17) A qualified corporation that elected S status after 1986, but before 1989, is not subject to built-in gains tax on long-term capital gain property, but remains subject to the tax on short-term capital gain or ordinary income property. Section 1006(g)(7) of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA); Rev. Rul. 86-141,1986-2 CB 151. Qualified corporations are generally those with a value of $10 million or less, with more than 50% of the stock held by 10 or fewer shareholders. TAMRA Section 1006(g)(6); see H. Rep. No. 99-841, 99th Cong., 2d Sess. II-206 (1986). (18) Shareholders are allocated a separately stated loss in the amount of the built-in gains tax, thus lowering the effective rate on such income. (19) Section 10227 of the Revenue Act of 1987 provides that this rule does not apply if, before Dec. 18, 1987, the corporation (1) requested a ruling expressing the intent to elect S status or (2) the board of directors passed a resolution to make the S election. (20) Sec. 1375(b)(4) provides that, to the extent income is subject to both this tax and the built-in gains tax, only the latter applies, so that there is no corporate-level double tax. (21) While the accumulated adjustments account is generally distributed before AE&P, Sec. 1368(e)(3) provides a bypass election. Regs. Sec. 1.1368-1(f)(3) allows this election to apply to deemed dividends. (22) In Rev. Rul. 94-43, IRB 1994-27, 8, the IRS revoked Rev. Rul. 77 220, 1977-1 CB 263, which had disallowed, as violative of the 35-shareholder limit, the S elections of three S corporations joined together in a partnership. The IRS held in Rev. Rul. 94-43 that administrative simplicity should not be affected by a corporation's participation with other S corporation partners. (23) Sec. 1361(b)(2) defines four specialized corporations that also are ineligible. (24) See Rev. Rul. 73-496, 1973-2 CB 312, as to when a transitory subsidiary will not invalidate the S election. (25) Sec. 6655(d)(1)(B), flush language, disallows the prior-year tax exception if the corporation did not file a return for that year showing a tax liability. (26) Regs. Sec. 1.1361-1(1)(1) provides that differences in voting rights are disregarded in determining whether a corporation has more than one class of stock. (27) Sec. 469(j). Sec. 469(e)(2) provides that closely held, nonpersonal service C corporations can use passive losses to offset active, but not portfolio, income. (28) See Notices 88-20, 1988-1 CB 487 (applicable to pre-1988 tax years), and 88-37, 1988-1 CB 522 (applicable to post-1986 tax years). (29) Temp. Regs. Sec. 1.163-8T. (30) See AICPA, Statement of Tax Policy 10, Integration of the Corporate and Shareholder Tax Systems (1993). See also Tax Currents, "New AICPA Position on Corporate Integration," 24 The Tax Adviser 129 (Feb. 1993). (31) S. 1690, introduced Nov. 19, 1993, and H.R. 4056, introduced Mar. 16, 1994. The AICPA Tax Division has been instrumental in promulgating the proposed S reform legislation.