S-CORP BENEFITS & PITFALLS
An S-Corp. election can significantly reduce taxes for small business owners and be part of a good tax plan but it is not for every situation. Here is why.
Let’s say an s-corp., after paying the owner reasonable compensation of $50k, earns a profit of $63K. Remember distributions of profits irrelevant. (For 2013 social security is capped at $13700). The owner would save $9639 in Social Security and Medicare. Great! When things go reasonably well the S-corp can be a beautiful tax saving vehicle.
Now for the other side. Let’s say the owner experience a couple of bad years and actually showed a loss. Assume also that the business earlier borrowed money to fund capital expansion, keep up with growth and was still paying off the debt, and the owner cosigned on the note. The business losses pass through to the owners, (just like income) and the owners get a nice deduction on their income, but only to the extent of their basis. Unfortunately loans to the company, even when guaranteed by and owner, (unlike partnerships or disregarded entities) do not count toward basis. In short if basis is $0 then deductions are $0. What’s even worse is any distributions in excess of basis are taxable as Capital Gains. This means you can have a loss on the business, not take the deduction and still have capital gains.
Let’s take this a step further. Lastly assume after a couple of bad years the business is turning around and the business makes 100K. However, equity & basis are still negative at end of year but the owner pulls out $75K to live on. In this situation there is pass-through income of $100K to be taxed AND capital gains of $75K. Not so much feeling the love now.
The above is a worst case illustration (at least we hope it is), and there are positions that could be taken lessen the impact. Officer loans could be established or even dissolution and reform as a different entity. For simplification, I have not addressed the differences between Retained Earnings, Accumulated Adjustments Account and Basis. Of Course, specific situations vary and you should consult your CPA when you are expecting these difficulties.
Tax entity selection can have some unforeseen consequences as individual situations evolve. You and your CPA should have frank discussions about what is happening with our business, outside the height of tax season.