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185 Reasons NOT to S-Corp, Downsides to S-Corp Election

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By Jason Watson ()
Updated September 29, 2014

This article has been expanded into several articles with in-depth analysis. Please click here to start reading-

https://watsoncpagroup.com/kb/introduction_332.html

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Not everything that glitters is gold so there are a handful of downsides, some manageable, to the S-Corp election. A lot of these examples stand alone, and some of these depend on the net income of the business. The Watson CPA Group can help guide you through the decision-making process.

And No, there are not 185 reasons- it was just a self-proclaimed catchy number.

Additional Accounting Costs
Paying shareholders through payroll and filing a corporate tax return costs money- but with a potential 4.6% to 7% savings of net income, the benefits will likely exceed the costs. And since the cost of payroll services and corporate tax return preparation is relatively fixed, the more profit you earn the more you’ll save. Something to discuss and consider.

Quick Numbers: $100,000 in net income saves you $5,000. The Watson CPA Group charges $800 per year for payroll and about $450 to $600 for the S Corp tax return (Form 1120S). Therefore, your net savings is about $3,700 annually ($5,000 minus $800 minus $500). Good savings for very little additional effort from you.

State Business Taxes (Not Just Income Taxes)
State tax laws might not treat S-Corp income and K-1 income in the same benevolent manner as the IRS. For example, California imposes a 1.5% franchise tax on S-Corp income with a minimum of $800. On top of that, of course, you also personally pay California income taxes. Yuck.

Other income tax free states, such as Texas, have similar taxations and various exemptions too. Franchise tax is another buzzword you might come across. Why do they call it a franchise tax or a business tax as they do in Washington State? They can’t call it income tax because of the Interstate Income Act of 1959. Yup. Way back when, and it is battled every year in court.

Before we get into that, there are two issues at play here. One, if you are a corporation headquartered in California, for example, you will be subjected to the franchise tax. Period. End of story.

But the other side of the coin is state nexus (which was discussed earlier) where you are not headquartered in California, but have a nexus or a presence in California. This too would subject your income sourced from California to the franchise tax. About half of the states have some sort of nexus rule and subsequent franchise, business or excise tax.

Back to the Interstate Income Act of 1959- it is against Federal Public Law 86-272 for states to charge an income tax on foreign businesses in certain circumstances. Remember, foreign does not mean domestic and international. Foreign is a business registered in Nevada doing business in California. Here is a snippet of Federal Public Law 86-272-

No state, or political subdivision thereof, shall have power to impose .. a net income tax on the income derived within such state by any person from interstate commerce if the only business activities with in such state by or on behalf of such a person during the taxable year are either, or both, of the following-

1. The solicitation of orders by such person, or his representative, in such State for sales of tangible personal property, which orders are sent outside the State for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside of the state; and

2. The solicitation of orders by such a person, or his representative, in such State in the name of or for the benefit of a prospective customer of such a person, if orders by such customer to such person to enable such customer to fill orders resulting from such solicitation are orders described in paragraph (1).

States are therefore prevented under Federal Public Law 86-272 from taxing out-of-state businesses on income derived from activities within the state if the activities are limited to mere solicitations of tangible personal property, and the orders are processed from outside the state. Note how this centers on tangible property and not services. Huge distinction! Is internet hosting a service or tangible personal property? How about an eBook?

So states came up with a tax that is NOT based on income or as least not called an income tax. Some states tax your gross receipts, no matter what your expenses are! Amazing. And it also noteworthy that Federal Public Law 86-272 does not protect businesses in the respective state (only interstate activities, not intrastate activities). But it appears that states keep things consistent, and impose a franchise tax, a business tax or an excise tax on local businesses just the same. Genius. Here are some sample state links-

www.wcgurl.com/1302 Oregon

www.wcgurl.com/1304 California

www.wcgurl.com/1307 New York City

Check out New York City! They don’t even recognize S Corporations as a pass-thru entity which means they are subjecting S Corporations to a franchise tax which could be as high as 9% thus negating any benefit of electing S Corporation status. Of course, LLCs have their own tax too in NYC, but it is not 9%.

