Is it Time to Terminate an S Election?

Is It Time to Terminate an S Election?

Is it Time to Terminate an S Election?S corporations are corporations formed under state law that elect to be taxed as pass-through entities for federal income tax purposes. Most states provide similar tax treatment for state income tax purposes.

S corporation status means that business income or loss passes through to owners and is taxed on their personal returns, in comparison to C corporations that are separate taxpaying entities. S corporations are the most popular type of corporation, accounting for about 68% of all corporate returns filed in 2015.

However, there is a growing list of reasons why S status may no longer be desirable. Here are some of them.

Proposed tax rate changes

There has been a great deal of talk about tax reform in 2017. The proposals call for a dramatic cut in the corporate tax rate. The proposals also aim to tax business income earned by pass-through entities at the same rate imposed on C corporations. And there is talk about eliminating the double taxation on C corporations, a condition that has been one of the key reasons for electing S corporation status. (Double taxation results when C corporations pay dividends that are not deductible by them but which are then taxable to their shareholders.)

While it’s too early to know exactly what the tax rules will be, and when they’ll go into effect, it’s certainly worth monitoring tax reform developments. If it turns out that tax rates favor C corporations, then existing S corporations that expect to be profitable may want to revoke their elections.

Seeking investors

If an S corporation needs money from outside investors, the election may have to be terminated:

  • Equity crowdfunding. In 2013, the JOBS Act allowed small businesses to raise money from the investors through online portals designed for this purpose. It took several years for the SEC to provide rules for equity crowdfunding, but they’re now in place. However, equity crowdfunding currently is not suitable for S corporations because such entities have a 100-shareholder limit. There has been a bill (H.R. 4831) to waive the shareholder limit for equity crowdfunding purposes, but this has not yet become law.
  • Going public. If the corporation wants to do an initial public offering (IPO), which can raise more money than permitted through equity crowdfunding, it cannot do so as an S corporation because of the 100-shareholder limit.

Health coverage

C corporations can provide tax-free health coverage to owner-employees. S corporations must report as taxable compensation any company-paid health coverage for S corporation owner-employees with a more than 2% ownership interest, although the premiums can be deducted on owner-employees’ personal returns as an adjustment to gross income. The problem: under the Affordable Care Act, it is not clear whether this arrangement is a healthcare plan subject to certain rules. In 2015, the IRS provided temporary relief, saying this tax treatment can continue until further notice. More specifically, the IRS said that an S corporation with a 2-percent shareholder-employee healthcare arrangement will not be required to file IRS Form 8928 (regarding failures to satisfy requirements for group health plans) solely as a result of having a 2-percent shareholder-employee healthcare arrangement. However, group health plan rules do not apply when there are fewer than two participants, so a one-person S corporation need not worry.

S corporations with two or more owner-employees that want to be sure that they are compliant with the Affordable Care Act, and that owner-employees receive tax-free health coverage, may want to terminate an S election.

Types of investors

One of the requirements for being an S corporation is having only specific types of shareholders. It cannot have:

  • Individuals who are nonresident aliens
  • Partnerships
  • Corporations

If a corporation wants any of these types of shareholders, the S election needs to be terminated.

Conclusion

If an S corporation wants to revoke its federal election, watch for time limits, and also check rules for terminating state-level S elections. Keep in mind that once revoked, no new S election can be made for five years without IRS consent. Discuss any proposed revocation with a knowledgeable tax adviser.

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