S Corporations
Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts
McCarter & English LLP
2002-08-02
A special subtype of the incorporated entity is termed the "S Corporation" (formerly "Subchapter S" Corporation), again the name taken from the location of the governing provisions in the Code. For most purposes, S Corporations are garden-variety corporations under state law, the distinguishing factor being that if they configure themselves to meet special rules of the Internal Revenue Code, no corporate tax is assessed, thereby passing through corporate income and losses directly to the shareholders. Under the Tax Reform Act of 1986, S Corporations became increasingly popular because, for the first time since 1916, personal tax rates were lower than the corporate tax rates, thereby putting a premium on the ability of a business entity to pass through its income to its shareholders without the imposition of tax. Moreover, while losses from passive activities may not be offset against income other than from passive activity under the Tax Reform Act of 1986, losses garnered by an S Corporation and allocable to a shareholder who materially participates–as an officer, for example–in the S Corporation's business may elude the "passive activity" trap and thus be more widely useful. Such losses are, however, limited generally to the shareholder's tax basis in his stock and any loans he has made to the corporation.
The constraints on the structure of S Corporations are relatively rigid and has led to the ultimate replacement of the vehicle by limited liability companies. The root problem is that Congress contemplated a limited exemption to the obligation to pay corporate tax, benefiting uncomplicated, modestly capitalized businesses.
For present purposes, it is sufficient to note that consideration of the question whether to elect S Corporation status should not stop at the federal tax level. The treatment of S Corporations for local tax purposes can complicate the issue substantially, since some states (and New York City) refuse to recognize S Corporations as "flow-through entities". Moreover, a large element of any individual or corporate tax strategy has to do with the treatment of fringe benefits. A person owning 2 percent or more of the voting stock of an S Corporation is a "partner" for certain fringe-benefit purposes … for example, group term life insurance and medical insurance … and a partner still fares less well in the fringe-benefit area than does a stockholder/employee of a C Corporation.
The good news is that S Corporation status is relatively easy to achieve and, when necessary, to surrender; a timely election approved by the shareholders and filed with the IRS is all that is required. There are constraints, as one would expect, in attempting to manipulate S Corporation status … that is, if a C Corporation builds up unrealized appreciation in its assets and then switches to S status prior to a sale of those assets in order to avoid double tax, the IRS has statutory weapons. However, it appears that the S Corporation device can be a useful technique to escape an "excess of accumulated earnings" problem.
A final word: many small, closely held corporations need not (and should not) bother with filing for S Corporation status; to avoid double tax, the management may simply pay out all the profits each year in year-end bonuses. If the company needs to retain earnings, the key managers can make loans back to the company, the company paying (and deducting) interest at the "federal rate" (the rate a loan must carry to avoid taxes on assumed interest). In fact, a company owned solely by shareholder/employees can wind up paying more tax if it elects S over C status. However, there are problems in pursuing the task of distributing all earnings in a venture context. If the founder is trying to bail out some day at a multiple of historical earnings, the clean-out-the-store approach leaves a slim trail of earnings to which a high multiple can attach. When such businesses are bought and sold, the income statement can be recreated pro forma, but the very fact an explanation is required may put the founder at a disadvantage in negotiating price.