Should you reevaluate your S election?

• Author: Brown, Charles H., III

After passage of the Tax Reform Act of 1986, many corporations filed S elections. Changes in the tax law since 1987, however, may necessitate a review of a corporation's tax status.

Benefits

Several factors had precipitated S elections prior to jan. 1, 1987. For the first time in years, the maximum individual tax rate of 28% was lower than the maximum corporate tax rate of 34%. In addition, with the repeal of the General Utilities doctrine, election of S status avoided double taxation on the sale of corporate assets and the corporation's subsequent liquidation. Other benefits included the ability to distributed accumulated S income to shareholders free of income tax and the inapplicability to S corporations of the accumulated earnings tax (AET). There was also the possibility of avoiding unreasonable compensation to an owner.

Shortcomings

The benefits of electing S status were not all positive, h major disadvantage was the requirement that fringe benefits provided for stockholders with a 2%-or-more stock interest had to be included in compensation. Another disadvantage was that the first $75,000 of S income could be taxed at a rate higher than that of a C corporation.

Changes

Several changes in the law implemented since 1986 have caused taxpayers to rethink the benefits of S elections.

Tax rates rise: The most dramatic change is that the top individual Federal tax rate has risen to 39.6%, while the top corporate tax rate remains at 34% for small and medium-sized corporations. (Corporations with taxable income exceeding $10 million have seen the maximum tax rate rise to 35%.) The top individual tax rate is effectively higher than 39.6% when the limitations on deductions based on adjusted gross income (the phaseout of personal exemptions, the 2% limitation on miscellaneous itemized deductions and the 3% limitation on itemized deductions) are also considered.

Deductibility of health care premiums: Since 1987, the deductibility of health insurance premiums on the individual returns of 2%-or-more S stockholders has gone from 25% deductibility, to expiration and reinstatement twice, and to 30% deductibility effective in 1995.

Multistate taxation: A negative consequence may arise at the state level. For S corporations doing business in more than one state, or those S corporations with nonresident stockholders, many states require S corporations to pay a nonresident withholding tax based on the percentage of income allocated to the nonresident...