Small Business: Rethinking Your Tax Status

To C or not to C? That's a question small businesses with subchapter S tax status might reconsider in light of Clinton's tax hikes. S corp status lets company earnings be passed to shareholders and taxed only as individual income. With regular, or C corp, status, where earnings are taxed twice--at the corporate level and as dividends at the individual level.

Before the tax hikes, S corps clearly had the edge. Since corporate taxes were 34%, paying the top individual rate of 31% was cheaper. Now, the top individual rate is 39.6%, 5.6 points higher than the 34% rate for companies with less than $10 million. Does that make the lower rate of C status preferable?

The short answer is no. Even with the higher individual rate, the double tax is usually more punitive. Let's say S corp X earns $1 million. The owner, in the top bracket, pays 39.6%, or $396,000, for net earnings of $604,000. If X were a C corp, it would pay 34% on the $1 million, or $340,000. The owner would then pay 39.6%, or $261,360, on the remaining $660,000, for a net of $398,640. The owner could reduce the tax bite by leaving some profits in the corporation, but there are limits on how much.

The single tax of S corps can also save money when the company is sold (table). Other pluses: S corps can often pass losses--deductible going back or forward three years--to shareholders. And interest incurred to buy S corp stock is deductible as a business expense. S corps can also use liberal accounting methods, and management compensation is less likely to be disallowed as unreasonable by the Internal Revenue Service.

S corps do have their limits. They're restricted to 35 shareholders--individuals, estates, or certain trusts; they can issue only common stock; they can't wholly own subsidiaries; and fringe benefits are taxable to shareholders who own more than 2% of the stock. Also, state tax compliance is more complicated.

SPECIAL PENALTY. If you're just starting out, most experts advise filing for S corp status right away. Most existing S corps should keep their status, says John Evans, a partner at Arthur Andersen in New York. But sometimes, it makes sense to switch. If the company is strapped for cash or unable to disburse dividends, converting to C status means paying only 34%. Owners dropping S status should first distribute earnings they have paid taxes on but have left in the company, says Mary Smalligan, director of tax services to closely held companies at Deloitte & Touche. Otherwise, they must pay out earnings in cash within the next year.

While it's extremely easy to switch to C, it's hard to go the other way, says Smalligan. C corps switching to S may be subject to prohibitively expensive taxes. With S corp status, the status quo is usually better.

                                            C Corp      S Corp 
      GAIN ON SALE OF ASSETS            $3,000,000      $3,000,000 
      CORPORATE TAX (34%)               -1,020,000              NA 
      DISTRIBUTION TO  SHAREHOLDERS      1,980,000       3,000,000 
      INCOME TAX (39.6%)                 -784,080       -1,188,000 
      NET AFTER-TAX                      $1,195,920     $1,812,000 
      NA=Not applicable      DATA: ARTHUR ANDERSON 
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