S corporation can sometimes defeat C corporation

The tax law recognizes two kinds of corporations. We call them “C” and “S” corporations based on the subchapter of a section of the tax law that applies to each form.

S corporations must meet certain qualifications and must also elect to be subject to subchapter S. Public companies cannot be S corporations.

The key distinction between the two forms is that S corporations have only one level of tax, at the shareholder level.

C corporations may have two levels of tax, one at the corporate level and another at the shareholder level.

Before the 1986 Tax Act there were a few ways for C corporations to avoid the corporate-level tax. Tax rates for corporations were lower than for individuals.

The 1986 Tax Act eliminated the ability to avoid a corporatelevel tax. The use of C corporations started a decline that has not stopped.

Things got interesting again in 1993 when the law added an exclusion for gains from the sale of qualified small businesses organized as C corporations.

This exclusion was initially 50% of the realized gain but in 2010 it increased to 100% of the gain. This exclusion applied to the C corporation stock.

In 2017 the law changed again and reduced the maximum tax rate for C corporations to 21%. The top rate for individuals could be 37%.

I know that’s a lot of information, but the various changes combine to create situations where the C corporation form can be better, or at least no worse, than the S form.

I’m an accountant, so numbers always help. Let’s say that you invest $5 million in a corporation. Assume that 8 years later, the assets grow in value to $15 million.

You now want to sell. We tax advisors would normally tell you that an S corporation would beat a C corporation. Paying one tax beats paying two taxes.

Assume you hold these assets in an S corporation. The corporation sells the assets. The gain is $10 million.

That gain will be taxed to you as an individual. The corporation will provide you with a K-1 form showing that you have $10 million of gain.

You report the gain, and it also increases your tax basis in your stock from $5 million (your investment) to $15 million.

You now receive a liquidating distribution of $15 million in cancellation of your shares. With a tax basis of $15 million the distribution creates no further gain.

Total gain is $10 million, taxed once. But at what rate? It depends on what these assets are.

Some gain might be “ordinary” taxed at 37% Other gain might be capital taxed at 20%. Let’s say it is 80% capital and 20% ordinary.

You pay a blended rate of 23.4% (80% at 20% and 20% at 37%). Your total tax is then $2,340,000 on a gain of $10 million.

Now let’s assume you had a C corporation. The corporation sells the assets and reports a $10 million gain. This gain is taxed at 21% so a tax of $2.1 million is owed.

The corporation next distributes $12.9 million to you. This is the sales price of $15 million minus the $2.1 million tax.

With a stock basis of $5 million you then have a $7.9 million personal gain when you receive a liquidating distribution of $12.9 million for your stock.

Normally you would pay a second tax. But if the stock is qualified small business stock (“QSBS”) your tax rate is zero.

QSBS must be issued to an individual at the original issue date. The C corporation must be engaged in an active business. The stock must be held for more than 5 years.

The gross assets of the corporation cannot exceed $50 million at the stock issuance date. The maximum gain exclusion is the greater of $10 million or ten times your stock basis. You seem to qualify. If so, there is no tax at the shareholder level. The total tax is $2.1 million less than for an S corporation.

You might even find yourself arguing that you didn’t meet the requirements to be an S corporation. You tell IRS that you are one of those “evil” C corporations.

Even if you say, yes, I did have an S corporation, you have a great fallback position if the IRS claims you violated one of the requirements.