Monday, January 12, 2009

S Corporations - A Summary Discussion

One of the concepts least understood by many business owners, and even others in the business community, are “S” Corporations. Although I’ll cover a few of the issues surrounding this entity type, my main goal here is to highlight why, in the vast majority of cases, it makes sense to be treated as an S Corporation for tax purposes. It’s a decision that all business owners should have already addressed or should be addressing. Over the years I’ve met business owners who have said that no one in their trusted advisor circle ever raised the issue for consideration. That’s truly a shame but it’s never too late to consider whether making the election to be treated as an S Corporation for tax purposes makes sense. I do not plan on getting into the details of who can qualify for “S” status as most contractors will be able to do so. Further, it always makes sense to consult with the company’s advisors to decide whether “S” status makes sense as certain circumstances may be present (unused NOL carry forwards as one example) whereby it would make sense to retain the C Corporation status.

The S Corporation is a tax concept, it does not affect the liability protection afforded by being incorporated or the accounting and reporting for the business (aside for accounting for income taxes). I’ve often been asked whether liability protection is diminished and I always give this same answer along with the suggestion that they speak with their corporate legal counsel to gain additional peace of mind. As “S” status is a tax concept, it affects how tax is assessed and who is responsible for the payment of tax. An S Corporation is not an income tax paying entity. The shareholders are responsible for paying the income tax to the government. The income tax is calculated, and reported, on the shareholders personal tax returns. The money to satisfy the tax obligation usually comes from the S Corporation itself in the form of a distribution. As the S Corporation is not an income tax paying entity, any deferred income taxes (including those arising from the use of a tax exempt method such as cash or completed contract basis) will not be the responsibility of the S Corporation and therefore not recorded on the corporate balance sheet as a liability. Most CPA firms will provide a footnote in S Corporation financial reports stating what the amount of the estimated personal deferred income tax liability is for the shareholders resulting from the S Corporation. One quick way to calculate this deferred tax amount is to, as long as the balance sheet in the tax return is reported on the tax exempt method (e.g. cash basis), take the difference between percentage of completion based retained earnings in the financial report and retained earnings reported in the tax return and multiply the difference by 40%. That should provide a reasonable estimate of the deferred tax liability to be paid by the shareholders in the future.

Perhaps the greatest reason for electing “S” status is the planning for the exit strategy; the liquidation event. Let me take you through an example that will illustrate the issue. In the first example let’s say that a contractor can sell her business for $5MM dollars. She owns the company, a C Corporation in this case, and the proposed buyout is an asset purchase (the prospective buyers do not want to purchase the stock as they want no part of any contingent liabilities, construction defect issues, etc.) The assets that are being purchased are owned by the C Corporation (Jane owns the stock of the C Corporation, not the assets themselves). The C Corporation sells the assets for $5MM and since the tax basis for the assets being purchased is nominal, we’ll assume that it’s all taxable gain. The full $5MM is taxed inside the C Corporation at 40% (Fed and CA combined) therefore the tax liability is $2MM. The remaining $3MM in cash is distributed out to Jane in the form of compensation and is taxable to her, again at 40% combined tax rates. The liability on the $3MM she takes out is therefore $1.2MM leaving her with roughly $1.8MM on the $5MM sale. That doesn’t seem like a great result.

Let’s go through the same example but this time with Jane having elected S Corporation at the time she started her business. The prospective buyers again are only interested in purchasing the assets of the corporation for $5MM. Since the S Corporation is not an income tax paying entity, no income taxes will be due by the corporation. In California however, S Corporations must pay a 1.5% franchise tax based on taxable income, so Jane’s S Corporation will owe $75,000 to the state of California on the company’s $5MM gain on the asset sale (again assuming nominal tax basis in the assets). Let’s set the $75K liability aside until the end of our example to keep the math easier. Jane wants to retire on this transaction so she pulls the $5MM out of the S Corporation and again, at the personal combined tax rate of 40%, the tax liability is $2MM with $3MM remaining. When we consider the $75K CA franchise tax discussed above, the net take home for Jane is $2,925,000. The difference between the take home for Jane owning a C Corporation ($1.8MM) and an S Corporation ($2.925MM) is over $1MM! Stated another way, the effective tax rate after the double taxation as a C Corporation is approximately 64% while the tax rate for the S Corporation transaction is approximately 42%. The difference is significant and can actually affect whether a transaction is actually done. Owners don’t care as much what they could sell their company (or its assets) for, they care much more about what they can take home after taxes. Owning an S Corporation will generally provide for a maximization of the “take home” amount and provide a greater likelihood a transaction can be structured to a seller’s liking.

As I write this, there is not a meaningful difference in the top tax rates for corporations versus individuals. Many years ago the top tax rates for corporations were significantly less than those for individuals, making the decision to be treated as an S Corporation a more challenging one. Time will tell if a divergence in those rates will affect whether “S” status makes sense. For now I’d suggest in the vast majority of cases, operating as an S corporation is the best entity choice for contractors.


Dale said...

I like how you described the S Corporation. It's good to know the concepts and the different factors behind it.

small business consulting

April Kulpinski said...

This article provides much clarity on the differences!
Thank you.