Changes brought by the Tax Reform Act of 1986 make it advisable for most small, closely held corporations to elect S corporation status. Since the TRA of 1986, I have advised many clients who were operating as a C corporation to switch to an S corporation. Some of the reasons why an S corporation is now favored under the tax law are outlined below:

Differences Between an S Corporation and a C Corporation

An S corporation operates much like a partnership; no taxes are paid by the partnership or the S corporation. Income and losses are passed through to the shareholders on a current basis and the shareholders report on their personal income tax returns, as income, their pro-rata share of profits and losses (except losses are limited to the shareholder's basis in his or her stock or debt). Generally, the corporation pays no tax; however, in California there is an S corporation tax of 1.5% on its taxable income. A C corporation is a separate tax paying entity with its own tax rates. The C corporation files a tax return and pays the tax on its profits. If the C corporation then distributes its earnings to its shareholders, the shareholders take that amount into income as dividends, creating a double taxation.

Start-up corporations generally have losses in the first few years of operation, and by electing S Corporation status the shareholders will receive those losses as individuals. Those losses can then be claimed on the individual's tax return. By contrast, a start-up C corporation may never be in a position to utilize its losses unless it turns a profit in the future.

Corporate Minimum Tax

A C corporation is subject to the new and extremely complex corporate minimum tax. Because of the way the corporate minimum tax works, corporations must keep two entirely separate sets of books for tax purposes. Also, a corporation can be taxed on its "book" income even though the income received is not considered income for tax purposes.

For example, a corporation which receives life insurance proceeds does not have income for tax purposes, but will have "book" income for purposes of calculating the corporate minimum tax. The same problem could arise if a corporation engages in a tax-free exchange of property under Sec. 1031 or a tax-free liquidation of a partnership interest under Sec. 732. Since an S corporation does not pay income tax, it is not subject to the corporate minimum tax.

Double Taxation on Capital Gains

Under the old law, a corporation could sell its assets to a purchaser and liquidate within 1 year without an imposition of a corporate level tax on its capital gains type property. Only the shareholders would be taxed on the gain, which was defined as the money, and FMV of property received, less their stock basis. For example, if a shareholder received $100 and had a stock basis of $20, his gain would be $80. The gain would also have been taxed under the old capital gains rate to a maximum of 20%.

Although capital gains are now taxed at the same rate as ordinary income, an S corporation does not pay tax on the gain attributable from the sale of its capital assets, that gain is only taxed once at the shareholder level. By contrast, a C corporation pays a corporate level capital gains tax, and if the remaining gain is distributed to the shareholders, the shareholders will pay tax on the amount of gain they receive.

While some tax advisors believe that a C corporation shareholder can sell his stock and a corporate level tax on the transaction, in reality a well-informed purchaser will not buy corporate stock. Purchasers will want to acquire the assets of the corporation since they receive a new basis in the assets of the corporation equal to the purchase price.

For example: Assume a corporation is worth $100, the adjusted basis in the assets of the corporation is $50 and the shareholder's basis in his stock is $10. If a purchaser buys the shareholder's stock for $100, the purchaser will have a $100 stock basis, but the corporation's basis in its assets remains at $50. But if the purchaser acquires the corporation's assets at $100, he will now have a basis for depreciation and amortization equal to his purchase price (less the amount allocated to goodwill). Because there is only one level of taxation for an S corporation, an asset sale may be successfully accomplished; however, an asset sale for a C corporation will usually cause a double tax.

When an existing C corporation converts to an S corporation, only the post-S conversion appreciation in the corporation's assets will qualify for single level tax treatment, unless the corporation's assets are sold more than 10 years after the date of conversion. This 10-year restriction is to prevent a C corporation with appreciated assets (and subject to double taxation on the sale of those assets and subsequent distribution of proceeds to its shareholders) from converting to an S corporation in order to achieve a single level of taxation.

