The state trap for S corporations.by Antognini, Walter G.
An obvious limitation on the use of the S Corporation vehicle is the requirement that the corporation be a small business corporation--IRC Sec. 1361(a). A corporaton cannot elect or maintain S Corporation status if the corporation has more than 35 shareholders. There are also other limitations including those that apply to the type of shareholder.
A more subtle deterrent to the S Corporation election lies in the state tax treatment of the S Corporation. Many states, including heavily populated states, do not regognize the S Corporation status. The states that tax S Corporations are California, Connecticut, Louisiana, Michigan, New Hampshire, New Jersey, North Carolina and Tennessee. Delaware, Utah and Vermont tax S Corporations to the extent of stock ownership by nonresidents. Also, New York City and the District of Columbia tax S Corporations.
These governments treat the S Corporation the same as any other corporation. Corporate income is taxed to the corporation, and distributions from these corporations are treated under normal distribution provisions. This state tax treatment leads to a bifurcated tax treatment of the corporation--federal law taxes the individuals on profitable operations of the corporation while state law still imposes double taxation. One of the benefits of S election is the ability to make distributions from the S Corporation without taxation. This ability is severely restricted if a state taxes those distributions. This problem is especially perplexing with regard to distributions needed to pay a shareholder's federal individual income tax caused by passing through corporate income to the shareholder.
While federal law imposes an individual level tax based on corporate level income of an S Corporation, federal law permits the shareholders to receive the means to pay this tax by tax-free distributions. Where state law does not recognize the S status, the wherewithal to pay the federal individual tax may be available only by subjecting the distributions to a second tax under state law. This prospect of immediate double taxation at the state level is especially troublesome in light of the underlying reason for the S election--the avoidance of double taxation.
State Treatment of S Corporations
Most states accept the federal S election or, in essence, do so if a conforming state election is made. For example, New York recognizes S status if a separate state election is made. New York State thus provides for a bifurcated treatment of corporations making a federal S election.
If the corporation also does business in New York City, the situation becomes more complicated; New York City does not recognize the S election. Thus, a corporation might be treated as an S Corporation for federal purposes but not for New York State or City purposes. Or, a corporation might be considered an S Corporation for federal and New York State purposes but not for New York City purposes. If, however, a corporation has not made an S election for federal purposes, the corporation will not be treated as an S Corporation for federal, state or city purposes.
This article refers extensively to the rules applicable in New York State in regard to both S Corporations qualifying for state S status and S Corporations not so qualifying. The treatment in most other states will be similar to one of those sets of rules. New York City's rules resemble the New York State rules applicable to corporations not making the separate state election.
If a separate New York State election is made, the corporation's results are then passed through to the shareholders in the same or similar fashion as that provided by the federal rules. For example, N.Y.S. Tax Law provides the general rules that an individual's New York AGI equals federal AGI with modifications. Federal AGI already reflects the items passed through by the S Corporation. Accordingly, the only modifications dictated for resident shareholders involve those corporations which make an S election for federal purposes but not for state purposes. A similar rule is provided for the pass-through of itemized deductions to shareholders. The tax consequences to nonresident shareholders of corporations making the state election are modified to reflect only that portion of the corporation's operations that are derived from or connected with New York sources.
While the corporate income is taxed to the shareholders, distributions can be made without state income tax in order to pay individual income taxes. As previously noted, New York AGI starts with the federal AGI. Federal AGI does not reflect S Corporation distributions to the extent of shareholder basis. New York State follows this result unless a separate elections is not made for state purposes. Without this separate election, a resident shareholder's AGI must be increased to the extent that S Corporation distributions are not included in federal income under Subchapter S.
Stock basif for purposes of computing gain or loss at the state level reflects the basis adjustments made on the federal level--increase basis to reflect income, decrease basis for distributions made. For example, New York State follows this federal treatment for the increase and decrease of stock basis if the S Corporation has made a separate state election. If a state election has not been made and a resident shareholder of an S Corporation has disposed of stock or debt in the corporation, then the AGI must be modified for amounts previously added to or subtracted from basis for federal purposes. Note that federal AGI includes gain or loss computed using the basis adjusted for these S Corporation items. The New York State provisions reverse out these federal basis modifications in computing gains or loss of shareholders of S Corporations not making the separate state election.
Some states totally ignore the federal S Corporation. This results in the corporation being taxed on its taxable income in the same fashion as a C Corporation. Each of these states taxes the income of a corporation that is attributed to that state. The determination of income attributable to a state is typically derived from the "three factor formula." The three factor formula involves revenues, payroll, and assets in allocating a portion of a corporation's total income to each state. State income taxes paid by S Corporations are deductible by the S Corporation in arriving at the corporate income to be passed through to the shareholders at the federal level.
