The Subchapter-S Corporation
Every week I have a client ask me about “sub-s” corporations. Will they fit her specific needs? What are the restrictions? Are they hard to run?
History
When I first started practicing law, almost 40 years ago, sub-s corporations were a very simple tax device for people running, essentially, incorporated proprietorships where they didn’t want to cope with the complexities of corporate taxation. The corporation still had to file its own tax return, but all of the “profit” fell through the bottom of that return onto the personal tax return of the owner. In those days you could only have ten shareholders and one class of stock. There were other restrictions, too. For instance, you were limited to partnership type retirement plans.
Then came the run up in “tax planning” and the planners (like me) used sub-s corporations for everything from incorporated basketball players to owning jet aircraft.
Over the years, the uses proliferated and the entities got more complex. Now, except for taxation, there isn’t a lot of difference between running a standard (“C”) corporation and running an “S” corporation
Requirements and Restrictions
(See Internal Revenue Code of 1954, as amended, Section 1361 and the Regulations propounded pursuant thereto.)
There are two kinds of requirements you need to pay attention to in considering the use of an “S” corporation: statutory requirements and operational requirements.
The statutory requirements are pretty much an expanded version of what they have been for fifty years:
100 or fewer stockholders (husband and wife, for this purpose only, are
considered only one shareholder).
Only one class of stock. Be careful; IRS will look at all stock, bond, note and other rights and if something else looks like stock, they will kill your “S” election.
People/things that can NEVER be stockholders:
Non-citizens of the United States (includes companies, trusts, etc.).
ESOPs
Any partnership or anything that is taxed like a partnership (LLC, FLP)
Another corporation, (be careful of charities formed as corporations).
Any kind of trust, except for:
Voting trust that is restricted
Grantor trust with QSST provisions
A 678 trust
Any kind of financial institution
Elect to be taxed as an “S” corporation. That requirement is met in two parts: write down the election in the corporate minutes and then file Form 2553 with the IRS (and a like form with the California Franchise Tax Board, if your corporation is going to “do business” in California).
Operational Considerations
The most important aspect of Subchapter S operation is the operation itself. This is a corporation, chartered under state law and you must comply with the state law on how you run your corporation. So, in California, for instance, you MUST hold a yearly shareholder’s meeting with correct waivers of notice and minutes, etc. In the current attack-dog atmosphere at IRS, it is also very wise to hold a yearly Directors’ meeting, too. That meeting will also have its own set of minutes and waivers.
Then, you need to actually operate it as a separate person:
Separate bank account(s) for the corporation
Print the name of the corporation on the checks, billing statements, invoices, weigh bills, business cards and the front door.
Don’t pay personal bills out of the corporation.
Then there is the question of how much salary to take. Under the Subchapter S formulation, you are going to get all of the “profit” on your tax return, anyway. So, why not just take zero salary, avoid the payroll taxes and let your personal tax return include the “profit” (or loss) in your personal taxes. Everyone will be happy (as happy as you can be paying taxes) and every last dollar will have tax paid on it.
It’s not that simple. You see, there are two kinds of income in a corporation that must be dealt with on a tax level. The first is the income collected from customers and paid to management. The other is the income collected from customers and paid out to shareholders as the cost of using their capital. That is called “dividends,” whether it is taxed at the corporate level in a “C” type corporation or “passed through” to the shareholder level in an “S” type corporation. Sub-chapter S affects only dividends and provides that there is no tax at the corporation level.
However, it does not address what the corporation pays its management. That is salary. The IRC allows deductions for corporate benefits paid on behalf of management employees, it allows the salary to be deducted and IRS defines any manager of a Subchapter S corporation who is also a shareholder as an employee. So, if you don’t allocate part of that “profit” to your salary and pay the payroll taxes on it, IRS will do it for you, years later, with penalties and all.
So, how do you tell how much to allocate to salary? One way is to look at what you think your tax burden will be on your personal tax return and give yourself enough salary to provide the withholding that deposits that amount of money with the IRS over the year.
Another method is to look at other executives in your particular business, see what they are paid and allocate something less to yourself as salary.
However, an easier way is to just cut the expected profit in four or five pieces, allocate 1 piece to salary and the rest to dividends. Some amount between 20% and 25% should pass muster with IRS, especially if the tax provided by the withholding comes close to paying your tax bill for the year.
One last operational consideration you should include into your planning is your exit strategy. Remember, a “C” corporation, an LLC and a limited partnership cannot own a Subchapter S corporation. Consequently, you can’t sell your Subchapter S corporation to any of those entities, only to another Subchapter S corporation or to an individual.
Conclusion
So, while there are restrictions and advantages, you must consider the whole picture before deciding on the use of a Subchapter S corporation for your business. Most of the time, given the right consideration, they work well up until time to sell. Look over your particular situation and see if a Subchapter S corporation might work for you.
JWH 7-‘08