Is Year-end Time for Planning?- Practice Shareholders Should Consider S-Corporation Status
During the 1992 U.S. vice-presidential debate, H. Ross Perot’s running-mate, Admiral James Stockdale, memorably introduced himself by posing two questions: “who am I?” and “why am I here?”
Saturday Night Live comedian Phil Hartman memorably re-enacted Stockdale’s performance a week later and likely helped cement the public’s perception of the failed candidate.
In a different context, these are very valid questions, with the addition of one additional question: “where do I want to go?”
They highlight the need for reflection and reconsideration of past decisions that, while oftentimes useful, frequently does not occur.
Physicians and other professionals often incorporate their practices to limit their exposure to certain corporate liabilities. Because of the nature of its activities, such a corporation is taxed as a ‘personal service corporation’ (PSC). A PSC is, generally, any corporation where substantially all activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and which is owned by employees providing these services. For a variety of reasons, however, existing PSCs should revisit their present tax classification. For reasons explained below, shareholders may wish to consider electing S status.
Health Insurance
A PSC is generally taxed as a C corporation, but is subject to a flat income-tax rate. The rate presently stands at 35{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}. If taxed as a C corporation, a practice organized as a PSC can provide its owners with several tax-favored fringe benefits paid by the corporation. In particular, C corporations receive a full deduction for medical-insurance premiums paid on behalf of a shareholder-employee, and the benefits are fully excludable from the shareholder-employee’s income. Because of the high cost of providing health coverage, this is indeed a very important benefit.
These same tax benefits are not available to S corporations and their owners. A 2{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} shareholder of an S corporation is treated as a partner in a partnership for purposes of fringe benefits. Because the exclusion for employer-provided health insurance is limited to employees, amounts paid for medical-insurance premiums by an S corporation for the benefit of a 2{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} shareholder are included in the shareholder’s gross income. These amounts are included on the shareholder-employee’s Form W-2 as compensation, but should not be subject to FICA and Medicare withholding.
However, while includable in his or her income, an S-corporation shareholder-employee may be eligible to claim an above-the-line deduction for health-insurance premiums. Previously, the inability of S-corporation shareholders to fully exclude health-insurance premiums discouraged many physicians and other professionals operating within a corporation from electing S status.
Advantages of an S (Versus C) Corporation
S corporations enjoy many tax advantages over C corporations, the most notable being the imposition of only a single level of tax. This is advantageous both during the period the corporation operates and when it liquidates. Many corporate-level provisions also apply to S corporations, although, generally, the income flows through to, and only one level of tax is paid by, the shareholders. In addition, when a PSC elects S status, the shareholders enjoy many additional benefits, including:
(1) Possible lower individual rates. S-corporation income is taxed at individual tax rates, which may yield a lower overall income tax than subjecting the same income to a flat rate of 35{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}. (Currently for taxable income over $464,850 filing married, the rate is 39.6{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5}. The nominal rate disregards several ‘phaseouts.’)
(2) Lower self-employment tax. S-corporation income, after reduction for shareholder wages, may be passed through to shareholders free of employment taxes. This is a tax savings of 3.8{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} for earnings in excess of $250,000. The corporation, however, must not pay unreasonably low wages. Otherwise, the distributions can be reclassified as wages.
(3) Simplified corporate accounting. After making an S election, the shareholders must no longer monitor compensation to employee-shareholders in an effort to ‘zero out’ corporate income at year-end and avoid corporate-level tax. Zeroing out income is especially critical for a PSC with a fiscal-year election in place.
(4) Less risk that compensation will be reclassified. There is less risk that the IRS will reclassify deductible compensation paid to employee-shareholders as non-deductible dividends when the corporation employs other physicians who are not shareholders.
The advantages of an S corporation are most apparent when comparing the shareholder provisions. For example, a C-corporation shareholder must generally recognize income on the receipt of a dividend and when he or she redeems his or her stock. S-corporation shareholders, however, can receive a dividend free of tax in many instances. Additionally, because a shareholder’s basis in his or her stock is increased by gain that passes through to the shareholder, the receipt of property in liquidation of his or her interest can often be accomplished without triggering additional shareholder-level income.
Disadvantages of an S (Versus C) Corporation
Along with the potential for the corporate-level built-in gains tax, which can be an article in itself, some other issues and several distinct disadvantages of S corporations as compared to C corporations should be considered, such as:
(1) Limitations on losses. Restrictions apply to the deductibility of pass-through losses by an S shareholder arising from insufficient tax basis in stock and debt.
(2) Eligibility requirements. The S corporation must comply with eligibility tests to preserve its S status. For example, an S corporation can have no more than 75 shareholders (100 shareholders for tax years starting after 2004), shareholders must generally be individuals (with the exception of estates and certain types of trusts), a shareholder cannot be a non-resident alien, and there can only be one class of stock (disregarding differences in voting rights). The one-class-of-stock requirement means that all cash-dividend distributions from the S corporation must generally be made proportionately to stock ownership. However, there is no restriction requiring equal salary payments.
(3) Loss of certain fringe benefits. The deductibility of certain fringe benefits provided to shareholders owning 2{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} or more of the corporation’s stock is limited, with a 2{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} S corporation shareholder being treated as a partner rather than as an employee. For example, while health-insurance premiums are now 100{06cf2b9696b159f874511d23dbc893eb1ac83014175ed30550cfff22781411e5} deductible by individual shareholders as discussed above, certain other fringe benefits, such as group-term life-insurance premiums, are neither deductible nor excludable by the individual. Even though the S corporation can claim a deduction for providing these benefits, they are included as taxable income by the recipient shareholders. For C corporations, the payment of these premiums can result in both a deductible business expense and a non-taxable fringe benefit to the shareholder-employee.
(4) More complex individual tax compliance. Because the S corporation’s taxable activity flows through to the shareholders, individual tax compliance becomes more complex (especially if the corporation engages in multistate activities). The tax advisor should assist taxpayers when evaluating whether to elect S status, and help them weigh the advantages, previously discussed, against the disadvantages of the election.
Conclusion
Historically, many PSCs decided against making an S election, in large part because, under C corporation rules that otherwise apply to them, they could provide health-insurance coverage to their owners in a tax-favored manner. Because health-insurance costs incurred by self-employed individuals, including certain S-corporation shareholders, are now fully deductible above the line, many PSCs should reconsider making an S election.
While the collection of cash-method accounts receivable subsequent to the S election could be subject to the built-in-gains tax, this tax can be reduced or eliminated with proper planning.
Similarly, if the S corporation later sells its assets, including corporate goodwill, the goodwill could generate a built-in gain. To the extent the shareholders can demonstrate that goodwill belongs to them in their individual capacities, however, the goodwill is removed from the built-in-gains-tax regime.