One of the most popular legal structures for a small business is the S corporation. An electing S corporation is simply a domestic business entity that is treated as a corporation for federal tax purposes and that has elected under Section 1362(a) of the Internal Revenue Code to be governed by Subchapter S of the Code. In recent years, this type of legal structure has become very popular due to the attractive feature of avoiding double taxation on the corporate income. S corporations elect to pass corporate income, losses and other deductions to shareholders who then become responsible for the tax effect in their individual tax filings at their individual income tax rates. Among the business population, there is a belief that electing the S corporation status is the best way to structure a business and the best choice for any business. However, before making the decision and filing to become an S corporation, business owners must consider the impact of current and future transactions which can trigger an S status disqualification or a possible disruptive taxable event at the corporate level. One thing is for certain, electing S corporation status is not for everyone.
The following are some examples of conditions which must be considered:
Company owners need to be aware of the taxable impact of having receivables on their books at the time of the S election. Regardless of the “flow-through” feature of an S election, collection of receivables may trigger a taxable event at the corporate level due to the concept of built-in gains. In many instances, accounting records which are not subject to periodic financial audits, are kept on the cash basis of accounting and do not reflect certain balances otherwise shown by accrual basis accounting. A poorly planned election under the subchapter S can overlook the existence of a built-in gain due to the existence of accounts receivable balances or other current assets, which have not yet been recognized for tax purposes.
This is one of the reasons why personal services corporations may not benefit from an S election. For example, a cash-basis corporation with a $500,000 accounts receivable balance at the time the S election is made will be subject to the built-in gain recognition and liable for a tax on the collection of those receivables. A corporation at 35% tax rate may be liable for a federal tax bill as high as $175,000 from the collection of these receivables. This built-in-gain tax would be in addition to the tax that may be imposed on its shareholders under the rules generally applicable to S corporations. Another area of concern is holding companies making the S election. A holding company exists for the sole purpose of controlling another company, rather than for the purpose of producing its own goods or services. Under the S corporation structure, a holding company with C corporation earnings and profits (E&P) could be subject to excise taxes if its passive income exceeds certain thresholds. Congress enacted the accumulated earnings tax (AET) to incentivize corporations to pay dividends to their shareholders on a current basis and penalizing them for not doing so. The AET currently imposes a rate of 20% on any corporation that is formed for the purpose of avoiding the income tax with respect to its shareholders by permitting earnings and profits to accumulate rather than be distributed.
Another important aspect to keep in mind is related to unexpired net operating losses (NOL’s) at the beginning of the period for which the S election applies. While an S corporation, these losses continue to roll forward and the carryforward period continues to toll. Under current law, NOL carry forwards expire in 20 years. However, any unexpired NOL’s could be used against any built-in-gains recognized during the 5-year recognition period by the corporation.