Financial Strategies: Why are S Corporations So Popular?

By |  January 19, 2016
photo: ©istock.com/jrwasserman

A corporation must be formed in accordance with state law in the state in which it intends to be domiciled. photo: ©istock.com/jrwasserman

Knowing the difference between a C corporation and an S corporation is essential for effective tax planning.

It’s important for pest management company owners to understand the differences between a C corporation (C Corp) and an S corporation (S Corp). For our industry, an S corporation is almost always more efficient. Let’s explore why.

Normally, a corporation is taxed on its own as a separate and distinct entity from its owners. In this manner, it is subject to its own tax rates and set of tax rules. Once net income is determined and its owners want to extract money from the corporation, it comes out as a dividend that can be taxed again at the shareholder level. This is how a C Corp is normally taxed, and why its use usually results in double taxation. With proper planning, there may be some other methods to escape some of this double taxation, however double taxation for a C Corp is the general rule.

There is a way to avoid this double taxation and preserve all the legal benefits of incorporation. Eligible domestic corporations can avoid double tax by electing to be an S Corp under the rules of Subchapter S of the Internal Revenue Code. With an S Corp, all items of income, deduction, credit, gain and loss are passed through on a pro rata basis to the individual S Corp shareholders to be included on their personal tax returns. There is no income tax at the corporate level, thereby eliminating the double tax issue a C Corp usually creates.
 

How is an S Corp formed?

A corporation must be formed in accordance with state law in the state in which it intends to be domiciled. Once established, Form IRS 2553 must be submitted and approved to make the election to be an S Corp. Several restrictions that apply include:
⦁ There must be 100 or fewer domestic individual shareholders.
⦁ There must be one class of stock.
⦁ The corporation must be made prior to the 15th day of the third month (usually March 15) to be considered for the current year.
⦁ Profits and losses must be allocated pro rata to shareholders based on ownership percentage.

Some states require a separate state election to be treated as an S Corp for state purposes. Other states do not recognize S corporations for state tax purposes at all. Check with a tax advisor in your state.
 

+Advantages to becoming an S Corp

⦁ An S Corp distributes profits with a single tax. However, income is taxable to the shareholder regardless of whether it is distributed. In many instances, losses from an S Corp can be used to offset other types of income that are included on a shareholder’s personal tax return.
⦁ S corporations are specifically exempt from the accrual rules in most cases, and can continue to use the cash-basis method of accounting. This is advantageous for most pest management firm owners.
⦁ With a C Corp, the profits on the sale of assets (otherwise known as a capital gain) is typically taxed at the ordinary corporate tax rate. As an S Corp, however, these capital gains are taxed at a lower rate on the shareholder’s personal tax returns.
⦁ As with any corporation, the Federal Insurance Contributions Act (FICA) is taxed only on wages and not on distributions from the S Corp. This is different from an unincorporated business such as a proprietorship, partnership or limited liability company (LLC) taxed as a proprietorship or partnership. Although FICA is not charged on S Corp distributions, it should be noted the Internal Revenue Service (IRS) can assert certain distributions constitute wages, as there needs to be reasonable compensation for active (shareholder) workers in the business prior to distributing profits.
⦁ Health insurance premiums paid by the company on behalf of a 2-percent-or-more shareholder are deductible to the corporation, but must be included in the shareholder’s W-2 form, subject to withholding. However, the shareholder can take a tax deduction personally and the amount is not subject to FICA tax on the benefit.
⦁ For those who have an adjusted gross income of more than $250,000 married and $200,000 single, and are actively involved in the operations of their S Corp, the S Corp income is not subject to the 3.8 percent Affordable Care Act (“Obamacare”) investment tax.
-Disadvantages to becoming an S Corp
⦁ There is no opportunity to accumulate corporate earnings, taking advantage of the corporation lowest tax brackets.
⦁ Profits and losses, credits, and gains and losses on the sale of assets must be distributed on a prorated basis in relation to shareholder ownership percentages. In this manner, they cannot be distributed by agreement to those owners where the benefits might be greatest, as with a partnership or LLCs taxed as a partnership.
⦁ If an S Corp shareholder is not a material participant, S Corp losses can only be offset against passive income on his or her personal return.
⦁ Greater recordkeeping is required because of the need to calculate shareholder basis.
⦁ Losses taken without a positive basis in the shares will not be available to deduct on a shareholder’s personal tax return until basis has been restored or the shares are sold.
⦁ Distributions in excess of basis are taxable as a capital gain. What are distributions in excess of basis? As a result of S corporations reporting income to shareholders and having it taxed on the shareholders’ returns, regardless of whether the income has been distributed, distributions are normally treated as tax-free to shareholders when made. However, when those distributions are made in excess of accumulated income in general, they may be taxable. Check with your tax advisor, as these rules are complex.
 

Separate reporting

Even though each shareholder reports taxable income on his or her personal tax return, the tax treatment of items flowing from the S Corp is determined at the corporate level. Shareholders are required to treat S Corp items the same way on their personal returns
as reported by the S Corp.

Items that are reported separately to shareholders include income from rental real estate, portfolio income, capital gains or losses, charitable contributions, health insurance costs, and Section 179 deductions, among others. The reason for separate reporting is so shareholders can classify these items that might be treated differently or subject to limitations so they can be presented properly on shareholder personal returns.

In most cases, an S Corp is a much more tax-efficient vehicle than a C Corp. However, before deciding to make an S Corp election, consult your tax advisor to determine whether it makes sense based on your particular circumstances.
 

Beware when selling

There are some pitfalls to avoid for those thinking of selling substantial assets or their entire businesses. Because the sale of assets is taxed at a higher rate as a C Corp, there is a special rule — the built-in gain rule — for those who make an S Corp election. It’s in place because the government doesn’t want C Corp owners to be able to make an S Corp election simply to immediately sell the assets of their corporation and get capital gains treatment on the sale of their assets, as opposed to ordinary income treatment normally afforded a C Corp just for the fact that they made the election in contemplation of the sale.

The built-in gain provision creates a waiting period on how to recognize a gain from sale.
A recent change in the laws has varied the waiting periods depending on when the S Corp election was made, but it normally varies from five
to 10 years. So if you are contemplating selling your business in the near future and you are a C Corp, you’ll need to consult your tax advisor to plan around this provision — or be prepared to pay a lot of taxes.

Dan Gordon is a CPA in New Jersey and owns an accounting firm that caters to PMPs throughout the U.S. He facilitates several peer groups that help PMPs increase growth, profitability and accountability in their firms. Visit www.pcobookkeepers.com for information about his firm, PCO Bookkeepers. Gordon can be reached at dan@pcobookkeepers.com.

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