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.

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