When is electing "Subchapter S" status a mistake?
While the S corporation option may save business owners lots of payroll tax, one should not automatically elect "Subchapter S" status. At least three situations exist in which the S corporation option doesn't save the business owner tax.
Situation #1: Shareholders make more than corporation
The first situation in which operating as an S corporation may not save money is when shareholders pay high tax rates and the C corporation makes a modest profits which it wants to retain. The C corporation tax rate on the first $50,000 of taxable income is 15%, for example. Accordingly, if the owners of an S corporation all have substantial personal income which means their top tax rate is 40% or higher, a modestly profitable corporation which wants to retain its profits may actually save tax by operating as a C corporation.
Situation #2: Past corporate net operating losses
Another situation in which electing S status may be a mistake is when a business has operated as a C corporation and has large net operating loss deductions to carry forward. These large net operating loss deductions from the C corporation years can only be used as offsets against future C corporation years' taxable income.
If the C corporation carrying these net operating losses elects to be treated as an S corporation, the net operating losses can't be used unless or until the S corporation reverts to C corporation status. Note, too, that C corporation net operating losses may be carried forward only up to 20 years and that any losses not used within that 20 year time frame (which will include any intervening S corporation years) are lost permanently.
Situation #3: Multistate tax burdens for shareholders
A final situation where an S election may be a mistake should be mentioned. In some cases, the usual S corporation approach may not save enough payroll tax to pay for the increased out-of-state, non-resident individual income tax owned by shareholders because of the S corporation's out-of-state profits.
This situation would typically occur in a situation where shareholders live in a no-tax or low-tax state. If this sounds vaguely like your situation, confer with a knowledgeable tax practitioner who understands the multi-state taxation of S corporations. He or she can perform what-if analyses that look at the tax bills you and your business pay if you operate as a C corporation versus the taxes that you and your business pay if you operate as an S corporation.
Additional Information You May Find Useful
If you want additional information about how to maximize the tax savings related to running a business or investment venture, you may also be interested in one of our downloadable e-books (see descriptions below). Each book covers a category of tax planning topics that easily save a business owner significant amounts of income or self-employment taxes (potentially thousands of dollars a year) and is instantly downloadable.
One of the most powerful tactics for saving small business taxes is maximizing your deductions. You can literally save thousands in taxes each year.Read More
Using an S corporation for your business? To maximize savings, you need to minimize the salary paid to shareholders. But this decision is tricky.Read More
Tax laws provide active real estate investors with giant tax planning loopholes. A little upfront planning on your part could save you thousands a year...Read More