When Is an S Corporation Ideal—and When Isn’t It?

You’ve heard of S Corporations. Your neighbor’s company is organized as an S corporation. And you’ve heard him go on an on about how awesome S corporations are. You’ve heard just about everyone (and their mother) tout S corporations as being the perfect entity. And they are—in certain situations.

You see, choosing an entity takes care and consideration and no entity qualifies as one-size-fits-all. So while an S corporation may be awesome for your neighbor (and his mom), the same may not be true for you.

When is organizing your company as an S corporation ideal? And just what makes them so awesome?

For starters, S corporations, unlike regular corporations, aren’t subject to double taxation. Regular corporations pay tax on income, and then you, as a shareholder, pay tax on the profits distributed to you (known as dividends). S corporations don’t pay income tax (though they may be subject to other taxes). The income is simply “passed through” to each individual shareholder, who then reports his share of income on his personal income tax return. The corporation can then distribute profits to each shareholder tax free (so long as there’s sufficient basis). Therefore, any amount distributed by the corporation to each shareholder is only subject to tax once.

This pass through nature of the S corporation is one of the reasons the entity can be ideal in some tax planning situations.

Here’s one situation where an S corporation may be ideal:

For some companies, particularly in the early years, the company may be operating at a loss. Each individual shareholder gets their share of this loss (assuming there is enough basis), which can then be deducted on their personal income tax return. This can be used to offset income that otherwise would’ve been taxable. And since S corporation owner-shareholders are supposed to pay themselves a reasonable salary, this loss can even be used to offset the wages paid to you by your company. Awesome, indeed.

There’s more… S corporations are eligible for Section 1244 treatment. So, let’s say this startup of yours is unsuccessful and the stock is later disposed of at a loss. This loss is allowed to be categorized as an ordinary loss, instead of what normally happens: treating the loss as a capital. Categorizing it as a capital loss means you can only net it against other capital gain or be limited to a $3,000 annual deduction. Being allowed to categorize the loss as ordinary means that the entire amount can be deducted at once.

Here’s another:

Quite the opposite of the above scenario, your company is very successful and actually has quite a bit of cash on hand. Your company’s future is looking pretty good. With a regular corporation, if you were going to distribute some of this wealth to shareholders, it would be ideal to be able to classify this as salary and not as dividends. Why? Because salaries, unlike dividends, are deductible to the corporation and they are taxable as ordinary income to the shareholder. The IRS, being the IRS and all, is obviously aware of this and is notorious for reclassifying unreasonably high compensation as dividends.

However, with S corporations, this isn’t necessarily an issue. And organizing as such minimizes any issues you’d have with unreasonable compensation. You either pay this as a salary (deductible by the corporation) or as distributions (not deductible by the corporation, but not taxable to the individual shareholder either).

The above situation is especially ideal when the corporation is a personal service corporation (PSC). PSCs are those companies that:

  1. At least 95% of the the time spent by the company’s employees is devoted to services in either the health (including veterinary), law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and
  2. At least 95% of the stock is held directly (or indirectly) by either the employees performing these services or retired employees who did perform these services or their estates, or any other person that in the two-year period starting with the date that such an employee died, acquired that individual’s stock because of his death.

That was a mouthful.

So, if my company was organized as a regular corporation, I’d be considered a PSC. So would my family physician, my dog’s vet, the architect that designed the building I live in, that ballet company… you get the idea.

This is important because PSCs are subject to a flat tax of 35%. That’s right, no graduated rates for PSCs. It would therefore be beneficial for the company to be organized as an S Corporation. Not only does the S Corporation get rid of that dreadful flat tax of 35%, it is free to distribute enough of the accumulated cash to each shareholder to pay the tax they’d be subject to (remember: income of the S corp. is passed through to each shareholder).

Let’s look at a few situations where you’d probably want to stay away from an S corporation.

As mentioned before, S corporations are pass-through entities, so the income is reported on each individual shareholder’s personal income tax return. Depending on the marginal tax rate, sometimes the tax can be cheaper when using the corporate tax rates than the individual. So it would make more sense to be organized as a regular corporation and have the corporation pay the tax.

Another situation is with fringe benefits. Fringe benefits of closely-held companies are normally taxable to an S corporation’s shareholder-employees. Again, another situation where you’d probably want to be a regular corporation.

Another reason you may want to stay away from S corporations is if you are looking for investors. Investors prefer regular corporations because S corporations aren’t allowed to have more than 100 shareholders, and they are limited to one class of stock, which means… no preferred stock.

Now, this obviously isn’t all inclusive. The point is, don’t just go out and form an S Corporation (or any entity for that matter) because someone told you to. The important thing to do before you create your entity is have some kind of understanding of the direction your company will likely head in and what’s important to you (investors, flexibility, lower income tax, etc.) and chose an entity based on that. And for goodness sake go talk to a decent tax accountant. Who probably isn’t your neighbor.

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