Recent conversations among tax professionals have caught the attention of shareholders and advisors of S Corporation banks and bank holding companies. The issue: Do recent tax code changes create a tax advantage to be gained by terminating an S Election and thereby converting the S Corporation to a C Corporation?
State and federal taxes apply to the recognized net income of both S Corporations and C Corporations. However, the tax rateapplicable on this income can vary depending on whether the corporation is an S Corporation or a C Corporation. The taxable income of a C Corporation is taxed to the corporation at the applicable corporate tax rates. The taxable income of an S Corporation is allocated among and taxed to its shareholders at the tax rates applicable to the individual shareholders. Where the marginal corporate tax rate is higher than the marginal tax rates of the various shareholders, there is an immediate advantage to being an S Corporation: current income is subject to a lower tax rate.
Recent state and federal tax rate changes, including significantly, the imposition starting in 2013 of a new 3.8% federal tax on investment income (sometimes referred to as the “Medicare Tax”), may have shifted the tax rate benefit of certain S Corporations. In some situations, depending upon the individual tax situations of the shareholders, these rate changes may now result in the taxable income of an S Corporation being subject to a higher tax than the same income earned by a C Corporation.
These rate changes have properly led advisors to consider whether a corporation should abandon its S Election, thereby saving taxes on the current net income of the corporation. However, whether the rate changes do indeed increase the immediate tax burden on earnings is a very fact-specific matter. The answer depends upon the level of corporate income, the individual tax brackets of each shareholder, and the nature of the shareholder’s participation in the business of the corporation. There is not a universally applicable answer to the question.
Although there may be a particular set of facts under which the rate changes do shift the current tax rate on income in a manner that favors C Corporation rates, there are many other factors to take into account before deciding to abandon the S Corporation status. Subchapter S provides other important benefits not available to shareholders of a C Corporation.
One of these benefits is that the shareholder’s tax basis in his or her S Corporation stock is increased by the amount of the income allocated to the shareholder. Although that basis is then reduced by the amount of tax free distributions received by the shareholder (such as distributions to cover the shareholder’s tax liability), the shareholder’s basis in his or her stock will increase over time unless all the income is distributed. This is important if that stock is sold by the shareholder. To the extent of the increased basis, the gain on a sale of the stock will be reduced.
The basis increase rules described above, coupled with the distribution rules, allow an S Corporation to make tax free dividend distributions of income that was taxed to the shareholders in previous years. Dividend distributions from a C corporation, on the other hand, are subject to tax when received by the C Corporation shareholders, a tax that is in addition to the tax paid by the corporation when the income was originally earned by the corporation.
Another S Corporation advantage comes into play on a future sale. In a stock purchase, the purchased corporation (now the property of the buyer) remains subject to all pre-purchase known and unknown liabilities of the corporation. In an asset purchase, the buyer may insulate itself from unknown liabilities of the selling corporation. The buyer of assets also has the benefit of a tax basis step-up in the acquired assets which can often lead to a willingness to pay a higher price. An S Corporation can sell its assets to a buyer with only a single tax being incurred. A sale of assets by a C Corporation incurs tax at the corporate level on the asset sale, and then a second tax at the shareholder level when the sale proceeds are distributed. That second tax on the gain is avoided if the corporation is an S Corporation.
Tax rates change from time to time. There is no assurance that the divergence between individual state and federal rates on the one hand, and corporate state and federal rates on the other will not be inverted. While abandoning the S Election can be done at any time, once abandoned, a new election cannot be made for a period of five years. Terminating the election should be done only after concluding that the perceived benefits of the termination will not reverse themselves in the intermediate term. If they are reversed, re-electing will not be available until the passage of the five year waiting period.
Decisions affecting the S Election of a corporation should be taken only upon careful consideration of the consequences in the context of the particular situation. While continual re-examination of the S Election is good, it is unlikely that recent rate changes alone will support the conclusion that an existing S Election should be revoked.