With all the hoopla about the benefits of organizing new businesses as limited liability companies, the good news for subchapter S corporations has gone almost unnoticed.
Although most new business owners are selecting LLCs as the method to organize their companies, more than 2 million existing firms are organized as subchapter S corporations, according to returns filed with the IRS in 1995. Everybody knows LLC organization offers many small businesses advantages over filing as a C corporation. However, it is sometimes overlooked that being organized as an S corp can also help a company out come tax time. With the latest tax changes available to them, S corps really have something to crow about.
As you probably know, with subchapter S corporations, the earnings of a business "flow through" to the owners, where they are then taxed at the owner's personal tax rate. This is in contrast to a regular C corporation, where the business is taxed as an entity separate from its owners, and then again according to the owners' personal tax rates. This means C corporations are taxed twice.
With the clear tax advantages S corps offer, regular corporations may be looking to make changes. "The option to become an S corporation is valuable for a regular C corporation that wants to move its earnings over to a single-tax situation," says Sam Starr, a partner with PricewaterhouseCoopers LLP.
The new benefits for S corps came about as a result of a 1996 tax law, but most of the changes didn't become available until 1998, when the IRS issued regulations interpreting the law. Within the past year, small businesses have been able to put the changes to work, and it's proving beneficial, says Starr. The regulations allow for a wider range of people and businesses to be involved in S corporations, and the tax rules are simpler to follow.
Joan Szabo is a writer in Great Falls, Virginia, who has reported on tax issues for more than 13 years.
Right On Q
One reform that's made life easier for owners of S corps is that they can now own 100 percent of affiliated companies. Essentially, this allows you to set up a number of qualified S corporation subsidiaries, or "QSubs."
One of the most attractive aspects of this change is that the subsidiaries can be treated as separate legal entities, but for tax purposes, they're treated as "divisions" of their parents, says Thomas P. Ochsenschlager, a tax partner with accounting firm Grant Thornton LLP in Washington, DC. In this way, the subsidiaries' assets, liabilities, income, deductions and credits are treated as if they were the parents'.
As a result of this change, the company only has to file one tax return, but it can maintain several legally separate subsidiaries. For entrepreneurs with a number of business lines, this greatly simplifies tax-filing and substantially lowers a company's annual accounting expenses.
In addition, using QSubs works well for entrepreneurs who want to protect the assets of one side of the business from another side's potential liability claims. Take the case of a product manufacturer who manufactures ladders and rubber bands. The rubber-band part of the business is profitable and subject to few liability problems. The ladder portion, on the other hand, doesn't always show a profit and often subjects the business to liability lawsuits. By making the ladder unit a subsidiary, the owner is protecting the assets of the rubber-band business from liability claims.
Another important tax benefit of a QSub has to do with business losses. Again, let's use the example of the business owner with the ladder and rubber-band companies. He is operating the ladder company at a loss due to large depreciation deductions, but he doesn't have sufficient basis in the corporation to be able to use the losses it generates. The rubber-band company may have sufficient basis, however. Under the changes in S corporations, the owner can use his "excess" basis in one company to offset the losses incurred by the other company. In this way, the owner enjoys the benefits of the combined basis of both companies, freeing up the losses, says Ochsenschlager. ("Basis" can be comprised of several elements. It can be the amount of capital you've put into the company, the amount you paid for any stock you've acquired, your share of undistributed earnings, and money you've loaned to the company.)
QSubs are also valuable in situations where you have a business that has great promise but is losing money. To take advantage of those losses as a corporation, says Ochsenschlager, the owner of an S corp needs to make a capital contribution or lend money to the corporation. Neither of those alternatives is very useful, however, because the business owner is putting his or her money at risk.
Under the new S corporation tax rules, it's possible to have the S corp set up a new company using the QSub election. Now the entrepreneur can lend the money to the subsidiary where it is kept in cash. Since the two corporations are treated as one for tax purposes, the owner now has the basis needed to claim the losses from the parent S corporation.
If the company becomes successful, the loan will be paid back, in which case the owner will not report income on the repayment of the loan, under most circumstances. What happens if the parent corporation goes bankrupt? QSubs are also beneficial in this situation because with a bankruptcy, creditors get paid before shareholders, so the creditors of the parent company receive the assets, which include the stock of the QSub. Because the owner lent money to the QSub, he is considered a creditor of the QSub. By loaning the money to the QSub rather than the parent, the owner will be paid back with the other creditors, and still have no personal risk in the S corporation.
And There's More
There are other changes benefiting S corporations. Here are some of them:
- A higher number of allowed shareholders. Now subchapter S corporations can have as many as 75 shareholders, with the number going as high as 150 if shareholder spouses are involved. Previously, the maximum number of shareholders was 35 (70 with spouses). Increasing the number of shareholders in an S corporation works especially well for family businesses, which can now bring in a number of children and grandchildren as shareholders.
- Eased estate-planning. S corps can now make use of a beneficial estate-planning tool known as an "electing small-business trust.' With this type of trust, the business owner can allow the income in the trust to accumulate, which was impossible before the changes took effect. Previously, the shareholder was required to distribute the income to the beneficiaries on an annual basis. These annual distributions could be a problem for parents and grandparents who didn't want their minor children and grandchildren to receive them until later.
Now the trust can sprinkle income and distribute it unevenly among multiple beneficiaries whenever the trustee decides it's time to do so. For example, if one child or grandchild needs funds for college or for medical expenses, the owner can make those distributions when needed. The downside is that the trust must pay taxes at a maximum marginal tax rate each year--a rate that could be as high as 39.6 percent.
- S corporation election can be retroactive. This change has an impact when an unprofitable C corporation starts to earn profits and the owner wishes he'd converted to an S corporation at the beginning of the year. Under the 1996 tax law changes, companies that acquire an existing S corp, or perhaps even form one, can transfer the stock of the C corporation to the S corporation at any time of the year and then elect QSub status for the subsidiary. In this way, the C corporation avoids corporate tax on the profits that are anticipated.
- Allowing tax-exempts as shareholders. The S corporation changes also allow tax-exempt organizations such as qualified pension plans or employee-stock ownership plans (ESOPs) to be eligible shareholders in S corporations. This can be helpful to S corps in funding their employee benefit plans. In addition, because the new law allows tax-exempt organizations to be shareholders, S corp owners can consider giving their stock as charitable contributions. Under prior law, such a gift would have disqualified the S corp.
But one unintended result has come about. Some single owners of S corporations are establishing ESOPs and putting most of the company's stock in the ESOP. Under the changes brought about by the 1996 law, an ESOP does not include S corp income in calculating its unrelated business income. As a result, some owners have been able to avoid paying tax on the income from the S corp until they retire. To rectify what many see as an abuse, Congress is likely to pass legislation restricting this type of activity by certain individuals who previously held a significant portion of a company's stock. While some glitches such as this have resulted, overall the changes from the 1996 law have given S corporations greater clout and provided them with more tax and business flexibility.
The QSub change, in fact, stands head and shoulders above all the others. "The increasing popularity of LLCs had made it appear that S corporations would become a thing of the past," says Ochsenschlager. "But the advent of the QSub, in particular, has made them more useful and popular than ever."
Grant Thornton LLP, (202) 861-4115, firstname.lastname@example.org