So, and this is important, at some point as income increases close to $200,000 or more, a non-S-Corp entity (LLC, sole proprietor or partnership) could actually pay fewer taxes without the S-Corp election depending on the state. But nothing is simple, several states that impose a tax on corporations also have exceptions based on income and / or industry type. Spaghetti.

And to complicate things even more, you have to apply nexus rules to all this. You might not be subjected to another state’s franchise or business tax if you don’t have an economic or physical presence in that state.

Bottom line- talk to your nexus experts at the Watson CPA Group to nail this down.

Deducting Losses
With an S-Corp or partnership you need sufficient shareholder/partnership basis in your ownership to deduct losses. For example, if you invested $10,000 into your business but the business lost $30,000, as an S-Corp shareholder you can only deduct losses up to the amount of your shareholder basis (in this example, $10,000). But as a single-member LLC without the S-Corp election, business losses have no theoretical limit on your personal tax return.

Tax Planning Tip: Any additional money injected into your S-Corp should be treated as paid-in-capital which adds to your shareholder basis, rather than calling the money a shareholder loan. If your S-Corp fails, you may deduct the additional investment as a capital loss. However, any loan you made to the S-Corp becomes a miscellaneous deduction subject to thresholds, limitations and alternative minimum tax (AMT) on Schedule A. Yuck.

And let’s not forget that the IRS hates shareholder loans. Is there a promissory note? Payment schedule? Appropriate interest? If not, you could be technically in some trouble.

Distributing Profits, Multiple Owners
S-Corp shareholders are distributed profits as a percentage of ownership whereas garden variety LLCs use an operating agreement. This can create headaches for silent partner situations, and other non-traditional ownership structures.

The author, Jason Watson, served on a jury trial about a decade ago. An S Corporation was formed with three people. One owner was a 10% shareholder, while the other two were split evenly as a husband and wife team.

The minority shareholder, the 10% guy, was constructively ousted from the daily operations of the company. He was not paid a salary. He did not receive any money from the company. And, shareholder distributions are not required to be dispersed evenly or according to ownership percentage.

The company began earning money, lots of money. And the minority shareholder was getting K-1s showing taxable income of several thousands of dollars. Good right? No. Not good. He had to report taxable income, but never saw any money in the form of a shareholder distribution.

Growing Company, Debt Service
In a perfect world, if you had a $10,000 K-1, hopefully you received close to $10,000 in cash. But growing companies might be re-investing all their cash back into the business. And if a company has high debt service, taxable income might be present without cash. For example, your company made a $50,000 loan payment. Perhaps $40,000 of this was principal payment and the remainder was interest.

If the company has $100,000 in earnings before accounting for debt service it will only have $50,000 in cash but have $90,000 in taxable income. This in itself is not bad, but if taxable income creeps up and principal payment allocation also creeps up (which is does usually), you could find that the income tax due exceeds your cash.

Cash is king. Plan ahead before paring down debt.

Note: This really isn’t a reason not to elect S Corporation status- it is a problem for any business entity.

Chapter 9 on Business Valuations, Sale has some more examples, including how depreciation might be your friend in the cash, debt service and tax issue.

Ridiculously High Income
As alluded to earlier when analyzing the savings with electing S Corp status, there is a point where the savings don’t justify the costs. This magic number varies for each situation based on retirement deferrals and overall marginal income tax rate including the net investment income tax. Generally speaking-

  • $60,000 to $200,000 in net income after expenses, slam dunk Yes to S Corp

  • $200,000 to $300,000 in net income after expenses, cautious Yes with other factors such as health insurance, retirement planning, and other fringe benefits

  • $300,000 and beyond, probably No unless there are other circumstances such as your clients and / or fringe benefits require a corporation, or you are designing some future ownership transfer, or a myriad of other circumstances.

The Watson CPA Group will model your specific scenario for about $250 to $300. Here is a recent example-

S Corp No S Corp
Business Income 260,000 260,000
Salary to Shareholder 85,000 0
401k Employee Contribution 17,500 17,500
401k Company Contribution 21,250 34,500
Spouse Outside Salary 40,000 40,000
Adjusted Gross Income (AGI) 253,248 237,264
Assumed Taxable Income 232,948 216,964
Income Tax 52,777 47,997
Self Employment Tax 0 21,471
Payroll Taxes 13,005 0
Total Taxes 65,782 69,468
Savings 3,686

In the previous example, the business owner wanted to maximize his 401k contribution which adds to the difference between the scenarios, and ultimately the savings. And Yes, perhaps $85,000 is a small salary compared to $260,000 in total business income.

