{The following
information is not intended to replace the services of a professional qualified
income tax consultant who can better understand how these issues fit into your
particular circumstances. Trying to set up and/or operate a corporation of
any kind without competent professional guidance is asking for serious
trouble.}
I continue to hear
attorneys and other allegedly knowledgeable authorities recommending the use of
Subchapter S corporations, when that ends up costing the clients a lot more in
tax dollars.I
guess it's time for another refresher on some of the big differences between
normal C corporations and S. This is not intended as a claim that one size fits
all in regard to business structure.There are times when an S corporation, or its newest corollaries, Limited
Liability Companies (LLCs) and Limited Liability Partnerships (LLPs), may be a good
idea.I
just think it is wrong to so quickly jump into such an arrangement without
evaluating all of the consequences of doing so.
Tax
Brackets
With our country's "progressive"
tax rate structure, it is very expensive to have too much income on any one tax
return.For individuals, the
nominal
rates go from 10% to 35%, with actual effective rates
much higher due to the phasing out of so many tax breaks as income increases.With an S corp, all of the corporation's income flows right onto the 1040
returns of the shareholders, pushing them up into higher tax brackets.A C corporation has its own progressive
tax
rate structure, ranging from 15% on the first $50,000 of net income, to as
much as 39%.My philosophy is to look at the overall tax picture for
individuals and their companies by smoothing income over the personal (1040) and
corporate (1120) tax returns.For
2012, a married couple's 15% tax bracket ends at $70,700 of taxable income.It then jumps to 25%, almost double the rate.However, if you consider that the couple's C corporation has its own
$50,000 15% bracket, their overall combined 15% bracket has more than doubled to
$120,700.That alone can save
several thousands of dollars per year in income taxes.
Income
Taxed
With
an S corp, the shareholders are required to pay income tax on their share of the
corporation's income whether they take any money out of the corporate account or
leave it in there.A few years ago, I wrote about the consulting client who had to include
over $300,000 of S corp income on his 1040, when he had only taken out about
$30,000. It wasn't bad enough that he had to pay more income tax than he had
received, but things were much worse.He had a child support arrangement requiring him to pay 29% of his
adjusted gross income (AGI) each year.This meant he had to pay 29% of the $300,000 to his ex-wife.It's not fair and I have never understood why child support is based on
the parents' income rather than the actual cost to feed and clothe the kids; but
that is how things are.If he had shifted all or part of his income into a C corporation, his
child support would have been much less expensive.
More
Deductions
As
I have described elsewhere, the
Section 179
expensing election is much more lucrative for owners of C corporations
because they can literally multiply their total deduction by splitting their
purchases of business assets among their different business entities (1040 Sole Proprietorships
vs. 1120 Corporations).With an S corp, the Section 179 deduction is limited to just the one
amount.Likewise, the deduction for
net rental losses is magnified by using a C corp because it can use rental
losses to offset all operating income. An S corp's rental losses are
subject to the restrictive passive loss rules.
Attack
On the Rich
As
I have described on many occasions, "Mean Testing" (penalizing
the evil rich) is a growing trend in this country, and is most often measured by
the AGI on your 1040.People over
certain thresholds lose tax breaks and have to pay in more taxes and penalties
than others do.Income from an S
corp will just make things worse.Income
on a C corp will not be counted in most mean testing.
Fiscal
Year
One
of the most useful tools in the tax game arsenal is the ability to shift income
between taxable years.Individuals report their taxable income based on the January 1 to
December 31 calendar year.S corporations are required to also use the calendar fiscal year,
allowing no opportunity to shift income between years.C corporations, however, can end their fiscal year at the end of any
month.The
first tax return will almost always be less than a full 12 months, so don't
worry about coordinating it with the incorporation date.How this saves on taxes is pretty straight forward.Toward the end of your personal fiscal year (12/31), you bleed off some
of your taxable income to your C corp by paying it for something like rent or
marketing services.In January, your corporation can pay it back to you.Near the end of the corp's fiscal year, bleed its net profits out by
paying yourself This back and forth income shifting can go on for a long time.Sometimes income is never taxed; or if it is, we make sure that it is
taxed at the lowest rate possible (15%).
Employee
Benefits
One
of the benefits of a corporation is having it provide lucrative employee
benefits that are deductible by the corp and tax free to the employees.Medical, life insurance, education, childcare, and retirement plans are
just a few of the types of benefits available.I don't have space here to go over the rules for each type of plan.However, on a side by side comparison, the tax free status of some of
these plans is much less generous for people owning more than 2% of S
corporation stock.
The biggest fear of c-corporations has to do with double taxation, where after-tax earnings are distributed to shareholders as non-deductible dividends. This is rarely a problem with small corporations because there are plenty of ways to pull money out of the corp in a manner that is deductible, and thus only taxed once.
Compensation - wages or consulting income
Interest Payments
Lease Payments
Royalty Payments
Contributions to Retirement Accounts
Remedying
A Bad Situation
If
you have an S corp that is hurting you more than it is helping you, how should
you fix it?While
this is something you definitely need to work on with your own tax advisor, I
can give some general advice. First, I have seen a lot of people confused as to
whether they even have an S corp or not.When you charter a corporation with your state, it is a normal C
corporation.Until
you file its first income tax return, the fiscal year is still changeable, even
if you said something else on the SS-4 form you filed with IRS to obtain an
identification number.You have to take the formal step of filing Form 2553 with IRS, signed by
all of the shareholders, in order to become an S corporation.
Now,
if you are an S-corporation, can you convert it to a C corporation?You can by filing a formal request with IRS, that carries the requirement
that you cannot change back to an S corporation for at least five years.You will however be stuck with the December 31 fiscal year, nullifying
any ability to use the income shifting tax saving strategy.IRS will not allow you to change your fiscal year because they know that
will save you money and that is contrary to their purpose in life.What I have found is that it is much easier to just set up a brand new
virgin corporation, especially in states like Arkansas and Missouri where it
only costs $50 in filing fees.In states like California, where the filing fees are in the thousands,
this strategy is a bit more expensive and needs to be evaluated a little more
closely.
Addendum
Lately, I have been receiving a lot of feedback
from various people around the country who have read this article, thanking me
for pointing out things that other advisors have been ignorant of. One area of
confusion still seems to be regarding exactly when a corporation becomes an S.
Many people believe that the decision to be an S or a C is made at the time when
the corporation is originally formed. That is not true. All corporations, when
originally chartered by the State, are C corporations. Do nothing extra and it
will remain a C corp.
However, to convert it to an S corporation, the shareholders must all sign and
submit
Form 2553 with the IRS to request that status. This can be done right away
after the corp is originally chartered, or several years down the road. You need
to be sure to watch the effective dates of the S election. Some States
automatically accept the IRS's S election, while others require a separate form
to be submitted to the State tax agency.
If a corp has been using a
fiscal year that ends in a month other than December, it will have to change
to a 12/31 fiscal year end if it changes to an S status. If the S status is
later revoked, you will not be allowed to change from the 12/31 year end.
