Sunday, February 7, 2016

Consider classifying as an S corporation

Congress’ year-end legislative bonus to business owners in the form of the Protecting Americans from Tax Hikes Act of 2015 included the permanent enactment of several beneficial tax provisions that previously had only been extended from year to year. The permanent enactment of one such provision — the reduction in the built-in gains (commonly known as BIG) recognition period — should cause C corporation business owners to consider an S corporation election for 2016. 

C corporations can be tax efficient in years that dividends are not paid. In fact, tax rates for C corporations are in most cases lower than the rates for S corporations. This tax efficiency for C corporations is lost, however, if dividends are paid by the C corporation, because dividends will generate a second level of tax to be paid by the shareholders at rates as high as 23.8%. 

In the early years of a business where profits are put back into the business, C corporation status may make sense. When the business matures and profits are available for distribution, the second level of tax on dividends makes C corporations very inefficient from a tax standpoint. This might cause the business owner to hold the cash in the corporation to avoid the double tax, but if a C corporation accumulates too much cash, the Internal Revenue Service will assert a penalty for accumulating earnings beyond the needs of the business. Other methods of taking profits out of a C corporation, such as salaries to shareholders/employees, are not an effective long-term alternative to dividends.

The most significant tax issue for a C corporation is when the business is sold in a transaction structured as an asset sale. In these transactions, the C corporation pays tax on the gain at ordinary income rates, and a second level of tax is paid by the shareholders on the distribution of the sales proceeds. Assume the assets of a C corporation (with no basis in its assets) are sold for $10 million. The tax on the sale would likely be close to $3.5 million for the C Corporation. The shareholders would in most cases pay another 23.8% tax on the after-tax proceeds from the sale, for an additional tax of nearly $1.55 million and a total tax bill of more than $5 million — more than half of the sales price for federal taxes alone. Compare this to a probable total federal tax of $2.38 million if the business was taxed as an S corporation. If the owners are active in the business, the tax bill would be even lower.

A common reason for not making an S election is exposure to the BIG tax that S corporations pay if assets that were held when the business was a C corporation are sold during a period of time, historically 10 years, following the S election. While Congress has made changes to the 10-year waiting period from time to time over the last decade, often these changes were made at the very end of the year, when it was much too late to do any tax planning. The 2015 Act, however, permanently reduces the waiting period to five years.

Even if the five-year timeframe is too long for the exit plan of a particular business, the amount of gain subject to the BIG tax is limited to the gain built into the assets at the time of the S election. 

When the company sells its assets for $10 million in 2020 (prior to the expiration of the five-year BIG recognition period), the BIG tax is only applicable to the $3 million in “built-in gain” that existed in 2016. The $7 million balance of the gain is taxed only once at the lower individual capital gains rates, even when the proceeds from the sale are distributed to the shareholders.

Of course, there are very specific requirements that must be satisfied for a business to qualify to make an S election, but many closely held businesses will satisfy these requirements. An S corporation election for 2016 is due March 15. Because of the reduction in the BIG recognition period, this is a good time to review those requirements and consider or reconsider the S election.