Imagine the liability protection of a corporation and the pass-through tax benefits of a partnership in one entity for your rural building business.
A unique type of business entity, the S corporation, offers its owners or shareholders the limited liability of a corporation while allowing income and deductions to pass-through to the tax returns of the owners or shareholders. Even better, United States lawmakers recently “reformed” the S corporation tax rules making these unique entities more attractive than ever.
According to the Internal Revenue Service more than 1.7 million small businesses operate as S corporations. Recently-passed, the Small Business and Work Opportunity Tax Act of 2007 included a package of S corporation reforms. The changes affect the treatment of passive investment income, partial sales of qualified subchapter S subsidiaries (QSubs), interest deductions by electing small business trusts (ESBT), as well as reduction in earnings and profits (E&P).
Stimulating S corporations
The S corporation is often far more attractive to the owner of a building business then a standard (or C) corporation. That is because an S corporation offers a number of appealing tax benefits while still providing the owner or owners with the liability protection of a corporation. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there is just one level of federal tax to pay.
An S corporation is a creature of the federal tax laws. For all other purposes, it is treated as a regular corporation. This means that, in order to form an S corporation, you first must incorporate under state law. Then you must file a special form electing to be taxed under a special provision of the tax law that preserves the corporation’s limited liability under state law, but avoids taxation at the corporate level. As a result, the annual income or losses of the S corporation are passed through to shareholders in much the same way that a partnership passes through such items to partners.
In addition, owners of S corporations who are not required to maintain inventory can use the cash method of accounting where income is taxable when received and expenses are deductible when paid. This is far simpler to use than the accrual method.
On the downside, S corporations face many of the same requirements as corporations and that means higher legal, tax and accounting expenses. They must also file articles of incorporation, hold directors and shareholder meetings, keep complete records and allow shareholders to vote on major corporate decisions.
Another major difference between a standard (or C) corporation and an S corporation is that S corporations can only issue common stock. Experts claim that this can hamper the building business’s ability to raise capital.
S corporation status is automatically terminated if any event occurs that would have prohibited the incorporated building business from making the S corporation election in the first place. Termination of S corporation status can be planned by the shareholder; it can be demanded by the IRS; or, all-too-often, it can be inadvertent.
Termination of the S corporation election is effective as of the date on which the disqualifying event occurs. It can also be retroactive to the date on which the disqualifying event occurred, regardless of when and by whom the terminating event was discovered.
The passive investment income test has long been a trap for S corporations that convert from operating as a regular C corporation. Passive investment income generally means receipts of royalties, rent, dividends, interest, annuities and sales or exchanges of stock or securities (at least to the extent of gains).
Heretofore, an S corporation was subject to tax at the corporate level – not on the usual shareholder’s tax return – at the highest corporate tax rate, on its excess net passive income. Of course, the building business had to have (1) accumulated earnings and profits at the close of the tax year and (2) gross receipts more than 25 percent of which are passive investment income. Even worse, an S corporation election is terminated whenever the S corporation has accumulated earnings and profits at the close of each of three consecutive taxable years and has gross receipts for each of those years more than 25 percent of which are passive investment income.
Electing small business trusts (ESBTs)
So-called Electing Small Business Trusts, ESBTs, were created to permit interests in family-owned corporations to be transferred to a trust in which the trustee has the discretion to accumulate income, rather than distribute it as a Qualified Subchapter S Trust (QSST) is required to do.
The S corporation stock held by an ESBT is treated as held in a separate trust while the building operation retains its status as an S corporation. The QSST’s income from the S corporation stock, on the other hand, is taxed at the highest individual rate (35 percent for 2007).
The new law allows an electing small business trust to deduct interest paid on money borrowed to acquire S corporation stock. Thus, leveraging S corporation ownership in an ESBT just became less expensive, given its newly-allowed deductibility against income otherwise taxed at the 35 percent rate.
Earnings and profits
Any corporation that had not chosen to be treated as an S corporation before December 31, 1996 is required to consider the accumulated earnings and profits (E&P) from those earlier years. The new law allows an S corporation to reduce its accumulated E&P by its pre-1983 accumulated E&P from years when the incorporated building operation was an S corporation. This benefit involving pre-1983 E&P had previously been available only to a corporation that was an S corporation for its first taxable year after 1996. The provision takes effect for tax years beginning after May 25, 2007.
Finally, the so-called “at risk” rule in our tax law does not allow losses that exceed the amounts that an investor has “at risk.” Generally, at risk is the amount of investment that an investor could lose. The “at-risk” rules apply to all individuals, including S corporation shareholders. The amount that a shareholder has “at-risk” is usually determined at the close of the S corporation’s tax year. Thus, an S corporation shareholder who realizes that his or her at-risk amount is low, and who wishes to deduct an anticipated S corporation net loss can make additional contributions to the entity.
Fringe benefits and S corporations
Only those fringe benefits received by employee-shareholders owning two percent or less of the S corporation stock are actually deductible by the builder or contractor as a business expense.
Today, an employee-shareholder who owns more than two percent of the S corporation’s stock and who is thus treated as a partner is entitled to deduct an amount equal to 100 percent of the amount paid for medical insurance for himself, his spouse and dependents. This amount is taken as an individual deduction on the owner/shareholder’s personal income tax return — along with the income and losses of the building business operating as an S corporation.
Mark Battersby is a tax and financial consultant, lecturer and writer with more than 30 years of experience with small business issues. Contact him at 610 789-2480 or MEBatt12@Earthlink.net