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Should you reevaluate your S election?

After passage of the Tax Reform Act of 1986, many corporations filed S elections. Changes in the tax law since 1987, however, may necessitate a review of a corporation's tax status.


Several factors had precipitated S elections prior to jan. 1, 1987. For the first time in years, the maximum individual tax rate of 28% was lower than the maximum corporate tax rate of 34%. In addition, with the repeal of the General Utilities doctrine, election of S status avoided double taxation on the sale of corporate assets and the corporation's subsequent liquidation. Other benefits included the ability to distributed accumulated S income to shareholders free of income tax and the inapplicability to S corporations of the accumulated earnings tax (AET). There was also the possibility of avoiding unreasonable compensation to an owner.


The benefits of electing S status were not all positive, h major disadvantage was the requirement that fringe benefits provided for stockholders with a 2%-or-more stock interest had to be included in compensation. Another disadvantage was that the first $75,000 of S income could be taxed at a rate higher than that of a C corporation.


Several changes in the law implemented since 1986 have caused taxpayers to rethink the benefits of S elections.

Tax rates rise: The most dramatic change is that the top individual Federal tax rate has risen to 39.6%, while the top corporate tax rate remains at 34% for small and medium-sized corporations. (Corporations with taxable income exceeding $10 million have seen the maximum tax rate rise to 35%.) The top individual tax rate is effectively higher than 39.6% when the limitations on deductions based on adjusted gross income (the phaseout of personal exemptions, the 2% limitation on miscellaneous itemized deductions and the 3% limitation on itemized deductions) are also considered.

Deductibility of health care premiums: Since 1987, the deductibility of health insurance premiums on the individual returns of 2%-or-more S stockholders has gone from 25% deductibility, to expiration and reinstatement twice, and to 30% deductibility effective in 1995.

Multistate taxation: A negative consequence may arise at the state level. For S corporations doing business in more than one state, or those S corporations with nonresident stockholders, many states require S corporations to pay a nonresident withholding tax based on the percentage of income allocated to the nonresident stockholders.

Other alternatives: Within the past several years, the limited liability company (LLC) has emerged and enabling laws have been adopted by most state Today, 47 states and the District of Columbia have provisions for LLCs. The LLC, if drafted accordingly, will be treated as a partnership by the IRS. An LLC is a viable alternative to an S corporation because it provides much more flexibility. It is subject to the lower tax rates like an S corporation and avoids the General Utilities doctrine and the AET. It may be subject to different state taxes than either a C or an S corporation. Conversion to an LLC, however, could be costly should there be significant taxable income generated by the liquidation of the S corporation. The pros and cons of liquidating an S corporation and becoming an LLC should be evaluated very carefully.

Main benefits still exist

The main benefits of retaining S status remain. If the assets of the business are sold and the corporation is subsequently liquidated, there will be only one tax--at the stockholder level. A regular C corporation under similar circumstances is subject to two levels of taxation--at the corporate level and at the stockholder level. However, corporations electing S status after 1986 will be subject to double taxation on the appreciation in assets held at the date of election if those assets are sold within 10 years after the election. Two other factors weigh in favor of retaining S status: tax-free distributions of accumulated S income can still be made to stockholders and S corporations are not subject to the AET.

Two examples serve to illustrate how to evaluate S status.

Example 1: Corporation A is owned 100% by stockholder X, and is in a "no-growth" business. Although the business provides reasonable income to X, it is unlikely that the business will ever be sold. if sold, the purchase price would probably not exceed book value. X has outside income and his tax bracket will likely be at least 36%. Based on these limited facts, a decision to terminate the election may be warranted for the following reasons: 1. The lower corporate tax rates on the first $75,000 of taxable income can be used. 2. it is unlikely there will ever be double tax on the sale of assets.

Example 2: Corporation B is a family business with about 30 stockholders, some of whom are active in the business and some passive. After a few years of significant losses, B has become profitable and the future looks extremely bright. Significant funds from a past sale of a B division have been invested in stocks and bonds. The sale of the business at some future time is a real possibility. B recently expanded its business into several new states. At the present time, several of the stockholders have a very low basis for their stock, and several have unused passive losses. The S corporation structure is frustrating to the executives because the stockholders pay tax on the corporate income, not the corporation. The stockholders' are frustrated because they cannot file their individual returns until the corporate return is completed. In spite of the executives' and stockholders' frustrations, retaining the S election seems to be the obvious answer for several reasons: 1. A future sale of assets, should it occur, might result in a significant gain subject to double tax as a C corporation. 2. The extremely liquid balance sheet could cause the corporation to have a serious accumulated earnings problem. 3. Some of the stockholders still have significant unused passive losses for which there would be no benefit if the S election were terminated. 4. Finally, family pressure for the corporation to pay dividends to inactive shareholders would result in double taxation.

A word of caution

An S election, once terminated, may not be reelected for five years. In addition, if the corporation uses the LIFO inventory method, the LIFO recapture tax provisions require the LIFO reserve to be restored to income when S status is reelected. This income is reported in the final C corporation year with the LIFO recapture tax paid over a four-year period, beginning with the last C corporation year.


Each corporation is unique and many items need to be considered when evaluating an S election. A careful review of the advantages and disadvantages of S status should be made prior to terminating the S election. Although it is desirable to review the corporate tax status periodically, it is probably rare that a corporate taxpayer or corporate stockholder will want to terminate an S election.

From Charles H. Brown, III, CPA, Ellin & Tucker, Chartered, Baltimore, Md.
COPYRIGHT 1995 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1995, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Author:Brown, Charles H., III
Publication:The Tax Adviser
Date:Oct 1, 1995
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