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Once again the darling form for many businesses. Find out why during this information-packed course. Practical, real-life examples give you ideas to apply immediately for your S Corporation clients. Review the advantages of the S Corporation tax rules. Minimize your client’s tax bill with the latest business and tax strategies that make S Corporations so popular. Comply with the unique tax reporting rules for completing Form 1120S. Decide if an S Corporation is your client's entity of choice.
Objectives:Prerequisite: None
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Chapter 1 - Why Subchapter S?
Learning Objectives
Upon completion of this chapter, you will be able to
• Explain the advantages and disadvantages of operating as a corporation.
• Recognize the advantages of S corporations.
Introduction
In this chapter, we will discuss the following:
• Limited liability
• Advantages of S corporations over C corporations
• Advantages of C corporations over S corporations
Choosing the most favorable type of business entity can be a difficult task. Owners of a new business can, depending on the circumstances, decide to operate as a proprietorship, partnership, C corporation, or S corporation. Furthermore, if a limited liability company (LLC) is formed, it may operate as any one of those types of entity, as long as it meets the applicable requirements.
In this course, we will examine some of the advantages and disadvantages of incorporation and then go through the requirements for electing to be an S corporation, as well as the rules for operating an S corporation.
During the course, we will address practical situations that occur in the operations of S corporations and will examine some tax return issues. A copy of the S corporation tax return, Form 1120S, and Schedule K-1 can be found at the end of Chapter 10.
Our discussion starts with a question – why should your client consider being an S corporation, or even a C corporation, at all? Why not operate as a proprietorship, if there is one owner, or as a partnership, if there is more than one owner?
Advantages of Corporations
Limited Liability
Most corporations are formed because the corporate entity offers some protection against personal liability. Unlike a general partner or proprietor, shareholders are generally liable for loss only to the extent of their investment. As a practical matter, however, before making a loan, a lending institution will usually insist that individual shareholders in a closely held corporation agree in writing to be personally liable for the debt. Although a professional person normally cannot protect himself from liability arising from personal negligence, he/she may be able to protect him/herself from lawsuits arising from the negligence of other professionals in the corporation.
Limited liability can also be obtained by forming a limited liability company (LLC) or limited liability partnership (LLP), discussed later.
Continuity of Organization
A corporation's existence depends on its charter and its outstanding stock, rather than circumstances relating to the owners of the stock. Therefore, the death, insanity, bankruptcy, retirement, resignation or expulsion of any shareholder will not, in itself, cause dissolution of the corporation.
Transfer of Interest
Shares of stock in a corporation can be transferred with relative ease. This provides gift and estate planning opportunities that are not so readily achievable in other forms of doing business. It also makes it easier to give a "piece of the action" to key employees or relatives who are moving into the business. If real estate is held outside of the corporation, or in a separate corporation, shareholders can sell or transfer stock in the business, while still retaining their ownership of the real estate.
Ordinary Deduction for Stock Losses
Under Sec. 1244, a loss realized because of the sale or worthlessness of C or S corporation stock may qualify as an ordinary loss, rather than a capital loss (see Chapter 7). A loss arising from disposition of a partnership interest is generally a capital loss.
Disadvantages of Corporations
Double Taxation Both regular corporations and, to a much lesser extent, S corporations pay tax at the corporate level. There can also be tax at the shareholder level when the income is distributed or passed through. There is never a tax at the partnership level.
Cost of Organization
Generally, the cost of incorporating is more than the cost of forming a partnership. Certain formalities and technicalities such as state filings, writing up bylaws, issuing stock, changing title to assets, and holding organizational meetings are all required. And attorneys' fees are also a normal expense of incorporating.
Rigidity of Operation
A partnership has more flexibility in its operation than a corporation. A partnership can make special allocations of certain income and expense items, if there is substantial economic effect for the allocations. Corporations must keep minutes of formal meetings, deal with complex payroll records, and file additional tax returns. Furthermore, S corporation items of income, loss, deduction, and credit must be allocated to shareholders based on the number of shares held by each shareholder.
Liquidation
The complexity of liquidation is another disadvantage of the corporate form. Liquidation must be formal, and many potential tax traps exist. Both the corporation and the shareholders may incur tax when the corporation liquidates.
Payroll Taxes
Sole proprietors or partners are not considered to be employees of their companies. However, in a corporation, persons who perform employee services for a corporation are employees even if they are shareholders and that means their wages are subject to withholding and payroll taxes. Remember, the IRS has the power to reclassify or reallocate income to ensure that salaries to shareholders are "reasonable." (Reasonable salaries are discussed in Chapter 6.)
Advantages of S Corporations
The overwhelming majority of S corporations are formed because of one or more of the following four factors:
1. Limited liability (discussed earlier)
2. No double taxation (generally)
3. Passthrough of losses and credits
4. Passthrough and distributions from S corporations are not subject to self-employment tax.
Basis. One important fact to remember at this point is that partners have an advantage over S corporation shareholders when it comes to the passthrough of losses, which are deductible to the extent of basis.
A partner is considered to have basis in any partnership indebtedness for which the partner is personally liable, and in certain nonrecourse debt. An S corporation shareholder has basis only in any indebtedness of the S corporation to the shareholder (Chapter 7).
Therefore, S corporation treatment would probably not be favorable to a company that was generating losses caused by depreciation of heavily mortgaged business property, such as real property rented to outsiders.
Escape Double Taxation
In an S corporation, income is generally taxed only at the shareholder level. In a C corporation, income is taxed at the corporate level, and taxed again to the shareholders when distributed. However, in certain situations an S corporation and its shareholders can face double taxation of built-in gains and passive investment income (Chapter 5).
Passthrough of Losses and Credits
Within limits, an S corporation passes through losses and credits to be used on the shareholder's personal return (Chapter 6). Therefore, corporate losses can offset other noncorporate gains and corporate credits can offset personal tax. C corporation losses and credits can only be offset against corporate income and tax.
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