The Investment Scientist

Despite higher tax rates, S corporations retain advantages over C corporations

Posted on: February 10, 2014

(I got this from Cal Klausner, a CPA friend of mine.)

Small Biz TaxAfter recent tax changes, owners of small businesses face a question: Should the business continue to function as an S corporation, or should the entity revoke its election under Subchapter S of the Code?

Despite a number of statutory constraints, conventional wisdom has generally favored an S corporation classification. An S corporation is a pass-through entity whose shareholders are subject to personal income tax based on the income of the corporation. A C corporation, by contrast, is taxed as a separate entity at corporate rates, and its distributions to shareholders are subject to the personal income tax. A small business corporation electing under Subchapter S may have no more than 100 shareholders, and may not have more than one class of stock. There are no similar constraints on C corporations. Nevertheless, an S corporation classification provides business owners a superior degree of flexibility and is therefore generally preferred. Specifically, by having its income flow directly to its shareholders, an S corporation is not subject to the double taxation that a C corporation may be unable to avoid.

Superficially, the American Taxpayer Relief Act of 2012 (P.L. 112-240), which was signed into law by President Barack Obama on Jan. 2, 2013 to avoid the “fiscal cliff,” appears to contradict the foregoing conventional wisdom. The legislation increases the highest federal tax rate for individuals to 39.6% and provides for an additional 3.8% tax on net investment income. Prior to this legislation, the highest tax rate for both individuals and corporations was 35%. The highest corporate tax rate, however, remains 35%.

Tax rates are not the whole story. Given that the highest federal individual tax rate is now higher than the corporate rate, it may seem like operating a business through a C corporation rather than a flow-through entity would present a preferable alternative for owners of small, growing businesses. They may reevaluate their decision to elect a classification under Subchapter S and consider such restructuring to take advantage of the lower corporate rate available to C corporations, with the intent to reduce the overall tax obligation that would otherwise burden its shareholders. Such a simplistic analysis, however, is imprudent. A number of tax considerations may still favor an S election, even in light of the generally increased personal income tax rate.

Medicare tax exclusion for material participation. The Medicare tax on net investment income applies to trade or business income resulting from a passive activity within the meaning of Code Sec. 469, or the trading in financial instruments or commodities as defined in Code Sec. 475(e)(2). As a result, the income received by a taxpayer from a trade or business in which that taxpayer materially participates is not subject to the additional 3.8% tax. This exclusion is not available to shareholders of a C corporation because the passive activity loss rules of Code Sec. 469 do not apply to C corporations unless they are closely held. The exclusion is, however, available to shareholders of S corporations that materially participate in the trade or business of the entity. As a result, S corporation shareholders that are involved in the operations of the entity’s trade or business activity on a regular, continuous, and substantial basis are not subject to the additional 3.8% tax on net investment income received as a shareholder of that entity.

Double taxation disadvantage. Other than the carve out from the additional 3.8% tax for material participation by shareholders in S corporations, a major reason to consider staying with S corporation status is to avoid double taxation imposed on income earned by a C corporation and distributed to shareholders. In addition, the risk of double taxation of corporate income arises in any scenario involving the sale of a business.

Conclusion. Choice-of-entity decisions are complex, and factors beyond the applicable personal or corporate income tax rates should be evaluated before determining whether to switch the organization of a business to a C corporation or to continue as an S corporation. Organizing as a C corporation is not always an advantage. Only by looking at the full tax picture—ideally with the help of an experienced tax professional—and by analyzing likely scenarios will one be able to determine what entity is most advantageous for your tax bill. It is imperative to take into account the risks of double taxation and other complex contingencies. Paying the higher rate on income flowing from an S corporation can still provide a more beneficial long-term tax situation. Right now, savvy business owners will avoid panic and impulsive decision-making by looking past the specter of the increased individual income tax rates and remembering that, even if corporate rates are lower, flow-through entities may still be the better way to go, all pertinent factors considered.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s


Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


%d bloggers like this: