S Corporations

As noted in the first installment of the series, the three most widely used entity form alternatives in the apparel, action-sports, accessories, and hard-goods industries (essentially consumer products) are the; C corporation (“C-corp”), S corporation (“S-corp”), and Limited Liability Company (“LLC”).  Part I of the series focused on the C Corporation.  Part II focuses on S Corporations and can be used as a for basic informational and discussion purposes to provide a background on the S Corporation and summarizes the advantages and disadvantages of this type of entity form.  The information below is not an substitute for or intended to replace your business attorney and CPA whom both should be consulted thoroughly prior to making a decision to select a particular entity form for your business.

Background

S Corporations provide the liability protection of a C corporation without the disadvantage of being subject to double taxation of distributions/dividends.  S Corporations operate as pass through entities.  This means that income generated by an S Corporation is not taxed at the corporate level for Federal purposes but rather is passed through to the individual shareholders based on their ownership percentages and taxed at the shareholder’s individual level.  Consequently, distributions by an S Corporation to its shareholders generally does not result in additional tax.  Note however that individual states impose different taxation requirements on the net income of S Corporations.  For example, California imposes a 1.5% tax on the net income of S Corporations with a minimum of $800 up to a maximum corporate rate in New York City of 8.84% for net income derived from within the city.

Advantages

• The primary advantage of an S corporation is that it is not subject to double taxation.  S corporation income is passed through to the individual shareholders to be taxed at their marginal tax rates (currently the maximum federal and California rates are 35% and 9.3%, respectively). California does impose a 1.5% tax on S corporation taxable income derived in California with an $800 minimum tax/franchise tax.
• Another advantage of operating as an S corporation is that income passed through to the individual shareholders is not subject to self-employment tax.  Currently, employer and employee FICA taxes are imposed at 10.4% for Social Security/old age survival disability insurance (OASDI) and at 2.9% for Medicare/hospital insurance (HI), for a total tax of 13.3% on the first $106,800 (for 2011) of wages.  Employee owners of C and S corporations can control to a degree how much compensation they pay themselves and, therefore, can limit their exposure to the 2.9% HI premium. On the other hand, general partners and LLC members treated as general partners cannot control the amount of self-employment income taxable to them. Therefore, they could easily pay much more HI tax than would similarly situated owner-employees of C and S corporations. This creates a current advantage in favor of electing S status.
• Another advantage is the avoidance of the corporate alternative minimum tax.  As discussed earlier, a C corporation pays tax on the higher of its regular income tax or its alternative minimum tax.  This tax is avoided by operating in S corporation form.  Note that S corporation shareholders are potentially subject to alternative minimum tax at the individual filing level based upon the shareholder’s individual circumstances.
• S Corporation’s are not subject to unreasonable compensation adjustments by the IRS.  As a means to bail out corporate earnings and avoid double taxation, C corporations sometimes pay unreasonably high salaries to its shareholders.  The IRS can re-characterize the salaries as dividends thereby resulting in double taxation to the shareholder.  S corporations, by virtue of their income pass-through nature, avoid the unreasonable compensation issue.
• Since all S corporation income is passed-through and taxed at the shareholder level, S corporations are not subject to the accumulated earnings tax.  S corporations are free to accumulate earnings within the corporation to any extent desired.
• Unlike a C corporation, S corporations are allowed to use the cash method of accounting even if the average gross receipts in the prior three years exceeds $5,000,000 (if not precluded by other tax law requiring the use of the accrual method of accounting).
• Unlike C corporations, the losses incurred during the initial years of a business may be passed through to the individual shareholders and used to offset other income thereby providing an immediate tax benefit.  The losses are subject to the normal limitations imposed by the passive loss, at-risk and basis rules.

Disadvantages

• One of the primary disadvantages of operating as an S corporation are the restrictions on the ownership structure.  In order to qualify as an S corporation, the following restrictions apply:
• 100 or fewer shareholders
• Eligible shareholders are limited to US citizens or resident alien individuals
• The corporation can only have one class of stock (no preference items), although voting and non-voting common stock is generally not considered separate classes.
• Shareholders cannot be C Corporations, other S Corporations, LLC’s, Partnerships, or certain trusts
• There is also a lack of flexibility in allocating income and losses to the shareholders.  In general, the income or losses generated by the S Corporation must be allocated to the shareholders based on their specific ownership percentages (pro-rata).  This is in contrast to LLC’s which are allowed to allocate income or losses without this restriction.Distributions from an S Corporation must also follow the ownership percentages, which can at times require distributions to shareholders who may not otherwise require a distribution.
• For S Corporations that operate in multiple states, it can result in additional administrative burdens at the shareholder level since the shareholders may be required to file individual income tax returns in the various states that the S Corporation does business in.  This burden can be reduced to some extent through the filing of composite returns for the shareholders relieving them of the filing burden.
• Unlike a C Corporation, shareholders that own more than 2% of an S Corporation generally are taxed on certain fringe benefits such as group-term life insurance, medical benefits, and meals and lodging.

Hopefully this gives you a high-level understanding of the advantages and disadvantages of a S Corporation as an entity selection option.  Part III of the series will go into the workings of the Limited Liability Company (LLC).  As stated in the intro paragraphs, the information above is not a substitute or replacement for in-depth consultations with your legal advisor and CPA prior to forming an entity.

Orion Barca, CPA

President

Barca Company, Inc.

Orion@BarcaCompany.com

949.235.6933

Circular 230 Disclaimer
Any tax advice contained in this communication, was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties that may be imposed on the taxpayer under the Internal Revenue Code or applicable state or local tax law or (ii) promoting, marketing or recommending to any other party any tax-related matter(s) addressed herein.