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Question:
As president of a closely held C corporation with substantial appreciated land and buildings holdings and at tax year end of April 30th should I recommend to the shareholders that they elect S corporation status and why? I have enclosed a copy of our prior year tax return to assist you. You should also be aware that one of the shareholders is the estate of a decedent.
Re: S corporation taxation and election
S corporation taxation is substantially more complicated both for the corporation and its shareholders than your current scheme of taxation, that is, as a normal C corporation. Though the benefits can be substantial, the tax traps, complexities and unintended results to the stockholders can be overwhelming. The following is an overview designed to assist you in recommending to your shareholders whether or not the S corporation benefits outweigh the disadvantages.
Advantages of an S Corporation
1. Double tax avoidance - The single most material advantage to a corporation with significant appreciated property is that S corporation status, subject to the built-in-gain ten-year transition cliff rule (discussed below), permits owners of a business to avoid double taxation on the sale of appreciated property. Rather than both a corporate tax and a shareholder income tax, a single federal income tax is assessed at the shareholder level. This can be an enormous advantage that can outweigh many of the disadvantages of operating an S corporation.
In general, shareholders can expect at least 32% savings at liquidation. For entities with significant appreciated asset value, this is material.
Operating taxable income, as well as losses (up to shareholder basis), are also passed through and taxed to the shareholder at his or her tax bracket. However, with the exception of losses, our experience for a closely held family corporation your size is that the individual tax rate is higher than the corporate tax rate, thus making it more expensive to accumulate earnings for debt repayment or capital expansion. For example, the C corporation income tax rate, Federal and State combined is 21.8% for the first $50,000 of taxable income. Many individuals are in the 28% or higher tax brackets. An offsetting advantage to these individuals is that their stock basis also increases, as opposed to a C corporation where there are no shareholder basis adjustments.
It should be noted however that the double level of taxation can be avoided by a C corporation selling its stock. However, since the buyer would not receive a “step-up” in the basis of the underlying assets, a discount equal to the liquidation tax is normal.
2. Shifting Income Within Family - By transferring stock to lower income bracket family members, such as minor children over the age of 13, an S corporation's income can be shifted. Such transfers must be bona fide. This advantage is similar to that offered under the family partnership taxation rules.
3. Avoidance of Tax On Excess Accumulations - Section 531 assesses a tax on corporations that accumulate cash in excess of $250,000 and that needed for reasonable working capital and other business needs. S corporations are exempt from this tax.
4. Tax-free Dividend Distributions - To the extent of positive accumulated S corporation earnings (already taxed to shareholders), dividend payments are federally tax free as a return of positive shareholder stock basis. However, if the shareholders are New Hampshire residents, their Interest and Dividend tax of 5% applies. It would be necessary for us to know the state of residency in order to inform you of State income taxation implications of the S corporation election upon shareholders. Note also that the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the tax rate on C corporation dividends to the capital gain rate (15% for 2003).
Disadvantages of an S Corporation
1. Complexity - Perhaps the most significant drawback are the number of tax traps for the unwary. The fact that courts have, in general, construed the technical rules against taxpayers adds to this problem.
2. Shareholder Basis Rules for Deductibility of Losses - Unlike its cousin the partnership, third party indebtedness will not increase an S corporation shareholder's stock basis. The basis of stock of a shareholder of an S corporation is only increased for capital contributed, loans made by the shareholder to the corporation, and earnings passed-through to the shareholder. A shareholder with an inadequate basis may be unable to deduct S corporation losses. However, losses allocated to a shareholder with inadequate basis are suspended and carried over until such time the shareholder obtains basis.
3. Allocation of Tax Attributes - Unlike a partnership, the S corporation cannot make special allocations of income and loss items. Rather, income and deductions are allocated on a per-share/per day basis.
4. Corporate Taxes - When a C corporation converts to an S corporation there are five taxes that can be imposed, the following two are most likely to effect your corporation:
a. Built-in gains tax
b. Passive income tax
Built-in Gains Tax
For ten post-conversion years any gain or income
that the corporation realizes on the sale or liquidation of appreciated
assets is taxed to the extent that the gain existed within such assets
on the conversion date. The gain flows through to the shareholders, net
of a 35 percent corporate level tax, creating a near double level tax.
For example, if the fair market value at the effective date of the election of your land and buildings exceed the basis of such assets by $1,000,000, then the corporation would incur a tax on the million at the current rate of 35% upon the sale or liquidation of those assets. In general, the shareholder would then have taxable income of $650,000, hence a double tax, just as if there was no S corporation election. After ten years, there is no corporate level tax, it drops off the "cliff". This rule has been in effect since 1987.
