NOTE: This MEMO is currently being revised. 11/11/02
NOTE: In order to qualify for S corporation status, there must be no more than 75 individual shareholders, estates and certain trusts. There cannot be non-resident alien shareholders and all shareholders must consent to the election. Since California is a community property state, the spouses of each shareholder must also consent to the S corporation election. Corporations and partnerships cannot be shareholders in an S corporation. Only one class of stock may be issued and if a corporation has been in existence as a C corporation, there are other requirements which may apply. S corporation stock may be owned by and LLC that is treated as a disregarded entity, according to PLR 200107025.
Changes in the S corporation law over the past 15 years usually make the S corporation the favored form of entity for small companies, when compared to a C corporation, however, the limited liability company, in many ways, surpasses the S corporation as the entity of choice. 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:
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 shareholders on a current basis and 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 tax on its income. 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 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.
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.
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 stock and not incur 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. If the purchaser, however, 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 prevents 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.
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 was 39.6%. The Economic Growth and Tax Relief Reconciliation Act of 2001 will reduce all individual marginal tax brackets over the next decade, however, because this new laws will not reduce the alternative minimum tax imposed on individuals, it is difficult to compare the actual tax rates for individuals, compared to C corporations.
Typically, 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 probably pay income tax at a higher marginal tax rate than an individual, there is no clear advantage to operating as a C corporation. 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.
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 in determining the issue. Therefore, it is dangerous to use salaries as a method of distributing retained earnings from the corporation to the shareholders. In my experience, this is the most heavily audited tax issue involving closely-held C corporations and the case law is all over the map.
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.
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 ($150,000 for personal service corporations - NOTE: these amounts are not indexed for inflation), 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 the highest individual tax rate (38.6% for tax year 2002) 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 $38,600.
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 the highest individual tax rate (38.6% for tax year 2002) 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.
An LLC files with the Secretary of State and, once approved, becomes legally registered in California. It must have at least one "member" which may be U.S. or foreign individuals or entities, such as partnerships, trusts, corporations, estates or other LLCs. Professionals (lawyers, accountants and doctors), however, are prohibited from registering as an LLC.
The LLC uses an operating agreement, similar to a partnership agreement, to control business, financial and tax provisions. The operating agreement may be oral, although it should be in writing and signed by all the LLC's members. It is not filed with the Secretary of State. Management of an LLC may be vested either in the members or in certain designated "managers." Managers do not have to be members of the LLC, and even corporations may serve as managers. Through its provisions, the operating agreement determines whether the LLC is taxed as a partnership or corporation.
Members of an LLC are shielded from personal liability to the same extent as corporate shareholders. In general, the LLC will be treated as a partnership for tax purposes; it will be a flow-through entity in which income and losses are reported directly by its members. Unlike an S corporation, special allocations of income, expenses, deductions and losses can be made among its members, and an individual member's losses are not limited by the member's investment in the LLC. For example, A LLC with 50% owners may distribute $100 of income as follows: $99 to Member A and $1 to Member B. An S corporation must distribute the income on a pro-rate basis, $50 to Shareholder A and $50 to Shareholder B.
Unlike a partnership, management can be vested in nonmembers. Unlike a limited partnership, members may be actively involved in the LLC's management, without risk of personal liability, as can occur to a limited partner.
An LLC is an ideal substitute for an S corporation when foreign shareholders, corporations or trusts are desired as shareholders. The LLC provides estate planning opportunities since trusts and estates are eligible shareholders. Also, the LLC could eventually eliminate both general and limited partnerships as business entities since it offers the same tax treatment and management opportunities, yet with the added advantage of limited liability to all its members. LLCs might also pay a substantially lower California income tax than an S corporation.
Because an LLC generally is considered a partnership (with limited liability for its members), there is a tremendous advantage to using an LLC, rather than an S corporation, for asset protection purposes (protecting one's assets against a lawsuit). With an LLC, a creditor is limited to a "charging order" which is a court order allowing the creditor to receive distributions made to a member, as and when they occur. The creditor cannot liquidate the LLC or compel the LLC to sale any of its assets to pay the claim against an individual member. Also, the creditor does not receive the right to vote or the power to manage the LLC. Thus, the creditor has no power to compel the LLC to make distributions, sell assets or liquidate. In contrast, if a creditor seizes the shareholder interest in an S corporation, the creditor becomes a shareholder. If the interest seized is a majority interest, then the creditor may gain control of the corporation which means the creditor will have the power to sell assets or liquidate the corporation.
The Disadvantages to an S corporation:
Although the S corporation rules have been relaxed, an S corporation defaults to a C corporation, which means if the S corporation fails to comply with the fairly strict requirements, it will become an entity subject to double tax. For instance, if a shareholder sells or transfers just one share of stock to a C corporation, partnership or other disqualified shareholder, the S corporation status will be lost and the entity will become a C corporation, The same is true if IRS determines that is a second class of stock. Unfortunately, the second class of stock rule can arise unexpectedly, such as debt that has an equity conversion feature or certain types of elections made by employees holding stock options. Also, in community property states, the spouses of shareholders must consent to S corporation status on the Form 2553. While inadvertent terminations can now be fixed by unanimous consent of the shareholders, this remedy will not prevent a termination caused by a shareholder who then refuses to consent.
There is a $70 filing fee with the Secretary of State when the LLC is first formed.
In addition to the annual $800 franchise tax, the LLC in
For tax years beginning on or after
$865 if the LLC's total income from all sources is $250,000 or more, but less than $500,000;
$2,595 if total income is $500,000 or more, but less than $1,000,000;
$5,190 if total income is $1,000,000 or more, but less than $5,000,000;
$7,785 if total income is $5,000,000 or more.
NOTE: The legislature just raised these fees for the year 2000, while reducing some fees for corporations.
For purposes of the fee calculation, total income is defined as gross income (under IRC Sec. 61) without deducting the cost of goods sold.
The fee is based on the LLC's income from
all sources, including income from sources both within and
The fee is payable with the LLC's
As a new entity, an LLC offers little legal precedent. Also, Congress has not passed any tax legislation establishing the LLC as a partnership for tax purposes. Employment taxes must be paid on LLC income if the LLC has trade or business income (rather than investment income) and because there is no longer a limited on Medicare taxes, there is no cap on these taxes. In contrast, an S corporation is not required to treat its trade or business income as employment income (usually the owners will be paid a reasonable salary and treat the excess as S corporation distributions, free of employment taxes), although the courts have ruled against professionals who have characterized their S corporation's earnings as distributions free from employment taxes.
In California, S corporations pay a 1.5% tax on their net income. Compare this to a 2.9% tax for Medicare, and the savings is 1.4%, provided the S corporation can legitimately argue that its earnings are not from personal services. LLCs are taxed on their gross receipts. So depending on the entity's ratio of gross receipts to taxable income, there may be an advantage to operating as an S corporation. For example, assume a grocery stock with $10,000,000 of gross receipts and profits of $200,000. As an LLC, the grocery store would pay $8,585 in taxes (the maximum for gross receipts, $800 + $7,785, but only $3,000 as an S corporation (1.5% of $200,000). However, if the entity earned $5,000,000 in income, as an LLC it would still pay the maximum of $8,685 in taxes, but as an S corporation, it would pay $75,000 in taxes (1.5% of $5,000,000). Thus, understanding the gross receipts to net income ratio of the entity is extremely important when deciding whether to operate as an S corporation or LLC.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**