Corporations

Mr. and Mrs. TP are in a very unique situation. They have four children ages 20, 22, 25, and 27, all of whom have no money management skills whatsoever. In order to keep their children with money in their pockets, the couple decides they want to transfer their investment portfolio of stock that they own to a new corporation in which the couple will own 20 shares of the voting stock and the four children will each own 100 shares of nonvoting stock apiece. The couple still plans to serve as the directors of the corporation as well as continue to manage the investment portfolio while the children receive the majority of the dividends annually. The couple can choose to run the corporation as an S Corporation, C Corporation, or a Limited Liability Corporation (LLC). We will explore the different tax consequences and burdens of operating as each type of corporation and determine which is most suitable for Mr. and Mrs. TP and family.

S Corporation

First, in an S corporation, the corporation in general will pay no tax, whereas the shareholders must include in gross income their proportionate share of corporate income whether or not the corporate earnings are distributed to them. The S corporation's income will be computed under the same rules presently applicable to partnerships in which deductions generally allowable to individuals are allowed to S corporations. The key characteristic of S corporation status is the "flow-through" of profits and losses, income, capital gains, capital losses, and any other tax consequences to the shareholders of the corporation, in proportion to their ownership interests. The idea is that taxes are not paid at the corporate level, but only at the shareholder level. This "flow-through" characteristic avoids the double taxation of C corporations, where profits are taxed as income and capital gains of the corporation and then taxed again when distributed to shareholders. Another benefit of the flow-through characteristic of S corporation status is that business losses are passed through to shareholders. For shareholders of new startup companies, which anticipate losses, the S status allows the write off of corporate losses on personal tax returns. Often the losses can be used to offset other gains or income of the shareholders, reducing personal taxes to be paid. Provisions governing the computation of income that are applicable only to corporations, such as the dividends-received deduction or the special rules relating to corporate tax preferences do not apply to S corporations. Items eligible for separate treatment, which could affect any shareholder's liability, are treated separately. Interest and dividends received by the S corporation must be separately stated as they comprise portfolio income to the shareholder in determining the investment interest limitation. The shareholders of S corporations are treated as partners and the corporation as a partnership for purposes of taxing the income, deducting the losses, and allocating other tax items attributable to the corporation. The couple estimates that the annual income from the portfolio to be available for dividends to be $72,000. Therefore, if the family corporation is operated as an S corporation, it will break down as follows:

Each child (4) would receive approx. 24% (100 of 420 shares) of the $72,000 = $17,280

The couple would receive approx. 4% (20 of 420 shares) of the $72,000 = $2,880

Each child (4) would be taxed at the 15% tax bracket on their $17,280 = $2,592

Each child (4) would have an annual income of $14,688

The couple would be tax at the 34% tax bracket on the $2,880 = $979.20

The couple would have an annual income of $1,900.80

One thing to consider is shareholders' holding an interest of 2% or more in an S corporation cannot take full advantage of tax-favored employment benefits. Life insurance, health insurance, medical expense reimbursement, death benefits and other employment fringe benefits which are tax deductible for other employees are taxable as income to 2%+ S corporation shareholders. The tax consequences to the each child are that they will have to pay taxes on the income they receive from the corporate earnings at the shareholders level. As for the couple, they will be taxed at the 34% tax bracket and at the shareholders level.

C Corporation

While an S Corporation generally has significant tax advantages over a C Corporation, under current tax rate structure, a C Corporation has certain favorable attributes of its own. A C Corporation has advantages if it is anticipated that its earnings will be reinvested in the business and not distributed to the shareholders. Stock can be held for appreciation, generally without subjecting the shareholders to current taxation on the earnings and profits of the corporation until they are distributed as dividends. And when the stock is sold, the shareholder can usually do so at capital gains rates. In addition, a corporation is not subject to the statutory requirements of an S Corporation. Thus, there is no restriction on the number of shareholders or their status as individuals, corporations, partnerships or aliens. Nor is there any limit on the ability of the corporation to issue more than one class of stock. However, since in this case the dividends are not being reinvested into the company and are being distributed to the shareholders, this would not be an advantage for Mr. and Mrs. TP to operate the company as a C corporation.

The two levels of tax involved in the sale or dissolution of a C corporation are the tax that the C corporation pays when the assets are sold at a gain to the corporation, and then the tax that the shareholders pay when the cash in the corporation is distributed upon dissolution of the corporation. The "flow-through" characteristic of S Corporations avoids the double taxation of C corporations, where profits are taxed as income and capital gains of the corporation and then taxed again when distributed to shareholders. This is a significant tax burden for a C corporation and its shareholders when dividends are paid to shareholders, and when cash or assets are distributed to shareholders as a result of a sale or dissolution of the business.

Dividend distributions to shareholders made from earnings and profits of the corporation are taxable to the shareholders and are not deductible by the corporation. Thus, income can be taxed at 38 percent at the corporate level, and when the balance (net of corporate tax) is distributed to the shareholders, is subject to tax at the shareholder