More Truth About Subchapter S Corporations

Like everyone else, I am concerned about making and saving money. Unfortunately, there are no easy solutions and the decisions we make require careful contemplation. Stress arises when we do not have all of the information we need to make an informed decision or when we do not understand the information that is presented. My friends, I will attempt to shine some light on the process I use to determine appropriate use of the subchapter S corporation. Warning, this article might contain information that is boring and sleep inducing. Please do not read this article while driving and avoid operating heavy machinery.

Let's start by defining what a subchapter S corporation represents. The entity is formed at the state level and serves to provide liability protection for its owner or owners. After the entity is formed, the decision is made to become a S corporation. This is a tax election. One files form 2553 with Internal Revenue by the 15th day of the third month of a given year and is afforded S corporation status for this year. As opposed to a C corporation (a taxable entity in and of itself), earnings from the S corporation flow through to its shareholders avoiding any corporate level tax. These flow-throws avoid the implementation of self-employment taxes (or SE tax) making it seem quite beneficial to would be taxpayers. As with many situations in the world of income tax, beauty is only skin deep leading us to a world of tax traps and audit magnets. What is a business owner to do when faced with making the decision to be a S corporation? The business owner should be listening to my show, "Better Business" as well as reading all of my articles to best inform himself of what lies ahead. As always, you are invited to get clarification of what I discuss through my articles or through my radio program (see below on how to get your questions answered for free).

If I am going to form a new business, I will first assess the need to limit liability. If I decide to form an entity at all, I will then decide on the best form for business and income tax considerations. The S corporation is good for single owners and situations where it is practical to allocate income and losses based on ownership percentages. Let's use the example of you and I forming a business entity and owning it on a 50/50 footing. We might set our salaries at $50,000 each with additional earnings allocated to us on a 50/50 basis. This will work fine as long as we both agree that we have the same value to the business. But what if you do more work than I do? Well, you could take more salary possibly and then we could split any remaining earnings 50/50. We could however, get to the point where we are taking out salary to balance our improprieties thus defeating one of the purposes of electing S status in the first place. Please give careful consideration as to who the owners will be and how profits and losses will be divided.

What about deducting losses incurred at the S corporation level on the personal returns of its shareholders?Is this allowable? I just read an article that said you can do this very thing. I caution you to beware. There is such a concept as basis limitation. If it is projected that losses will result in the first few years of operation, one must have basis in order to deduct these losses personally. Basis in subchapter S stock will consist of capital contributions such as stock and loans made by the shareholder or shareholders directly to the entity. We cannot simply personally guarantee the loans and have the proceeds then deposited in the S corporation. If we are going to borrow money to loan to the entity, we must do so personally and then transfer the proceeds from our personal accounts to the S corporation accounts. This will then give us basis to take losses. Now I think it is important to mention here that as we repay these loans to ourselves, we will have to pick up income on our personal returns either as ordinary or capital gain income. If we put the proceeds in as capital stock or paid-in capital , we will not have to worry about recapturing this income as we will not be permitted to get the funds repaid. If this does not suit our needs, we may be better off forming a partnership or sole proprietorship.

There are many other instances that one should be made aware of while considering the formation of a S corporation. The S corporation is not permitted to provide fringe benefits to more than 2% owners
of the entity. If one is looking for deductible fringe benefits, look to the C corporation as a possibility. If one expects to be very profitable right out of the gate, the S corporation can provide protection against unreasonable compensation charges that might be assessed against a C corporation and can provide SE tax savings that might otherwise be levied against sole proprietorship earnings. If a corporation wishes to make the S election after having operated as a C corporation, it will need to have its assets valued as of the date the entity first operates as a S corporation. This will identify assets that have what is known as, "built-in gains". If any of these assets are sold during the next ten years, they will trigger corporate level tax even though the entity has elected S corporation status. If one is going to convert from C corporation to S corporation, seek competent professional help to make certain that assets are valued properly and that their values are allocated appropriately.

In the future, I will add more information regarding S corporations to my collection of ezine articles and I invite you to visit my website at www.mwibonline.com and you are always welcome to the most complete business program on radio, "Better Business".