A client of mine recently asked me what I thought was the best organizational structure for a small business, all things considered, especially related to the tax issues. So, I put together a list of advantages and disadvantages of all four entity types that I thought were most relevant. They are C corporations, S corporations, single member LLCs and multi-member LLCs.
I immediately excluded sole proprietorships and partnerships because these entity types do not protect a business owner’s personal assets from business liability, and the owner or owners personally assume the liability of both types.
I believe based on my analysis that S corporations are the best option for almost any small business. Let’s compare the advantages and disadvantages of S corporations.
Of course, the shareholders’ tax brackets and effective tax rate are important. An effective tax rate is the actual rate a taxpayer pays, calculated by dividing total tax by taxable income. A marginal tax rate is the rate at which the next dollar of income is taxed. I wouldn’t consider the marginal tax rate. The top tax rate is important. While the top tax rate is a flat 21 percent for C corporations and personal service corporations, the top rate for shareholders of an S corporation is 37 percent, but it is a graduated rate, so I believe the effective tax rate must be considered.
Another issue that must be considered for this analysis is that it appears most likely that we will have a new presidential administration next year, and some of the benefits of any entity type may very well disappear. That complicates tax-planning matters, but not entirely.
There are issues related to the recognition of income, the deduction of expenses and tax credits that should be considered, but many of these are the same for every business type. Note that I did not include the tax provisions of the CARES Act and the Families First Coronavirus Relief Act below because many of those issues are temporary. The tax credits in each, and the deferral of payroll taxes, apply to all entities.
Some advantages of an S corp are:
1. Shareholders are not subject to double taxation on income in retained earnings.
2. The income and loss of the S corp are allocated pro rata on a daily basis to each shareholder based on their ownership of all the shares of an S corp.
3. Capital losses are also allocated to the shareholders based on their daily pro rata share of total shares in the S corp.
4. An S corp is not subject to Social Security and Medicare taxes on pass-through income because it is not “self-employment income.”
5. An S corp can pay its shareholders a reasonable salary and only be taxed for Social Security and Medicare purposes on that salary, and not on the distributive allocation. The best source of information to determine the reasonable salary is the government’s own Bureau of Labor Statistics, but the IRS doesn’t normally get concerned about this unless the compensation is zero or very little.
6. The corporation can have an unlimited life and shares can be transferred easily to other people or entities.
7. Shareholders get the maximum protection for their personal assets if they keep their business affairs completely separate from their personal affairs. The courts can pierce the veil of a corporate entity if business affairs are not kept separate from personal affairs.
8. S corps are not subject to the Net Investment Income tax.
9. Fringe benefits for employees and owners of 2 percent or less of the S corp are not considered income for the shareholder or employee. They are also deductible by the S corp.
10. A greater than 2 percent owner of an S corp can deduct 100 percent of health care premiums paid by the corporation under a plan established by the corporation.
11. An S corp is eligible for the 20 percent Section 199A deduction on qualified business income, except as disallowed by law generally for certain service corporations.
12. A shareholder has basis in certain debts of the S corp to the shareholder, to be adjusted over time.
13. No gain or loss is recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in the corporation and, immediately after the exchange, the people who are in control (as defined in section 368(c)) of the corporation. Section 368(c) defines control to mean the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation. Other property received, called boot, is taxable in the transaction.
14. A shareholder can include loans the shareholder made to the S corp in basis, but not liabilities to outside persons or entities.
Some disadvantages of an S corp are:
1. It can only have 100 shareholders. A husband and wife are one shareholder but become two shareholders if they divorce.
2. It cannot have nonresident aliens as shareholders.
3. Shareholders must be individuals and certain trusts.
4. Partnerships, C corporations and multi-member LLCs cannot be shareholders.
5. It can generally only have one class of stock.
6. State tax law may not recognize an S corp.
7. A shareholder cannot include debt in their basis of the entity for debt to outside parties.
8. An S corp with more than 100 employees earning at least $5,000 in the prior year cannot claim the pension plan startup costs credit.
9. Shareholders in an S corp may be subject to the tax on income items related to their investments in the corporation.
10. There are restrictions on the ordinary income treatment on Section 1244 qualified small business stock.
11. Owner-employees who own more than 2 percent of the S corp stock may have to include fringe benefits in their gross income.
12. An S corp that is not a closely held corporation must use the “simplified look-back” method of accounting for long-term contracts if almost all of its income under a long term contract is from sources in the United States.
13. There are limitations on some deductions that are generally itemized deductions of shareholders and certain other expenses such as alimony.
14. Distributions to shareholders may be taxable if they exceed the AAA account first, earnings and profits second, and then the remaining basis in stock.
15. S corps must generally use a calendar year for reporting profits and losses, but may apply for a fiscal year from the IRS for business purposes, or it can elect a Section 444 tax year.
16. An S corp must make a proportionate allocation and distribution based on ownership interest.
17. A deduction for health insurance benefits is not allowed in excess of the earned income of the owner-employee from that business.
18. An S corp can have “built-in gains” if it does not become an S corp in its first year. Built-in gains are gains that are embedded in an S corp’s assets before it became an S corp. The gains on assets in this case are frozen and are then taxable to the S corp at the applicable corporate rate when they are sold. The gain or loss on “built-in gains or losses” is allocated to all shareholders on a pro rata basis, even when the property creating the “built-in gain or loss” was contributed by one shareholder, or several specific shareholders.
19. The “at-risk” rules apply to S corporations and this is applied at the shareholder level Shareholders cannot deduct losses unless they are at risk of losing property or paying a liability in the amount of the loss. Shareholders of an S corp cannot be liable for non-recourse debt.
20. The passive activity rules also apply at the shareholder level, but certain determinations related to a passive activity must be made at the corporate level.
21. An S corp can only claim a deduction for stock given to an employee for services in the amount and the year the employee includes the stock in income. This generally occurs when the stock vests in the employee and the amount of income is the difference between the amount the employee paid for the stock and its fair market value at the date the employee vests in the stock.
