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S corporations offer benefits, but guidelines must be followed carefully

S corporations have been around a long time as a form of business organization. It offers liability protection with a great degree of certainty to its shareholders, and all income, losses, deductions and credits pass through to the individual tax returns of the S corporation shareholders

The number of shareholders is limited to 100, but the business can have any number of employees.

Larry Lefoldt, a CPA with offices in Ridgeland and Biloxi, says there is no double taxation of an S corporation as in the case of C corporations. “C corporations are taxed both at the corporate level and the shareholder level, as well,” he said.

The Internal Revenue Service says it is likely to launch more audits of S corporations to help agents find situations where businesses paid little or no salary to owners to minimize tax liability.

Susan A. Riley, a CPA with Nicholson & Company in Hattiesburg, doesn’t think an IRS audit will make any difference to her clients who are organized as S corporations. “They’re so straightforward; they’ll be fine,” she said. “The IRS just decides to look at different types of organizations from time to time.”

She says, for example, a business consultant could benefit as an S corporation because he or she could pay a W-2 salary taxed through the corporation. “Distributions are not taxed, but individual incomes are,” she said. “The income of an S corporation flows directly through to an individual as an ordinary business income, but they can take the distributions income that is not taxed and that reduces the tax liability.”

Among her clients who are S corporations are an automobile dealer and a waterworks company. “My clients have found it to be a tax advantage and everyone is looking for a tax break,” she said.

Lefoldt, who’s been a practicing CPA for 34 years, recommends operating as an S corporation for specific business models. “I suggest it for the business that is excepted to generate high taxable profits from operations, and the owners want to withdraw essentially all the resulting cash flow,” he said “In this scenario, avoiding any risk of double taxation is the primary tax planning goal. The S corporation achieves that goal.”

Another type he recommends this to is the business that will own assets that are likely to appreciate by substantial amounts, especially when such appreciation would be taxed at preferential long-term capital gains rates if passed through to individual shareholders.

“In this scenario, avoiding double taxation and taking advantage of preferential long-term capital gains rates (e.g. 15%) are the primary tax planning goals,” he said. “The S corporation achieves both goals.”

Riley, who’s been active in peer review oversight with the Mississippi Society of CPAs (MSCPA), says that usually her clients have their minds made up about the type of business they want to organize when they come to her. “I try to help them with any business form they want,” she said, “but if they don’t have their mind made up, I give them all the options and that includes S corporation.”

However, there are pitfalls to this type of corporation. Lefoldt lists several:

• Deduction of pass-through losses by the shareholders may be limited by insufficient tax bases in stock and direct loans to the corporation.

• Pass-through losses and credits at the shareholder level may be limited by passive activity loss rules.

• Eligibility criteria may be a barrier or result in unintended termination.

• Nontaxable fringe benefits are curtailed for shareholders owning directly or indirectly more than 2% stock.

• A calendar year must be generally used for tax return purposes.

• Taxation of income to shareholders may not be consistent with cash flow to shareholders.

• The S election results in potential Alternative Minimum Tax at the shareholder level.

• Possible adverse state income tax consequences, including non recognition of S status by the state, additional individual state returns and shift of S income to state of shareholder residency.

Riley advises clients to make sure they meet all time deadlines, noting it’s a matter of what an individual is looking for and how detailed they want to be as to organizing as an S corporation or some other business form.

“I’ve been busy with them for 26 years, but LLCs are also very popular right now,” she said.

Lefoldt has taught an eight-hour course on “Annual Update for Accountants and Auditors” for the MSCPA for several years. For his S corporation clients, he advises that shareholders/employees must be paid a reasonable compensation and to avoid paying disproportionate distributions to shareholders.

“I also advise them to have a shareholders agreement in place that restricts the transfer of stock as well as the number of shareholders,” he said. “Additionally, I tell them to avoid debt obligations disguised as equity which creates a second class of stock.”

As the S corporation’s year end approaches, he advises they monitor the corporation’s income to ensure they achieve maximum tax benefits of year-end planning opportunities, such as paying bonuses, buying additional equipment or making shareholder distributions.

Contact MBJ contributing Lynn Lofton at llofton656@aol.com.

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