If the salary was increased to $138,000 which allows the maximum 401k contribution of $52,000 total, then the savings drops to $2,892. But that is still some good savings! Chapter 8 has more information on retirement planning.

If the salary was $100,000 with no 401k deferrals or contributions, the savings from an S Corp would be $5,569. At 50% salary, or $130,000, the savings would be $3,083. It is easy to see that a little swing in salary results in a huge swing in tax savings.

Again, every situation is unique. Spousal income (or being single), exemptions, itemized deductions and phaseouts, and state income taxes can all slightly add or takeaway from the savings. Retirement goals change things too. We can provide modeling for your exact set of circumstances.

Stock Classes
One of the rules of an S-Corp is to only have one class of stock, and this can be a problem at times if you are trying to bring in a new partner or create a vesting schedule for future owners. However, you can actually have two classes of stock as long as the only difference is the voting rights between the stocks (see IRC Section 1361(c)(4)). Amazing information!

So if you want to provide distributions to a person but not give them control, give him or her nonvoting stock (such as a retired parent who needs some money and enjoys a lower tax bracket than you). Setting us quasi-vesting schedules and buy-in schemes for an S-Corp requires a business law attorney who can draft the corporate governance documents correctly. And, this stuff is state-specific. Let us know if you need a referral, or help in selecting a proper attorney.

Bad Loans to the S-Corp
If your loan is not in writing or does not have a firm schedule for repayment, it might be labeled as a second class of stock which will nullify your S-Corporation. We know it’s a pain but go through the hassles of creating a proper instrument when lending money to your company (see IRC Section 1361(c)(5)(B)). More amazing information! The Watson CPA Group can help sort through all this hoopla.

As with most things in the IRS world, there are exceptions. And many exceptions are called Safe Harbor provisions. In this situation, there is a straight debt safe harbor which allows for a loan by a person who is eligible to hold stock in an S-Corp or is a business engaged in lending. The loan must not be convertible into stock, and there are some other rules. Let’s not muddy the waters quite yet.

Other W-2 Income
You might not reap the benefits of S-Corp election and subsequent self-employment tax savings if you have other W-2 income. Let’s say you are an IT consultant for ABC Company, and you also do some outside consulting. If ABC Company pays you $120,000 in wages, you are already max’ing out your Social Security contributions, and therefore any supplementary income regardless of your entity will automatically avoid additional Social Security taxes. You still obtain a small savings in Medicare taxes (up to the high income limit).

And the problem with piling extra W-2 salary from your S-Corp onto W-2 salary from your main job is the S-Corp’s portion of payroll taxes. While both salaries might exceed your individual Social Security cap ($117,000 in 2014), any salary in excess will unnecessarily increase the tax burden of your S-Corp by 6% (the employer portion of Social Security taxes). Huh?

In other words- your main job will stop contributing to Social Security when your salary reaches the limit. If you pay yourself another salary with your S Corp, your company will be required to pay into Social Security on your behalf but shouldn’t since your combined salary has reached the limit. This can potentially happen because each company does not know about each other. Nobody talks anymore. And even if they did, how would they divide up the burden? If you over-contribute to Social Security, you get that money back on your personal tax return but this does not solve the corporate side.

So in this situation perhaps a garden variety LLC is more prudent. Having other W-2 income, however, could actually work in your favor- more on that later in this book (see Tricks of the Trade later).

As a side note, having multiple sources of income can mess up your withholdings come tax time. Each source of income on its own withheld correctly, but when combined the income was in a higher tax bracket. Again, payroll tables don’t know about other jobs or sources of income, and can only make assumptions. Some tax planning is a must.

Social Security Basis
If you believe Social Security will remain funded by the time you retire, you might be short-changing yourself since your salary will be used to gauge future retirement benefits. Remember, shareholder distributions are not subjected to self-employment taxes and therefore will not count towards your Social Security benefits basis.

