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Don't abandon your S-corp status.

Many home building companies are reevaluating their S corporation status in the face of higher individual income tax rates in the 1993 Revenue Reconciliation Act. But if you already operate as an S corporation, you probably should remain one.

The new income tax rates. At first blush, the income tax rate differential makes relinquishing S corporation status the obvious choice. It seems senseless to pay 36 percent and 39.6 percent (and higher, because of the phase-out of itemized deductions) on S corporation business income when that same income would be taxed at lower rates if it were earned by a C corporation.

Such an analysis. however. doesn't account for the corporate surtax that phases out the effects of the lower tax rate on the lower income brackets. For example. corporate taxable income between 8100,000 and $250,000 is taxed at a 39 percent rate, while the individual rate is 36 percent or less.

In comparing the corporate and individual rates before and after the '93 act. you'll find they're the same until you reach the $140,000 income level (see chart below). Above that level, the individual rates are higher than they were in 1992. Yet, because corporate rates increase faster and at lower income levels than individual tax rates, corporations pay higher taxes than individuals do, even after the individual rate exceeds the corporate one. So, although the rate spread makes it appear that the S corporation shareholder is paying $28,000 more in taxes at a $500,000 taxable income level, in reality, corporate taxes exceed individual taxes by $4,500 at this level.

Any S corporation considering relinquishing that status should perform the appropriate calculations to determine if it would pay lower taxes as a C corporation.

Other factors. One of the most notable differences between the two types of corporations is that S corporation owners increase their basis every time they pay taxes on earnings that are not distributed and are retained for growth. This reduces the gain on which the shareholders will have to pay taxes when they sell their interests in the corporation. For example:

C Corp. S Corp.

Company income $500,000 $500,000

Shareholder salary $250,000 $250,000

Taxable income $250,000 n/a

Tax on income $73,250 0

Tax to shareholdor $75.529 $174,529

Total tax paid $148,779 $174,529

While this simple comparison makes it appear that the S corporation owners are paying more on the company's income than the C corporation shareholders, this isn't the case in the long run. Because the S corporation owners paid tax on the $250,000 that was left in the company, the owners increase their basis by that amount. Completing the example, suppose the shareholders sell the company after this year of operation.
                           C Corp.    S Corp.
  Additional basis              0    $250,000
  Additional gain        $250,000           0
  Tax at 28 percent       $70,000           0
  Total tax on income    $218,779    $174,529

Thus, although S corporation shareholders may pay more income tax on the company's earnings, the C corporation shareholders end up paying more overall.

A decision to revoke an S election based solely on the higher individual income tax rates would also be ill advised if it turns out that corporate rates rise as well. A corporation that has revoked an S corporation status generally cannot re-elect that status until after it has been a C corporation for five years.--Lee O'Connor is a senior rnanager with Grant Thornton's 0ffice of Federal Tax Services in Washington, D.C.
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Title Annotation:Business; home construction firms
Author:O'Connor, Lee
Article Type:Column
Date:Mar 1, 1994
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