The Protecting Americans from Tax Hikes (PATH) Act of 2015 accomplished more than just extending certain tax breaks. It also made some taxpayer-friendly provisions permanent, including the shortened recognition period for companies that convert from C corporation to S corporation status. This change is causing many corporations to reevaluate their corporate status for tax purposes.
After weighing the pros and cons, many companies are electing Subchapter S status to gain enhanced flexibility in business decisions and to lower taxes. Here are some important issues to consider before you convert.
C corporations pay taxes twice. First, they must pay corporate-level income taxes. Shareholders then pay tax personally on the dividends paid them by the corporation. Subchapter-S corporations, however, are flow-through entities for tax purposes which means the corporation’s income, gains and losses flow through to the owners’ personal tax returns. S corporations generally aren’t taxed at the corporate level.
The double taxation of C corporations may become an even bigger issue when the owners decide to sell the assets of the corporation. Historically, if a company elected Subchapter S status and sold assets any time within a 10-year “recognition period,” it was charged corporate-level tax on any built-in gains that occurred while the company was a C corporation. Any gains that occurred after making the S election passed through the owners’ personal tax returns.
Under the PATH Act, the recognition period has been permanently shortened to five years. Therefore, as long as the corporation does not sell assets within five years of electing S status, none of the gains from the sale of the assets will be subject to corporate-level tax.
It’s important to establish the company’s fair market value at the conversion date and to allocate it to all of the company’s assets. This enables taxpayers to quantify which portion of the gain should be taxed as C corporation gain and which portion should be taxed as a flow-through gain to its shareholders.
Subchapter S qualifications
For businesses contemplating a Subchapter S election, now may be the best time to start the clock on the five-year recognition period. But not every business qualifies for this election. It’s available only to domestic corporations that have no more than 100 shareholders, all of which must be individuals, certain trusts and estates. Qualifying corporations must also have just one class of stock although differences in voting rights are permitted.
Subchapter S status restricts how the company distributes cash and liquidates assets. All payouts must be made to shareholders on a pro rata basis. If these rules aren’t followed, the company will lose its S status.
Although S corporations are required to make pro rata distributions to shareholders, they aren’t required to distribute income to shareholders. So shareholders who lack control over making distributions may find themselves required to pay personal-level taxes on S corporation income, regardless of whether the company distributed any cash to cover those tax liabilities.
The annual tax burden can be substantial for highly-profitable S corporations, and even more substantial for high-income taxpayers. To alleviate this burden, most S corporations pay enough distributions to cover shareholders’ tax obligations.
A tough choice
Before electing S status, your business must obtain the approval of all shareholders. Although there are many benefits to making the switch, especially now that the recognition period to avoid corporate-level tax on the sale of its assets has been permanently shortened, it’s not a prudent option for every business.
Please contact your MarksNelson advisor at (816) 743-7700 if you have any questions or would like more information regarding whether making this election is the right decision for your company.