Question

A client is trying to decide how to reorganize a subsidiary corporation in a consolidated group and has come to you for advice. The subsidiary currently has a net operating loss, but your client would like to sell it in the near future. For an optimal tax outcome, should the subsidiary corporation be reorganized as a C corporation or an S corporation?

Your analysis should be 4-5 pages

Answer 1

S corporation vs. C corporation: The similarities

The C corporation is the standard corporation, while the S corporation has elected a special tax status with the IRS. It gets its name because it is defined in Subchapter S of the Internal Revenue Code. To elect S corporation status when forming a corporation, Form 2553 must be filed with the IRS and all S corporation guidelines met. But C corporations and S corporations share many qualities:

• Limited liability protection. Both offer limited liability protection, so shareholders (owners) are typically not personally responsible for business debts and liabilities.
• Separate entities. Both the S corp and C corp are separate legal entities created by a state filing.
• Filing documents. Formation documents must be filed with the state. These documents, typically called the Articles of Incorporation or Certificate of Incorporation, are the same for both C and S corporations.
• Structure. Both have shareholders, directors and officers. Shareholders are the owners of the company and elect the board of directors, who in turn oversee and direct corporation affairs and decision-making but are not responsible for day-to-day operations. The directors elect the officers to manage daily business affairs.
• Corporate formalities. Both are required to follow the same internal and external corporate formalities and obligations, such as adopting bylaws, issuing stock, holding shareholder and director meetings, filing annual reports, and paying annual fees.

S corporation vs. C corporation: The differences

Despite their many similarities, S corporations and C corporations also have distinct differences.

• Taxation. Taxation is often considered the most significant difference for small business owners when evaluating S corporations vs. C corporations.
  • C corporations. C corps are separately taxable entities. They file a corporate tax return (Form 1120) and pay taxes at the corporate level. They also face the possibility of double taxation if corporate income is distributed to business owners as dividends, which are considered personal income. Tax on corporate income is paid first at the corporate level and again at the individual level on dividends.
  • S corporations. S corps are pass-through tax entities. They file an informational federal return (Form 1120S), but no income tax is paid at the corporate level. The profits/losses of the business are instead “passed-through” the business and reported on the owners’ personal tax returns. Any tax due is paid at the individual level by the owners.
  • Personal Income Taxes. With both types of corporations, personal income tax is due both on any salary drawn from the corporation and from any dividends received from the corporation.
• Corporate ownership. C corporations have no restrictions on ownership, but S corporations do. S corps are restricted to no more than 100 shareholders, and shareholders must be US citizens/residents. S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships or many trusts. Also, S corporations can have only one class of stock (disregarding voting rights), while C corporations can have multiple classes. C corporations therefore provide a little more flexibility when starting a business if you plan to grow, expand the ownership or sell your corporation.

S corporation (S corp) election

To become an S corporation, you must file Form 2553 with the IRS. The IRS instructions—which can be a bit tough to follow—require that an election is considered effective in the current tax year only if the Form 2553 is completed and filed:

• Any time before the 16th day of the 3rd month (for calendar year tax payers, this means it needs to happen by March 15th)
• Any time during the preceding tax year (however, an election made no later than 2 months and 15 days after the beginning of a tax year that is less than 2½ months long is treated as timely for that year).

Generally, an election made after the 15th day of the 3rd month but before the end of the tax year is effective for the next tax year (unless you can show failure to file on time was due to reasonable cause).

Keep in mind that some states also require you to file a state-level S corporation election after incorporating your business.