Keep in mind that the tax money you save today can make excellent retirement investments which can counteract the loss in Social Security benefits. In other words, the savings in social security taxes today might exceed the loss in future social security benefits if those savings are invested correctly. And the Watson CPA Group has an in-house financial planner to model this scenario. Consider this- if your salary is around $54,000 you will be eligible for about two-thirds of the maximum Social Security benefit (for 2014).

Payroll Taxes on Children
Children do not pay any Social Security or Medicare taxes until they reach 18 years of age if he or she-

  • works for a parent who owns a sole proprietorship or partnership

  • works in domestic service (babysitting, chauffeurs, etc.), or

  • delivers newspapers (who does this anymore?)

However, with an S-Corp election this blows up because the child is now working for a corporation, and not the parent. In other words, when you run your business as a sole proprietor, you and the business are one in the same. Same thing with a partnership. But an LLC with an S-Corp election now becomes a corporation for taxation purposes, and your child loses this exception.

Trapped Assets
As the only shareholder of an S-Corp, you might think that everything the business owns you also personally own. Not true. The relationship you have with your S-Corp is not a marriage. So, if you want to move assets out of an S-Corp or convert them to personal use, you will trigger a taxable event. A big one.

Sole proprietors and garden-variety LLCs enjoy a bit more flexibility under certain circumstances.

Assets within your S-Corp can also be problematic upon death. If you own an asset at the time of death, the asset is re-valued and your heirs get a step-up in basis (cost). So when they sell the asset their gain is lower. For example, you buy a painting for $5,000. And when you die, the painting is valued at $20,000. If your heirs sell the painting for $25,000, they will only realize a $5,000 taxable gain.

If the asset is sitting in the S-Corp upon your death, the S-Corp’s stock value might get a step-up in basis, but it is much harder to prove than the increased value of one particular asset.

C Corp to S Corp Problems
There are several potential problems when electing a C Corporation to be taxed as an S Corporation. First is called the built-in gains tax, or BIG tax for short. This is a tax that is paid on appreciated assets that are transferred from the C Corp to the S Corp upon election. This also means your assets need to be appraised as of the conversion date.

For example, if an S Corp that was recently converted from a C Corp sells some real estate that increased in value when owned by the C Corp, the S Corp will probably pay taxes on the appreciation even though the corporation is now an S Corp. The BIG tax is for any asset sold within 5 years of S Corp election (it was a 10 years look back period, then whittled down to 7 due to the American Recovery and Reinvestment Act of 2009 and then 5 thanks to the Small Business Jobs Act of 2010).

More bad news- Net Operating Losses (NOLs) can be carried forward and used in future years, but unused NOLs will be lost forever unless the C Corp can use it for previous years through an amended tax return. Otherwise the NOL cannot be used by the S Corp nor its shareholders.

Other issues arise from accounts receivable, inventory, and rents, royalties and investment income. More discussion is always required when dreaming of converting your C Corp to an S Corp.

Going Concern
Is your S Corp going to be needed next year, or the year after that? While an S Corp might make sense in the immediate future, the costs and hassles of startup and shutdown need to be amortized or spread out over a handful of years at the minimum. In others, if your consulting gig might turn into a W-2 job next year, perhaps wait or defer the creation of an S Corp.

Marriage
Marriage in itself is not a reason to elect S Corporation status. But an S Corp is like a marriage- easy to get into, hard to get out. The S Corporation needs to be terminated, the business needs to reclassify itself as an LLC, a final tax return needs to be filed, payroll accounts need to be closed, etc. We are not trying to alarm you or dissuade you, but at the same time many people forget about the back-end issues. And Yes, the Watson CPA Group can take care of all this.

Recap
There are several issues where an S Corporation election does NOT make sense. Be wary of all the accountants and other business owners who automatically check the Yes box when asked about making the election. As you can see, it is not for everyone or every situation. The Watson CPA Group will ask questions to ensure the fit is correct and that it makes sense.

Taxpayer's Comprehensive Guide to LLCs and S Corps
This KB article is an excerpt from our book which is available in paperback from Amazon, as a free PDF from us, and as an eBook for Kindle, Apple iBook, Barnes and Noble Nook, among others. You can cruise through these KB articles, click on the fancy buttons below or visit our webpage which provides more information at-

www.watsoncpagroup.com/book

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