The election to operate as an S corporation generally permits the income and losses of a business to be taxed directly to the shareholders of the business rather than to the corporate entity itself. However, the decision to make an S corporation election for your business is not one that should be quickly made. Listed below are some of the factors that should be considered and weighed in each individual situation. The decision should primarily turn on the presence or absence of a number of different factors affecting both the current and long-term tax liabilities of the corporation and its shareholders.
Projected Income or Losses
If losses are expected for the year of the proposed election, you should determine the tax impact of the pass-through of these losses to the shareholders, including their ability to make use of the losses after taking into account their bases in the stock and the passive loss rules.
When a corporation elects an S status, the electing shareholders are not entitled to a net operating loss deduction resulting from a carryover or carryback of a loss from a C corporation year. A C corporation, on the other hand, may carry over or carry back net operating losses within broad time periods.
A determination should be made as to whether any available tax credits are best used at the corporate or at the shareholder level.
The tax liabilities of the business operating as a C corporation should be compared to the tax liabilities of the shareholders if an S election is made.
Retention of Income
After an S corporation election is made, shareholders are taxed on all income, whether it is distributed or undistributed. Before making the election, you should decide on an earnings distribution policy that satisfies the needs of the shareholders, including the need to distribute enough money to cover taxes owed or to give investors a certain return on their investment.
Number of Shareholder/Employees
If most of the shareholders are highly compensated employees, then much of the corporate earnings will be taxed at the shareholders' lower individual rates regardless of an S corporation election. However, if only a few of shareholders are employees, the business that does not elect S status will be taxed at higher rates on undistributed earnings.
Effect on Stock Basis
The basis of a shareholder's stock in a C corporation is generally its cost. However, in an S corporation, items of income taxed to shareholders increase their basis, while distributions decrease their basis. This is important to shareholders who plan on selling their stock.
The effect of not making an S corporation election on any accumulated earning tax liability should be calculated.
An entity operating as an S corporation is not entitled to the dividends received deduction.
Employee fringe benefits such as life, accident and health insurance, and meals and lodgings provided by a C corporation are generally deductible by the corporation and not taxable to the recipient employees. This tax benefit is not available to shareholders who own more than two percent of the corporation. However, they may be able to deduct up to 100 percent of health insurance costs.
Choice of Tax Year
Generally, S corporations must use a calendar year, whereas C corporations are not limited by this rule.
Alternative Minimum Tax
S corporations are not subject to the alternative minimum tax. Items subject to the tax are passed directly through to the shareholders and must be taken into account in calculating the shareholder's individual alternative minimum tax liability.
In addition to the tax implications of making an S corporation election, there are nontax factors to be considered. Among these are the one-class-of stock limitation and the limited marketability of S corporation shares to potential investors.
Copyright 2007 LexisNexis, a division of Reed Elsevier Inc.