S-Corporation Questions

Recently we’ve encountered several situations where clients own corporate shares that have made a subchapter S election. Electing to have your corporation treated as an S-corporation has some pros and cons. First, the pros. From the standpoint of taxation, the S-election essentially makes your corporation “pass through” for purposes of reporting income. That means simply that the corporation itself is not required to pay taxes. Rather, the income passes through to shareholders, and taxes are paid at the shareholder level.

The benefits of pass through taxation are obvious. Most importantly, making an S-election avoids the problem of double taxation that owners of C-corporations (i.e. corporations that haven’t elected S-status) have to deal with. Clearly, that adds to the bottom line.

Another benefit of S-corporations is that owners of these shares have the ability to characterize income as dividends rather than ordinary income, which means that some earnings can be taxed at a lower rate. The IRS is aware of this little “trick,” however, and now requires that reasonable compensation be paid in the form of wages. Nonetheless, if you have an S-corporation, you should check with your tax advisor to make sure that you’re getting all the benefits available tax wise.

Drawbacks of S-Corporations

From an asset protection standpoint, S-corporations have some pretty serious limitations. For one, when a person owns S-shares, those shares can be “alienated.” That simply means that the corporate shares are counted as assets that a court could order you to give to a judgment creditor. The gist is that you could potentially lose your company if you hold S-corporation shares. In many states, this problem is avoided by using limited liability companies that are often protected by charging order statutes making it impossible for a judge to give your business away.

Another drawback is the restrictions imposed on who can own S-shares. The general rule is that only U.S. individuals can own these types of shares. So it often becomes difficult to “layer” of entities for strategic or protective purposes. Another drawback is that if S-shares are held by a properly formed offshore trust, then any triggering of that trust to an offshore jurisdiction could cause the S-election to be lost, which could have very adverse tax consequences.

Plan Your Business for Protection

The best thing you can do when starting a business is to begin with the end in mind. In most cases, it makes more sense, on balance, to use a limited liability company than an S-corporation. The reason is that the interests are just easier to protect and easier to work with. Again, check with you tax advisor or CPA on the best way to preserve income and avoid double taxation by using limited liability companies.

If you have any questions regarding whether you should use an S-corporation or an LLC, please give us a call.