When choosing the type entity to operate your business there are several legal and financial aspects to consider. These considerations vary, and carry different weight, depending upon each set of facts and circumstances. However, if you operate your business entity as a corporation - TLB recommends you recheck your reasons for not making the so-called “S” election. Some of the reasons why the S-election is advantageous are as follows:

1. Your selling your business - Upon the sale or distribution of corporate assets or business, tax is paid at both the corporate and shareholder level. If you are thinking of retiring or selling your small business in the future, you should seriously consider the advantages of making an S-election.

2. Unreasonably high compensation issues - C-Corporations have to worry about paying unreasonably high compensation. In order to get money out of a C-Corporation most taxpayers take out cash in the form of compensation bonuses. On an IRS examination, agents consider these unreasonable high compensation issues to determine if taxpayers are trying to avoid paying a corporate level tax and tax at the individual level for the receipt of dividends. If raised during examination the service will hit you for the tax and for substantial penalties. This issue doesn’t exist for the S-Corp, as all the corporate income flows through to the shareholder and is taxed only at that level.

3. Accumulated Earnings - O.K. if you avoid the unreasonable compensation issue noted in number 2 above, perhaps you will run into too high a level of accumulated earnings. In this scenario, the IRS may try to assert that the C-Corporation is not paying this cash out because of a desire on the part of the taxpayer to avoid paying taxes on the dividends. Again, this issue just doesn’t apply to the S-Corp, because all income flows through each year.

4. Personal expenses - lets face it many taxpayers try to funnel personal expenses through the business, or perhaps something that every body thought was legitimately a business expense is disallowed upon IRS examination. In a C-Corporation environment this could be disaster. Most likely the IRS will consider the payment of the personal expenses a dividend - so the taxpayer has to pickup the tax on that. In addition, now that the corporation loses the expense, its taxable income is increased and the corporation has to pickup the tax on its level. Add on penalties and something as innocuos as disallowed auto expenses totaling, lets say $10,000, will now cost the taxpayer an additional $7,000 - $9,000 in tax and penalties. Lets hope tax preparers out there are encouraging their clients to play it straight when it comes to personal expenses - especially with their C-Corp clients.

5. Utilization of losses - As a C-corporation any losses generated by the business, stay with the corporation, but may be carried forward. This is nice, but isn’t particularly useful if you are generating income otherwise (other businesses, earned compensation, etc.) The S-Corp allows losses to flow through to the shareholders, which can then utilize these losses to offset other income.

6. Save on payroll taxes - As noted in number 2 above, many taxpayers pay themselves a salary higher than they normally would in order to get the cash out of their C-Corporation and to avoid having to pay the corporate level tax. In this scenario, the taxpayer is paying 12.4% (6.2 employee, 6.2 employer) for social security on approximately the first $95,000 of wages plus 2.9% medicare on the total wages paid. If you were an S-Corp you might pay yourself a more reasonable wage, say comparable what you might pay an outsider and save yourself up to 15.3% in employment taxes by taking the resulting corporate profits as flow through income.

7. Keep the cash basis of accounting - C-Corporations that exceed $5million when applying the average annual gross receipts test (Is your accountant monitoring this every year for you?) are required to convert to the accrual basis of accounting. This could result in a huge change in taxable income, expecially in the first year. In this scenario, an S-election could save you and the use of the cash basis of accounting, particularly in light of IRS Revenue Procedure 2002-28, which provides for safe harbor provisions.

8. Is your C-Corporation a QPSC or a PSC? If so an S-Corp may be for you.

In many small businesses TLB has found that the S-Corporation is the preferred corporate entity and just seems to make the most sense. Of course there may be reasons one would want to operate as a C-Corporation - sounds like a future post. As always, please consult with TLB on any and all of these issues, before taking action, to determine the ramifications of an “S” election (i.e. the built in gains tax) and to plan accordingly.

When operating a business entity it is not uncommon for a taxpayer to incorporate for a number of reasons, two of which are individual protection from liability and several potential tax advantages. In selecting to organize as a corporation (and not electing to be treated as an S-Corporation) commonly referred to as a C-Corporation, small business owners need to also consider whether or not their corporation is going to be considered a “personal service corporation” or a “qualified personal service corporation.” Each of these classifications significantly change tax implications when compared to a C-Corporation that is not classified as a PSC/QPSC.

One pitfall of a PSC/QPSC is that it is denied the graduated tax rates for corporations which start at 15% and incrementally reach 34% up to a maximum of $100,000 of taxable income, and is instead taxed at a flat 35% rate on taxable income. However, over $100,000 careful planning is required for the PSC/QPSC corporation, as the graduated rates fluctuate at various income levels between 34% and 39%, which, in some cases might make the flat rate of 35% desirable.

Section 269A(b)(1) of the Internal Revenue Code states that the term personal service corporation means a corporation the principal activity of which is the performance of personal services and such services are substantially performed by employee-owners.

Section 448(d)(2) provides that the term qualified personal service corporation means any corporation which (A) substantially all of the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting, and (B) substantially all of the stock of which is held directly or indirectly…

Another pitfall of the PSC is that internal revenue code section 280H restricts the amount that can be deducted by a personal service corporation for amounts paid to owners if the corporation has elected a non-calendar tax year. This could have very costly consequences in the year of disallowance and at the least minimizes a taxpayers planning opportunities.

There are several options to avoiding tax traps with PSC/QPSC corporations, including making a subchapter “S” election; minimizing time spent in the business in order to avoid the so-called function test; and transferring at least 6% of the corporations stock to someone who is not an employee (maybe a spouse) and who is permitted to own the stock in order to avoid the stock ownership test.

The traps and consequences that befall unwary PSC/QPSC corporations was recently illustrated (ironically) in the Tax Court case Rainbow Tax Service, Inc. v. Commissioner (128 T.C. No. 5 – 3/8/2007). In this case, a tax preparation and bookkeeping firm attempted to make the case that it was not providing accounting services, which is specifically referenced in code section 448(d)(2) as an element of a QPSC. The court held that these services were considered to be in the “field of accounting,” and therefore Rainbow Tax Service, Inc. was subject to the flat 35% corporate tax.