Although S corporations have some disadvantages compared to partnerships and limited liability companies, they also have some important advantages.
S corporations are much easier to operate and the tax return preparation for them is simpler than for other passthrough entities because they don’t have the flexibility the other types have. Since there are no special allocations, income and deductions are mostly allocated based on the percentage of corporate stock owned.
Unlike partnerships and LLCs where the shares of income of active owners are subject to Social Security and Medicare taxes (self-employment tax), only the wages paid to S corporation shareholders are currently subject to these taxes. On audit, the IRS will attempt to impose these taxes on dividends paid to the shareholders as “disguised wages”. The undistributed income isn’t subject to social security or medicare tax. This is a big advantage for businesses that are reinvesting their earnings. Hopefully any extension of self-employment taxes to S corporation earnings will be limited to distributed earnings.
Since only wages are subject to employment taxes, it’s also easier to administer qualified retirement plans, including 401(k) plans, for S corporations. For partnerships and LLCs, the self-employment income of owners might not be determined until months after the year end, so the earnings on which contributions are based are also unknown. What if you have withheld “owner-employee” share 401(k) contributions and it turns out the business had a loss? The clean up is an inconvenience, and usually isn’t necessary for an S corporation. What happens when the business is audited, resulting in a change in the taxable income from the business? Again, not a problem for an S corporation, but possibly a problem for a proprietorship, partnership or LLC.
If you have multiple real estate rental properties, an S corporation management company can be used to “manufacture” earned income for retirement plan contributions and for a self-employed (“above the line” deduction) medical insurance plan.
In California, LLCs that have $250,000 or more of gross income are subject to a “fee” or tax based on the gross receipts of the business, which applies even if the business has a tax loss. The gross receipts fee is in addition to the $800 annual tax. An $800 annual tax applies to limited partnerships doing business in California. No partnership-level tax applies to general partnerships doing business in California. S corporations have a 1.5% corporate income tax on California-source taxable income, to which the $800 annual minimum tax is applied.
These advantages are important ones favoring S corporations when a business doesn’t hold substantially appreciating assets, such as real estate or intellectual property like patents or trade secrets. With the current exception of assets inherited from a decedent who dies during 2010, these assets are eligible for basis adjustments when there is a sale or inheritance of an ownership interest in a partnership or LLC, but not in an S corporation. Again, these assets might be held in a separate entity from the S corporation that is eligible for basis adjustments.
Always consult with legal counsel and tax advisors before making any major decisions about the form of a business, especially when making a change in form. It can be easy to adopt a change, but hard to reverse it later.
IRS Circular 230 Disclosure:
As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this communication was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.