The Pros and Cons of Electing an S Corporation Status

The S corporation status has been available to most corporations for many years. According to the Internal Revenue Service, S corporations are now the most common corporate entity.

It is increasingly rare to come across a company that qualifies to be an S corporation (and would benefit from being one) that has not gone ahead with the conversion process. That’s not to say that all companies have taken advantage of this potential benefit.

If your business continues to be structured as a C corporation it is well past time that you at least investigate the possibility of converting to S corporation status. A sub chapter S election for most companies can substantially enhance shareholder benefits, both on an interim basis and at the time of an eventual sale of the company.

Primary Advantages of Making the S Corporation Election

• Single Layer of Taxation. Shareholders escape double taxation of income as taxes are only paid at the shareholder level and not at the corporate level (a flow-through entity for tax purposes). While the income of the business continues to be taxable, shareholders incur no additional tax liability for receiving distributions.
• Step-Up in Basis. Shareholders in S corporations receive a step-up in the basis in their stock based on upon the amount of earnings retained each year. As with the avoidance of double taxation, a step-up in basis also reduces a shareholder’s tax liability if the shares are ever sold because less of the proceeds are subject to capital gains tax.

These advantages can enhance after-tax proceeds to shareholders upon the sale of a business. Many transactions are structured as the sale of assets, rather than the sale of stock. Purchasing assets is generally more beneficial to the buyer and can generally lead to a maximization of the transaction price.

An asset sale of a C corporation will lead to a double layer of taxes (gains inside the company being taxed as well as taxes paid in getting the proceeds out to the shareholders).

An S corporation structure, with the single layer of taxation and the step-up in basis, typically provides more efficiency in terms of after-tax shareholder proceeds.

The Downside of Making the S Corporation Election

While the economics of an S election can be favorable, there are certain drawbacks, including:

• Cash Flow vs. Tax Liability. Regardless of whether a distribution is paid, shareholders will owe their pro rata share of taxes on the company’s earnings. While this is a potential problem, proper understanding and planning of cash flow needs can easily eliminate any surprises in this area.
• Built-in Gains. If the entity or any of its assets are sold within ten years of S Corporation election, then the gain, based on the value at the conversion date, is taxable to the company. While this could be a downside relative to being an S Corporation without such built-in gain, there is no way to go back and convert at an earlier date. For a growing company, converting sooner rather than later will at least minimize the amount of gains captured for the ten year period.
• Shareholder Limitations. Initially, the Small Business Job Protection Act passed in 1996 specified that the company may have no more than 75 shareholders in order to qualify for an Selection, and those shareholders must be qualifying shareholders (no IRAs or corporations). The American Jobs Creation Act of 2004 (“AJCA”) increased the number of eligible shareholders to 100. AJCA also allows that family members who are shareholders of an S corporation can elect to be treated as one shareholder.

Conclusion

While the above discussion outlines some of the primary advantages and disadvantages of an S election, any company considering such an election should discuss their specific considerations with their accountant or tax advisor.

If a company determines it should take advantage of its option to elect S Corporation status, a fair market value appraisal of the company is required as of the election date. If you are considering converting to an S Corporation and, therefore, require a valuation, please let us know if we can be of assistance.