Advantages and Disadvantages of Electing to be Taxed as an S Corporation

Choosing to be taxed as an S corporation offers both benefits and drawbacks for business owners. In this article, we will explore the advantages and disadvantages of this election, based on the information available from IRS sources and other credible business resources.

Advantages of Electing to be Taxed as an S Corporation

Taxation Advantages:

Exemption from Corporate Income Tax: Unlike a C corporation, the income of an S corporation is not subject to corporate income tax. This can lead to significant reductions in overall tax liability. Pass-Through of Losses: Similar to partnerships, S corporations pass through business losses to the shareholders, allowing for potential tax deductions on their personal tax returns. Untaxed Undistributed Income: Income that has already been taxed to the shareholder is not taxed again when subsequently distributed. This avoids double taxation on distributed earnings. Classification of Income: Income from capital gains dividends and tax-exempt income is separately stated and passed through to the shareholders, potentially reducing taxable income. Pass-Through of Deductions, Losses, and Credits: Deductions, losses, and tax credits are separately stated and passed through to the shareholders, which can lead to increased tax benefits. Exemption from Alternative Minimum Tax (AMT): S corporations are not subject to the personal holding company tax and accumulated earnings tax, which are applicable to C corporations. They are also exempt from alternative minimum tax (AMT).

Operational Advantages:

Ownership Flexibility: S corporations may split income between family members, providing greater flexibility in income allocation. Simplified Tax Year: S corporations are generally restricted to using a calendar year, which simplifies record-keeping and compliance.

Disadvantages of Electing to be Taxed as an S Corporation

Tax Liabilities:

No 15% Tax Bracket: While C corporations can use the 15% tax bracket, S corporation earnings are taxed to the shareholder even if not distributed, meaning more income is subject to self-employment or ordinary income tax rates. Excess Net Passive Income Tax: S corporations may be subject to an additional tax on excess net passive income, which may be applicable to high-income individuals. LIFO Recapture Tax: Under certain circumstances, S corporations may be subject to a LIFO (Last-In, First-Out) recapture tax on employee discounts and other transactions. Built-in Gains Tax: In some scenarios, S corporations may be subject to the built-in gains tax, which can be a significant liability for previously untaxed gains.

Operational Restrictions:

Dividend Deduction: Dividends received by an S corporation from other corporations are not eligible for the dividends-received deduction, which can increase tax liability. Income and Loss Allocation: Income and loss are allocated based on stock ownership on each day of the tax year, which can be complex without proper accounting. Pass-Through Loss Limitations: The loss limitation for S corporations is smaller compared to that of partnerships, potentially limiting the amount of tax losses that can be carried forward. Shareholder and Investment Restrictions: S corporations are restricted in the type and number of shareholders allowed, and types of investments that can be made. This can limit the flexibility of the business structure. Year-end Compliance: S corporations are generally required to use a calendar year as their tax year, which can be inflexible for businesses with year-specific financial needs.

Conclusion: While electing to be taxed as an S corporation offers several tax benefits, it is important to carefully consider the operational and tax liabilities involved. Each business case is unique, and it is strongly advised to consult with a tax expert to determine the best course of action for your specific situation.

Keywords

S Corporation, C Corporation, Partnership, Tax Benefits, Tax Liabilities