C corps vs. S corps: how tax law changes may prompt switching.

• Author: Smith, Greg W.
• Position: Private Companies

For private companies formed before the limited liability company (LLC), the corporation was typically the business entity of choice. Some elected to be taxed as small business corporations or "S corporations" to gain tax advantages over regular "C corporations."

However, many privately held corporations decided to be taxed as C corps. One reason was that C corp owners believed they would pay less in overall tax versus their S corp peers. Also, many privately held corporations were not eligible under prior Internal Revenue Service (IRS) rules to undertake a small business election.

With the enactment of the 2003 and 2004 Tax Acts, owners of closely held C corporations may want to reevaluate conversion to an S corporation.

Congress made the C corp vs. S corp conversion decision more interesting when it lowered the maximum individual income tax rate from 39.6 percent to 35 percent--matching the maximum corporate income tax rate. Fully phased in during 2003, this tax rate reduction dispels the argument that a private company owner would pay less tax as a C corp. In contrast, if the entity's income had "passed-through" to the S corp owner, it would have been taxed at the higher individual tax rate (39.6 percent).

Prior tax rules limited S corps to having no more than 75 shareholders--forcing some privately held corporations into C corp status. However, the 2004 Tax Act increased the limit to 100 shareholders for tax years beginning after 2004. And, since many private companies are family-owned, the new legislation also allows up to six generations of a family to elect to be treated as a single shareholder with respect to the 100-shareholder limit. These provisions will enhance the ability of larger closely held C corps to elect S corp status.

S Corporation Tax Advantages

S corps enjoy many significant tax advantages, including:

* Single level of tax. Income earned by an S corp is generally only taxed once, at the shareholder level. Income earned by a C corp is ultimately taxed twice--once at the corporate level, and again as dividend income to shareholders upon distribution.

* Exit strategy. An S corp's taxable income flows directly through to its shareholders, increasing their tax bases in the corporation's stock. This increased tax basis will ultimately reduce the gain on any future stock sale, generating more after-tax cash to the owner. A C corp owner is not entitled to an increase in the stock basis for his or her share of the...