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Should your business switch to S corp status?

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in Small Business Tax,Small Business Tax Deduction Strategies

The deadline for electing S corporation status for the current tax year is rapidly approaching.

Strategy: Take time to figure out if a switch makes sense for your incorporated business. Under the current federal income tax rate structure, some owners of incorporated businesses are better off bypassing this option.

The election must be made by the 15th day of the third month of the current tax year. In other words, a calendar-year corporation has until March 15, 2015, to decide whether to make the election for the 2015 tax year.

What are the main attractions? The shareholders (owners) of an S corporation benefit from the same protection from personal liability as do shareholders of a C corporation. So a corporate creditor can’t go after your private assets to satisfy a debt of the corporation.

Significantly, taxable income and loss items and tax credits are passed through to the S corporation shareholders, just like with a partnership. Thus, there is no “double taxation” at both the corporate and shareholder levels like there potentially can be with a regular C corporation.

Also, S corporation shareholders can be employees of the business and draw salaries. You may also receive dividends from the corporation as well as other distributions that are tax-free to the extent of your investment in the corporation. And S corp stock can be transferred without triggering any adverse tax consequences, as long as the transfer is to a qualifying shareholder (individual and certain types of trusts count as qualifying shareholders). Sounds like switching to S corporation status is a no-brainer, right? Wrong.

Key factor: For years, most individual shareholders were taxed at a lower federal rate than the maximum corporate rate. But the current top individual federal income tax rate of 39.6% is almost 5% higher than the top average corporate rate of 35%. Plus, tax reform calls to lower the corporate rate, which would create even more separation, are getting louder each year.

Finally, consider these potential drawbacks:

  • An S corporation can have only one class of stock (although it may have both voting and nonvoting shares).
  • Because amounts distributed to a shareholder can be classified as dividends or salary, the IRS often scrutinizes payments to ensure compensation is reasonable.
  • Due to the one-class-of-stock restriction, an S corporation can’t allocate a disproportionate share of tax losses or taxable income to a particular shareholder or group of shareholders.

Tip: An S corp election is made on Form 2553, Election by a Small Business Corporation.

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