Distributions of earnings from S Corporations to shareholders resident in nonconforming states are taxes as dividends. For example, if a New York resident receives dividends from an S Corporation which has not made a separate New York State S election, then the shareholder must add these dividends to income for state tax purposes. Earnings will not increase stock basis nor will distributions decrease stock basis for purposes of computing the state income tax liability in these nonconforming states.
The overall treatment of S Corporation in these nonconforming states is a federal shareholder level tax on the corporate income and a state corporate level tax imposed on the corporation for its income attributable to the state, followed by a state shareholder level tax on dividends received from the corporation. Because shareholders must pay the federal tax on corporate income, shareholders must have an access to funds. The primary access will likely be the corporation itself. Distributions of income will generally not have adverse consequences on the federal level, but will trigger double taxation on the state level.
Consider, for example, what would happen if "X Corp.," with taxable income of $1,000, made an S election on the federal level but did not qualify for similar treatment at the state level. Assume that the federal individual income tax rate is a flat 28% are while the comparable state rate is 9%. Further assume a state corporate tax rate of 8%. Because the corporation is treated under Subchapter S for federal purposes, there would be no federal tax at the corporate level. The corporate level state tax would be $80. This tax would be a deduction in arriving at the corporate level income to pass through to the shareholders for federal purposes. So, the federal individual income tax attributable to corporate income would be approximately $258 ($920 X 28%). The question then becomes, how will the shareholder be able to pay this liability of $258? One possiblity is a distribution of $258 from the corporation. This distribution to a resident shareholder will not give rise to a federal tax, but will give rise to a state tax of approximately $23. This state tax would presumably give rise to a deduction on the federal level, reducing the necessary distribution, but the shareholder would need an additional distribution to pay the $23, etc. In total, the corporation would need to distribute $275.45 to satisfy all shareholder level tax liabilities.
If the corporation distributed all of its earnings, the state individual tax would be approximately $83 ($920X9%). The federal tax would be reduced to approximately $234 $1000 -- $80 --$ 83) X 28%.
While this discussion and example ignore any possible impact of the alternative minimum tax, the possibility of it applying in this context should not be overlooked. Planners should be particularly concerned about the impact of Sec. 56(b)(1)(A)(ii) which provides that in computing alternative minimum taxable income, no deduction is allowed for state income taxes that were taken as an itemized deduction.
Tax Planning to Avoid State Tax Trap of S Corporations
As can be observed, the advantage of an S election can be greatly diminished if the state does not accept the S election. Assuming all earnings are distributed, the overall state tax would be approximately $163 ($80 in state corporate taxes, $83 in state individual taxes). The overall federal tax would be $234. The state involved represent a substantial part of the overall taxes. Note that the overall tax bite in electing S status would still be less than if the election were not made. Prior to the Reagan era tax acts, the federal tax consequences were far greater than the state tax consequences. This difference has been largely eliminated and as a result, there is a heightened need of state tax planning for S Corporations.
There are techniques available to reduce the state tax bite imposed on corporations. One of the more obvious methods is to change the amounts entering into the three factor formula. For example, a corporation might consider placing facilities in low or no tax states. Obviously, a decision to relocate substantial facilities cannot be made in a vacuum. The possibility of tax savings is just one factor to be considered; underlying business reasons must also be taken into consideration.
In addition to the techniques used to reduce the corporate level tax, one should consider techniques to make corporate funds available to the shareholder to pay the shareholder level taxes imposed on the pass- through of corporate income. A simple distribution would produce a shareholder level state tax in nonconforming states.
A disguised bailout of earnings, through a redemption or otherwise, would typically produce tax because the nonconforming states usually follow federal law treatment of C Corporations. For example, N.Y.S. Tax Law provides that an individual's state AGI equals federal AGI with modifications. One modification requires that the shareholder of a nonelecting corporation (i.e., a corporation which has not made a separate New York State election) include any distributions excluded from federal income under the Subchapter S provisions the Subchapter S provisions enumerated include the general distribution exclusion rule of IRC Sec. 1368, the post-termination transition period distribution exclusion of Sec. 1371(e) and the exclusion of distributions from undistributed taxable income prior to 1983 provided in Sec. 1379(c). IRC Sec. 1371(a)(1) provides that the rules of Subchapter C shall apply except to the extent that they are inconsistent with Subchapter S. The rules relating to redemptions treated as distributions under IRC Sec. 302 and sales of stock to related corporations treated as distributions under IRC Sec. 304 (through Sec. 302) would presumably continue to apply. Therefore, the distributons which would be excluded for federal purposes under the Subchapter S provisions would include these transactions treated as distributions pursuant to Secs. 302 and 304. These distributions excluded for federal purposes would, however, be included in New York income under N.Y.S Tax Law Sec. 612(b)(20).