Additionally, the built-in gains tax applies to cash basis corporations such as yours. Specifically, the net of all trade receivables and refunds less trade payables at April 30th (your year end), would be subject to the built-in gains tax. Due to the nature of your business, one would expect that this would be a negative amount and no tax would result. However, it is important to measure this to make certain there are no surprises. As a result of this rule there is a significant tax trap for cash basis entities whose accrual basis books would include large receivable causing an enormous double level tax.
Passive Income Tax
It appears from your April 30, 19XX corporate tax return that your corporation as accumulated Earnings and Profits. As a result, it might become subject to the passive income tax imposed upon "excess net passive income". This can be a serious problem due to the fact that not only would such passive income cause a corporate level tax, but after a three-year successive period of passive incomes the S corporation status would terminate.
In general, passive income is comprised of interest, dividends, royalties and in certain circumstances, rents. Thus, if the corporation decided to rent its property rather than operate the business, it is likely that a passive income problem would be created.
We utilize two techniques to negate this problem: first, by assuring that within each three-year sequence the corporation sustains a loss, or alternatively, the corporation elects to distribute as a taxable dividend to the shareholders the accumulated earnings and profits of the prior C corporation. (In your case this looks like about $xx,000, painful, but possible). Accordingly, it is important to maintain precise historical records, particularly depreciation, capital transactions and adjustments.
5. Taxation of Fringe Benefits to Shareholders - Employee fringe benefits including the most popular, health insurance and group term life, are taxable to S Corporation shareholders who receive those benefits. Given todays expensive health insurance premiums, and dependent upon the number of employee shareholders, this can be an expensive tax over the long-term.
6. Tax Year End of Corporation - Your corporation would be required to change its tax year. Though year ends of September though December are permissible, we would recommend the corporation elect to change its year to December 31 from April 30 due to the nature of its seasonal income. In effect, the shareholders would be taxed on operations from May 1st through December 31st 2XX0 without benefit of losses sustained from January through April 2XX1. However, this is a one-year bump in income. Thereafter, shareholder would be taxed on twelve months of operating results. For fiscal year entities click here for information on compliance issues.
7. Cash Basis Method For Shareholder Transactions - Unlike C corporations wherein accrued expense paid within two and one half months after year end to less that 50% shareholders are deductible, all S corporation shareholders are on a cash basis with the corporation.
8. Limits on Permissible Shareholders - S corporation have precise technical requirements. For example, there can only be one class of stock, though varying voting rights are permitted. Certain entities are not permitted to be S corporation shareholders. Should they become a shareholder the S corporation election would be terminated. Ineligible shareholders include nonresident aliens, certain tax-exempt organizations and most irrevocable trusts unless certain elections or criteria are met (so-call QSST and ESBT rules). In the case of the current Estate holding stock, it would be necessary for us to determine the period of time the estate could hold such the stock before being forced to make distribution. In PLR 7951131 an estate was permitted to make an initial election. There is also a limit on the number of shareholders, specifically 75, wherein husband and wife are considered a single shareholder.
Due to these holding restrictions, we strongly urge that the shareholders enter into a stock restriction agreement to protect from an accidental termination of the S corporation election. All shareholders are required to sign form 2553 making the S corporation election.
S Corporation Election
We have attached form 2553 and instructions for your review. However, as noted above, we strongly urge that the shareholders enter into a stock restriction agreement to prohibit accidental termination or intentional termination by one shareholder holding the other shareholders hostage by threatening to transfer his or her shares to a non-qualified shareholder. We can provide you a template for these provisions.
The form discloses each shareholder's name, address, social security number, number of shares held, date shares where acquired and their tax year end (normally December 31st). Additionally, each shareholder and the corporation must sign the election.
We strongly urge you not to complete the form yourself since a technical failure could constitute a very, very expense mistake. We recommend you fill in the information which is readily available and allow us to complete the remainder. We also recommend that the corporation conduct a formal joint meeting of directors and shareholders to adopt S corporation status. An appropriate resolution might read as follows: "After a general discussion, upon motion duly made, seconded and unanimously adopted, it was RESOLVED, that the corporation hereby make an election to be treated as an "S corporation" under IRC Section 1362(a) for its taxable year commencing May 1, 2XX0".
In order for the election to be effective on the first date of its current tax year, May 1, 2XX0, the corporation and its shareholders must make a qualified election on or before July 15, 2XX0. We strongly recommend that the election be mailed certified mail, return receipt requested for proof of mailing.
As stated previously, this discussion is intended as an overview and should not be viewed as comprehensive. Please do not hesitate to contact us to further discuss the many taxation issues discussed above. I would be pleased to meet with you and the other shareholders to answer any questions. Clearly, this election should not be taken lightly and if made should be in the context of the shareholders’ future plans for the corporation and its property.
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