The Future of Pass-Through S Corporations

Financial

The Future of Pass-Through S Corporations

By Mark E. Battersby / Published April 2017

 

S corporations have been around for some time and are very popular with pressure cleaning businesses. However, while it’s too early to predict what effect any tax legislation in 2017 will have on the 4.6 million businesses operating as S corporations, significant changes may be in the works.

As the entity’s popularity has continued to grow, it’s easy to see why: Owners of pressure washing businesses operating as an S corporation can protect themselves against personal liability and have income and gains taxed only once, as opposed to the double exposure of regular “C” corporations and their owners who are taxed at the corporate level and again on their individual returns.

Most states follow the federal pattern when taxing S corporations; they don’t impose a corporate tax, choosing instead to tax the business’s profits on the shareholders’ personal tax returns. About half a dozen states, however, do tax an S corporation like a regular corporation.

Not Always Small S Corporations

An S corporation is merely an incorporated manufacturer, distributor, or contractor that has chosen to be treated as a partnership for tax purposes. It offers some appealing tax benefits while providing its owner/shareholder with the liability protection of a corporation. The income and losses of S corporations are passed through to its shareholders and included on the shareholder’s personal tax return. As a result, there is just one level of federal tax to pay.

On the downside, S corporations are subject to many of the same requirements that corporations must follow, resulting in higher legal and accounting fees. The S corporation must also file articles of incorporation; hold directors and shareholders’ meetings; keep corporate minutes; and allow shareholders to vote on major corporate decisions.

Another major difference between a regular corporation and an S corporation is that S corporations can only issue one class of stock despite the limit of having up to 100 shareholders. Experts say this can hamper the pressure cleaning operation’s ability to raise capital.

S Corporation Rules and Requirements

Choosing to operate as an S corporation is usually pretty straightforward. All shareholders must agree and sign the form (IRS Form 2553, Election by a Small Business Corporation). In many states, no separate election is necessary as filing the federal form automatically qualifies the corporation for S status in the state; in others a separate state form must be filed.

Generally, the form must be filed within two and a half months of when the corporation first has shareholders. Existing corporations can elect S status for a year by filing Form 2553 by the 15th day of the third month of the operation’s tax year (March 15 for calendar year businesses).

No one wants to find out some years down the road that S corporate status has been denied. Unfortunately, violating the many state and federal rules governing S corporations can result in a loss of S corporation status. Should that occur, shareholder losses will be disallowed and profits will be taxed at the corporate level.

There are several requirements S corporations must meet:
• The maximum number of shareholders is 100;
• Shareholders can only be individuals, estates, or certain trusts;
• Shareholders must be citizens or residents of the U.S.; and
• There can only be one class of stock.

The first requirement is unlikely to cause a problem for most incorporated pressure washing businesses. All members of a family and their spouses are considered as a single shareholder for determining the 100-shareholder limit.

The second and third requirements can present pitfalls. Partnerships, corporations, and nonresidents cannot be shareholders. If an existing shareholder sells his or her shares to one of these persons, the S election will be terminated. An IRA cannot be a shareholder.

The last requirement sounds innocent, but while the business is unlikely to inadvertently issue preferred shares, the IRS has held that unequal distributions to shareholders can result in a second class of stock.

Money Out

Salaries, distributions, and business income are among the most misunderstood areas of pass-through entities. Basically, whenever the shareholders of a pressure cleaning business operating as an S corporation take anything out of the pass-through entity, they will be taxed.

The IRS requires every officer/shareholder to be paid a salary for services rendered. The salary taken will be subject to the usual FICA and Medicare taxes (as well as state and federal unemployment). Naturally, only a share of the FICA/Medicare taxes are withheld from the shareholder/owner’s salary; the business pays the other half, just as if the shareholder/owner were an employee at an unrelated employer.

Fringe Benefits

One of the drawbacks of S corporations is that certain fringe benefits paid to a more-than two-percent shareholder of an S corporation are not deductible. The fringe benefits generally include these expenses:
• health and accident insurance,
• qualified transportation fringes,
• group term life insurance premiums on the first $50,000, and
• meals and lodging furnished for the convenience of the employer.

Health insurance premiums are deductible, but only if included on the employee/shareholder’s W-2. The employee can then deduct the amount toward his or her adjusted gross income on their personal tax return.

Passive Activities and Material Participation

The complexity of the S corporation rules stems from the ability to pass through losses to the owners. Congress wants to deny losses to passive investors while allowing them to owners who are active in the business. They arrived at the concept of “material participation.”

If the owner materially participates in the business (as most small business owners do), the losses can be used to offset other income such as dividends, interest, salaries, etc. On the other hand, owners who do not materially participate (so-called “passive investors”) cannot use these losses to offset other income. They can, of course, be used to offset other passive income or used to offset other income when the investment is completely disposed of.

What’s material participation? Pass any one of the IRS’s tests and the shareholder/owner is materially participating. Most business owners will pass one of these three tests:
• Participating in the activity for more than 500 hours during the tax year.
• That participation constitutes substantially all of the participation in the activity of all individuals (including nonowners) for the tax year.
• Significantly participating in the activity and total participation in all significant participation activities during the year exceeds 500 hours. The threshold for significant participation is 100 hours.

Although there are four other tests, most small business owners qualify using the three listed above.

Loss Limits

While the income and losses of S corporations are passed through to the shareholders, shareholders can only deduct those losses up to the amount they have invested in the pressure washing operation—their basis. Basis includes equity investment (adjusted for profits and losses) and any direct loans made by the shareholder to the corporation.

Coming Attractions

The basic structure of the S corporation places them in the bulls-eye of the debate over tax reform and lower tax rates. Congress and President Trump are promising to reform the corporate tax laws. However, maintaining the current tax rates on upper income Americans will hit more than a million S corporations. Congress long ago reduced the top tax rate from 91 percent to today’s more humane 39.6 percent.

As a consequence of Congress long ago reducing the top tax rate to 39.6 percent, business income migrated from the corporate to individual tax rates. Today, thanks to S corporations and other pass-through business entities, most business income is taxed at the individual tax rate, inflating the annual incomes of business owners.

There’s general agreement that the marginal tax rate on regular C corporations is too high, but if that’s cut, pass-through S corporations wouldn’t get a cut and may even face a tax increase. One suggested alternative would give pass-through businesses a reduced rate compared to the wage income proposals of President Trump (a 15 percent rate cap) and the House GOP (a 25 percent rate cap). Both plans have a top ordinary tax rate of 33 percent, according to reports.

Unfortunately, creating a special rate for pass-through entities can encourage gaming, giving business owners an incentive to recategorize their wage income to business income since pass-through business income would be taxed at a lower rate than wage income. It would also, at least according to many experts, increase the tax differential between corporate investment and pass-through investment.

Braving Uncertainty

By electing to become or to continue operating as an S corporation, a pressure cleaning business can benefit from the legal advantages available to incorporated businesses as well as the tax advantages available to partnerships. Such provisions have been made primarily in order to promote small businesses and relieve them from the financial burden of double taxation.

Although the rules for switching to or becoming an S corporation are complex and require monitoring in the months ahead, the many advantages for manufacturers, distributors, and contractors in the pressure washing industry make the sums spent for professional advice and/or guidance well worthwhile.