It has become relatively rare for an accountant or attorney to recommend the use of an S corporation for a newly-formed, closely held business.  Instead, the LLC, taxable as a partnership, has become the entity of choice for most start-ups, and for good reason: it is a flow-through entity for income tax purposes, and it is not burdened by restrictions on its ownership.  In addition, it affords great flexibility in the allocation of profits and distributions.

The fact remains, however, that there are many S corporations in existence, so an advisor cannot afford to be ignorant of the rules governing them.  Moreover, there are still a great number of closely-held C corporations, many of which may be better served to elect S corporation status.

Converting into an LLC?  Have You Thought It Through?

       In most cases, a corporation may be “converted” into an LLC, but not without triggering corporate-level and shareholder-level income tax.  These tax liabilities may be significant, because the conversion, in whatever manner it is accomplished, will be treated as a liquidating distribution (i.e., a taxable sale of its assets) by the corporation.  As a result of the deemed liquidating distribution, the corporation’s shareholders will be treated as having received the distributed assets in exchange for their shares of stock in the corporation.  Consequently, each shareholder will recognize gain equal to the excess of the fair market value of those assets over the shareholder’s adjusted basis in his shares.

Consider Electing Sub S

In contrast to the result of an LLC conversion, a qualifying C corporation may  achieve pass-through treatment without triggering an immediate income tax hit by electing to be treated as an S corporation.

In general, in order to qualify for the S election, the corporation must satisfy the following requirements:

–          It must not have more than 100 shareholders;

–          Its shareholders may only be individuals (other than nonresident aliens), estates and certain trusts; and

–          It may have only one class of stock.

Once a qualifying corporation’s “S” election becomes effective, each of its shareholders will be required to report on the shareholder’s income tax return his pro rata share of the corporation’s items of income, gain, loss, deduction or credit.  Thus, the shareholder will be taxed upon this share of the S corporation’s taxable income.  The corporation itself shall not be taxable, subject to certain exceptions.

Phooey on S Corps?

Notwithstanding the favorable pass-through treatment, S corporations still have many detractors.  These folks point to the single class of stock requirement and to the limitation on who may be an S corporation shareholder.  They also point out that there is pressure on S corporations to pay reasonable compensation to those of its shareholders that work in the corporation, thereby triggering employment taxes.  More recently, these detractors have indicated that, without mandatory distributions, passive shareholders face the prospect of phantom income, which subjects them not only to income tax but also to the new surtax on net investment income.

The shareholders of a C corporation, they continue, are not subject to any income tax or surtax until the corporation distributes a dividend.  Meanwhile, the compensation paid by the C corporation to the active shareholders effectively results in only one level of income tax, at least as to the compensation amount (provided it is reasonable for the services rendered); the profit remaining in the corporation is subject to corporate level tax, but at a maximum rate that is currently less than the maximum rate applicable to individual taxpayers.

The Asset Sale: An S Corp Trump Card

These are all valid points, but they overlook one critical item:  the tax consequences on the sale of the corporation’s business.  While it is true that some taxpayers have successfully bypassed the corporate-level tax on an asset sale by allocating a portion of the purchase price to a consulting agreement for each of the key shareholder-employees, or by maintaining that the goodwill associated with the business resides not in the corporation, but in the key shareholder, these “techniques” are either of limited benefit (especially where only some of the shareholders are active in the business) or may be difficult to support (as in the case of so-called “personal goodwill”).

The fact remains that, for an established, closely-held corporation, the S election offers the best means for avoiding corporate level tax, provided the sale occurs beyond the corporation’s recognition period.

Built-in Gain Tax: Losing Its Bite?

Unlike C corporations, S corporations generally pay no corporate-level tax.  Instead, items of income and loss of an S corporation pass through to its shareholders.  Each shareholder takes into account its share of these items on its individual income tax return.  Thus, any gain recognized by an S corporation on the sale of assets is passed through and taxed to its shareholders.

There is an exception to this rule for asset sales by S corporations that were previously taxed as C corporations.  Specifically, a corporate level tax, at the highest marginal rate applicable to corporations (currently 35%), is imposed on that portion of an S corporation’s gain that arose prior to the conversion of the C corporation to an S corporation (the “built-in gain” inherent in its assets at that time; “BIG”) and that is recognized by the S corporation during a specified period of time following the conversion (the “recognition period”).

The amount of corporate BIG tax imposed upon the S corporation is treated as a loss taken into account by the corporation’s shareholders in computing their individual income tax.  The character of the loss is based upon the character of the BIG giving rise to the tax; thus, the sale of an asset that produces a capital gain would generate a capital loss, thereby reducing the net amount of capital gain reported by the shareholder.

Given the economic impact of the BIG tax, shareholders have historically been reluctant to cause their S corporation to sell its assets during its recognition period.  After a number of reductions to the length of the recognition period in the past few years, the period recently was restored to ten years.  However, a discussion draft proposal being considered by Congress would “permanently” enact a five-year recognition period for S corporations, effective for taxable years beginning after December 31, 2013. Under this proposal, if an existing C corporation elected to be an S corporation effective January 1, 2014, its recognition period would expire at the end of 2018, after which it may sell its assets without incurring any corporate-level income tax.

 Consider Electing Now

Though nothing is certain in Washington, there is a fair likelihood that some version of this proposal will be enacted into law, effective retroactively to the beginning of 2014. In light of that possibility, it may behoove a qualifying C corporation to consider electing S corporation status as soon as possible so as to start the running of the BIG recognition period. This is especially so for corporations in which the key shareholder-employees are approaching retirement and have no one to succeed them. In that situation, where the only option will be a sale of the business, making the S election may substantially reduce the corporation’s income tax liability and increase their net proceeds from the sale.