Tax Brackets

Under the Tax Reform Act of 1986, for the first time individual tax brackets were lower than corporate tax brackets. This made operating as an S corporation a distinct advantage over paying tax at the higher "C" corporation rate. Under the Revenue Reconciliation Act of 1993 ("RRA 93"), however, Congress raised the tax bracket for "high income" individuals to 36% for individuals with taxable incomes over $115,000 and joint filers with incomes over $140,000. In addition, there is a 10% surcharge for all taxpayers, individual or joint filers with taxable incomes over $250,000. Therefore, the highest tax rate is now 39.6%.

The tax rate for a C corporation is initially lower, averaging 22.25% for the first $100,000 in taxable income [15% on the first $50,000; 25% on the next $25,000 and 34% on the next $25,000], but there is a phase-out of these lower brackets once the corporation exceeds $100,000 and the new tax bracket is 39% from $100,000 to $338,000. Thereafter, the C corporation will pay tax at 34% until it reaches taxable income of $10 million at which time the tax bracket increases to 35%.

Therefore, for a C corporation with taxable income over $100,000, it will pay at approximately the same rate as an individual; there is no clear advantage to operating as a C corporation, even under RRA 93. Even if a corporation managed to keep its taxable income under $100,000 per year, there will be another level of taxation once the retained earnings are distributed to the shareholders or are accumulated beyond the reasonable needs of the business.

Difficulty in Distributing Retained Earnings to Shareholders

Although distributions to shareholders can be made by payment of a salary - a salary is deductible to the corporation, therefore, there is only one level of taxation - salaries must be deemed reasonable in amount or the excess will be treated as a dividend. Also, there are employment taxes, which must be paid in connection with the payment of a salary. The determination of what constitutes a reasonable salary for purposes of dividend characterization is a heavily litigated area and the courts use a case-by-case method of determining the issue. Therefore, it is dangerous to use salaries as a method of distributing retained income from the corporation to the shareholders.

Use of Salaries and Retirement Plans

Some tax planners try and keep corporate profits to below $100,000 and pay the remaining profits to the shareholders as salaries and contributions to a retirement plan. As stated above, salaries must be reasonable, a vague and potentially dangerous concept. Also, there is nothing preventing an S corporation from paying a reasonable salary and forming a retirement plan. With the S Corporation, it is clear that any profits in excess of the reasonable salary amount will be paid to the shareholder directly (there is no potential for a double taxation). In essence, with an S corporation, one loses the advantage of accumulating income at a lower rate under $100,000 for the certainty that the money will never be subject to another tax once it is distributed to the shareholder.

Additional Tax Problems from Operating as a C Corporation

Accumulated Earnings Tax

A corporation that takes advantage of the initial lower corporate tax brackets for taxable incomes under $100,000 and accumulates its income, may run afoul of the accumulated earnings tax. After a corporation accumulates $250,000 ($175,000 for personal service corporations), the corporation must affirmatively justify the reasonable business need for its accumulated earnings. The calculations involved are extremely complex and the corporation will probably needs to retain all its tax returns, corporate minutes and records relating to all purchases of plant, office buildings and equipment. The corporation's accountant may have to reconstruct the corporation's entire history of its earnings and profits and an expert witness testimony may be necessary to justify the amount of retained earnings.

The tax on a corporation that accumulates its income beyond the reasonable needs of its business is now 39.6% (the highest individual tax rate) on its "accumulated taxable income." Accumulated taxable income is, generally, the corporation's taxable income, less the federal income taxes paid on that income. For instance, assume a corporation had unreasonably accumulated its earnings, rather than pay them out to its shareholders. In the current year, the corporation, which had $138,000 in taxable income and paid a corporate tax of $38,000, would have accumulated taxable income of $100,000 and would be subject to an accumulated earnings tax of $39,600.

Personal Holding Company Tax

A personal holding company tax may be imposed on corporations that are controlled by a limited number of shareholders and which derive a larger percentage of the income from "passive income" sources such as dividends, interest, rents, royalties, compensation for use of corporate property by shareholders and personal service contracts. If the personal holding company applies, then the tax is 39.6% of the undistributed personal holding company income. Therefore, a "C" corporation that attempts to take advantage of the lower tax brackets and whose income is mostly from passive sources, may be subject to the personal holding company tax.