Another important factor involves the basis adjustment rules in N.Y.S Tax Law Secs. 612(n)(1) and (2). As previously discussed, these provisions indicate that the federal basis adjustments must be backed out of shares of an S Corporation not making the separate state election. This can become important when a corporation makes a distribution in excess of its earnings and profits. Whether this distribution would be considered a return of basis under IRC Sec. 301(c)(2) or as gain from the stock under Sec. 301(c)(3) can depend in part on the amount of basis available. This analysis under Subchapter C would carry over to New York if no separate state S election is made. In the New York analysis, however, the basis would be without any Subchapter S adjustments. Therefore, the New York analysis would parallel federal C status analysis.
For example, an individual owns 100% of "X Corp.," having formed the corporation with a capital contribution of $100. X makes the federal S election but not the New York State election. X earns $15 in each of its first 10 years and $0 in year 11. X makes a cash distribution of $300 in year 11. The federal stock basis has increased from $100 to $250 due to the S Corporation earnings. Because of the S election, the distribution will be a return of basis for federal purposes to the extent of the basis of $250. The remaining $50 will be gain from the stock. Because these basis adjustments would not be reflected in determining New York basis, the state basis would remain at $100. Earnings and profits will be $150 for New York purposes. If not forthe S election, the distribution would therefore have resulted in federal dividend income of $150. This $150 will be dividend income for New York purposes. Of the remaining distributions of $150, $100 will be a return of the New York basis of $100, and $50 will be treated as gain from the sale of the stock.
An advance of money from the corporation to the shareholder would also be subject to attack. One possible attack would treat the advance as a disguised distribution. Also, if the advance does not provide sufficient interest, it could be attacked under the now codified imputed interest rules. For federal purposes, the corporation would have additional income--the imputed interest. This would be passed through to the shareholders as additional income (causing an increase in basis). The shareholders would also have interest expenses, but they would be largely nondeductible as personal interest. The advance would give rise to personal interest expense because the proceeds are being used to pay personal income taxes. the imputed interest would also be treated as a distribution. The distribution would merely reduce stock basis for federal purposes, but the distribution would be taxable income for state purposes. In any case, the advance could serve as only an interim solution because the advance would eventually have to be repaid.
Paying wages to shareholders represents a more permanent solution. The wages could be used to pay the shareholder level federal tax. The advantage of this source of funds is that double taxation on the state level could be avoided. The payment of wages would presumably be an expense of the corporation, which would be deductible. For federal purposes, while the receipt of wages could increase income, the payment of wages would decrease corporate income which would then decrease the pass-through to the shareholders. In the nonconforming states, the receipt of wages would also be an increase in income to the shareholder- employee, but the payment of wages would reduce income subject to the state level corporate taxes and would eliminate the need for a distribution taxable at the state level. Thus, to the extent of the wages paid, there would be only one level of taxes--that imposed on the individual level. This net result is similar to the results achieved by electing S status.
There are pitfalls to this method of avoiding double taxation by nonconforming states. First, the corporation and the individual might be subject to payroll taxes. Second, if the wages are not proportionate to stock ownership, shifts in taxable income between shareholders result. Third, one must determine what amount of wages are needed to satisfy shareholder requirements.
A more difficult in pitfall lies in determining whether the payment of wages is reasonable. The attempt to avoid double taxation by paying increased salaries to shareholder-employees is not a new device. The concern for federal purposes is largely eliminated by the S election. S Corporations pay one shareholder level tax whether or not wages are paid to shareholder-employees. The concern remains for state purposes. Excessive compensation could be recharacterized as a distribution which would not be deductible by the corporation. Thus, the excessive compensation would be subject to double taxation in the nonconforming states. There are at least two issues raised. First, would the use of wage payment increase the likelihood of finding excessive compensation? Second, the determination of excessive compensation is decided on a case-by-case basis. The federal taxing authorities typically have little or nothing to gain from an excessive compensation determination. This substantially decreases the likelihood of a federal challenge. Will the states independently investigate and attack these situations? The answers to both of these issues are far from clear.
The S election presents an opportunity for significant savings of federal taxes. But the corporation's income may continue to be subject to significant double taxation by states which do not recognize the S election. This nonconformity to the federal treatment is especially problematic if a distribution must be made to pay the federal shareholder tax on corporate income passed through to the shareholder. There are methods available to minimize the state tax impact so as to maximize the benefits intended by the federal S election. But these methods are not quick and easy fixes. Instead, the methods require serious consideration and planning of both the tax and the businesss consequences.
Walter G. Antognini, JD, CPA, is Assistant Professor of Taxation at the Lubin Graduate School of Business, Pace University, NY.
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