Rethinking the S election: disadvantages of S status may outweigh benefits.

• Author: Yanoshak, John

Although the tax benefits of S corporations have existed in some form since 1958, tax practitioners seldom found the S election advantageous for their clients until the early 1980s. First, the Economic Recovery Tax Act of 1981 reduced the highest individual tax rate from 70% to 50%, while retaining a 46% top corporate tax rate. This 4% spread contrasted sharply with the 24% (and higher) historic spread. Second, the Tax Equity and Fiscal Responsibility Act of 1982 created parity for retirement plans of S and C corporations. Finally, the Subchapter S Revision Act of 1982 removed much of the complexity of the S corporation provisions and made them more workable. The result of these three acts was to significantly broaden the appeal of subchapter S and to give tax practitioners more opportunities to decide whether an S election should be made.

The Tax Reform Act of 1986 (TRA) significantly added to these benefits to make the S corporation the entity of choice. The top individual tax rate was lowered below the top corporate rate. In addition, the repeal of the General Utilities doctrine(1) by the TRA meant that, generally, the S election would result in lower taxes over the life of the entity.

However, the Revenue Reconciliation Act of 1993 (RRA) reversed the favorable legislative trend, by raising the top individual rate above the top corporate rate, and adding an exclusion under certain circumstances for 50% of the gain from the sale of certain small business C corporation stock.(2) Although some S corporation advantages remain (such as the increase in a shareholder's basis for income retained in the business, and the absence of the corporate alternative minimum tax (AMT), personal holding company (PHC) tax and accumulated earnings tax (AET)), the S corporation should not always be the entity of choice. Entities contemplating electing or maintaining S status should examine the reasons not to make or continue an S election. This article will explore these reasons.

Tax Rates

One of the most common reasons for not electing S status is the belief that income retained in the business will be taxed at a lower rate if the entity is a C corporation. This occurs when the corporate tax rates of 15 of the first $50,000 and 25% of the next $25,000 of taxable income are lower than the shareholder's individual marginal rate on the same income. However, this apparent disadvantage must be analyzed further.

While the total Federal tax on the first $75,000 of income can be less at C corporate rates, the total tax on income can be greater, depending on the amount of corporate income and the shareholder's marginal rate. For example, if corporate income is effectively taxed at 28% at the shareholder level, the break-even point (above which total C corporate tax is greater than total S corporate tax) is $152,272 (0.28x = $22,250 + 0.39 (X - $100,000)).(3) Thus, if an entity's taxable income will exceed $152,272, S status may be preferable.

This break-even point increases substantially at higher marginal shareholder rates. In fact, if calculated at the highest individual rates, the tax on C corporate earnings, whether retained or not, would seldom be less than the tax as an S corporation. Current tax savings should not be the only consideration, however, since they can be outweighed by the tax incurred on eventual liquidation or sale of stock. The undistributed earnings of a C corporation do not increase a shareholder's stock basis, but the undistributed earnings of an S corporation do. By operating as an S corporation, the corporate-level tax imposed on a liquidation or sale of assets of a C corporation could also be avoided.

Indirect Tax Increases

Tax on income from operations as an S corporation can be greater than that of a C corporation for other reasons.

* Fringe benefits

Employee fringe benefits paid on behalf of 2%-or-more shareholder-employees do not receive the favorable tax treatment they would if paid by a C corporation.(4) Due to the 35-shareholder limit, most S corporations have at least one 2%-or-more shareholder-employee. This is why most personal service corporations (PSCs), which typically pay out all corporate earnings as compensation, do not find an S corporation to be advantageous.

While Sec. 1372 does not specify which fringe benefits, if paid to 2%-or-more shareholder-employees, are neither deductible by the S corporation nor excludible from the recipient's income, the following fringe benefits (except the last) are discussed in the Senate Report to the Subchapter S Revision Act:(5)

* The cost of up to $50,000 of group-term life insurance.(6)

* The $5,000 death benefit.(7)

* Meals and lodging furnished for the convenience of the employer.(8)

* Employer payments under accident and health plans.(9)

* Cafeteria plans.(10)

* Dividends received deduction

Sec. 1371(a)(2) disallows an S corporation the dividends received deduction (DRD). For a C corporation that is a shareholder, Sec. 243 provides a 70% exclusion of qualifying dividends from income (80% if the investor corporation holds 20% or more of the stock). The deduction results in less of the dividend being taxed.(11)

This disadvantage to S corporations and their shareholders can be significant in the case of entities exporting U.S. goods, because the primary tax incentive for most U.S. exporters--foreign sales corporation status--is useless unless the dividend can be excluded.

* Other disadvantages

When operations are conducted through multiple corporations, an S corporation's inability to file consolidated returns can prove to be disadvantageous. A consolidated return would allow the income of one corporate entity to be sheltered by the loss of another member of the controlled group. Losses-of one S corporation may not offset the income of a related entity because of the basis, at-risk and passive loss limitations imposed at the shareholder level. Intercompany transactions are also less likely to be challenged under Sec. 482 when a consolidated return is filed.

The income of an S corporation can be greater than that of a C corporation, because Sec. 267(a)(2) requires the matching of deductions and income for expenses paid by an accrual-method corporation to a cash-method shareholder. The deduction is deferred until the income is includible in the shareholder's income for expenses accruing to any S corporation shareholder, but only to a...