When Congress passed the Tax Reform Act of 1986 (TRA '86), it created a historic change by establishing a higher corporate income tax rate (34%) than individual (28%) income tax rate. Prior to the passage of TRA '86, the highest corporate tax rate was 46%; the highest rate for individuals was 50%.

In addition, TRA '86 repealed the General Utilities doctrine. The result was a rush of C corporations electing to become S corporations.

The General Utilities doctrine permitted nonrecognition of corporate- level gain on certain distributions of appreciated property to their shareholders and on certain liquidating sales of property. Under IRC Sec. 337, a corporation did not recognize gain or loss on a sale of property if it adopted a plan of complete liquidation and distributed all its assets or sold its assets and distributed the proceeds to its shareholders within 12 months of the date of adoption of the plan of liquidation.

Under TRA '86, Congress amended IRC Sec. 336(a) to provide for recognition of gain or loss to a corporation on the distribution of its property in complete liquidation as if such property were sold to the distributee at its fair market value.

The result of the repeal of the General Utilities doctrine was C corporations could no longer avoid double taxation on the distribution or sale of assets in liquidation.

The 1993 Act Changes the Rules

Under the Omnibus Budget Reconciliation Act of 1993 (1993 Act), the corporate/individual tax rate differential for high-income taxpayers is back to its historical position, i.e., higher individual (39.6%) than corporate (35%) marginal income tax rates.

The 1993 Act also increased the individual alternative minimum tax (AMT) rates to a range of 26 to 28%. The corporate AMT rate remains at 20%. With individual income tax rates five to six percent higher than corporate rates and individual AMT rates now eight percent higher than corporate AMT rates, the once clear choice of electing S corporation status now requires a closer look.

Advantages of S Status vs. C Status

Even with a five to six percent higher individual tax rate, the following factors still favor S corporation status for closely held businesses. This is not a complete list of all factors to consider. Also, different taxpayers will give different weights to various factors.

Unreasonable Compensation. A corporation is entitled to deduct "a reasonable allowance for salaries or other compensation for personal services actually rendered." If a C corporation is found to have paid an unreasonable amount of compensation, the portion of such compensation determined to be excessive could be reclassified by the IRS as a nondeductible distribution. At the shareholder level, the excessive amount would be reclassified as a dividend (to the extent of current or accumulated earnings and profits) as opposed to salary income. Unlike a C corporation, an S corporation generally does not have to contend with the issue of unreasonable compensation deductions.

No Accumulated Earnings Tax. An Accumulated Earnings Tax (AET) is imposed on a C corporation that is determined to have accumulated its earnings and profits beyond its reasonable business needs. C corporations with unreasonable amounts of accumulated earnings and profits run the risk that the IRS will assert that the AET applies. If the IRS wins, an additional 39.6% AET tax applies on accumulated taxable income. The IRS will most likely become more aggressive on their attack on C corporations for AET since the 1993 Act increases the AET rate from 28 to 39.6% effective for tax years beginning after December 31, 1992.

If a taxpayer's business is expanding and accumulated earnings and profits are required to fund the expansion, the taxpayer in all likelihood would not be subject to the AET. Based on these facts, the AET would not be a discouraging factor in considering a taxpayer's decision to be a C corporation.

Unlike a C corporation, an S corporation is not subject to the AET. Thus, an S corporation may retain an unlimited amount of S corporation earnings without incurring any additional tax.

No Double Taxation on Current or Liquidating Distributions. A C corporation is subject to double taxation on current and liquidating distributions. A distribution by a corporation to its shareholders is a dividend if it is made out of current or accumulated earnings and profits. Assume a C corporation holds a parcel of land with a fair market value ("FMV") of $1,000,000 and an adjusted tax basis of $100,000. If the corporation sells the property, it will recognize a $900,000 capital gain. If the net proceeds, i.e., the $900,000 less the corporate-level tax, were distributed, the shareholder will recognize a second-level tax on the distribution of such net cash proceeds since the corporate-level capital gain creates current earnings and profits that classifies the distribution as a dividend to the shareholder.

The corporation could choose to distribute the property to the shareholder instead of selling it. IRC Sec. 311(b) provides that if a corporation distributes appreciated property to a shareholder the distributing corporation will recognize gain as if such property were sold to the distributee at its fair market value. Similar to a sale, the shareholder will recognize a second-level tax on the distribution of the net cash proceeds, since the corporate-level capital gain creates earnings and profits that may cause the distribution to be classified as a dividend.

If an S corporation sold the appreciated property to an elated party, the S corporation would recognize a $900,000 gain that will pass-through to the shareholder. The shareholder's stock basis would increase by $900,000. In addition, any gain recognized by an S corporation on the sale of the property would increase the S corporation's accumulated adjustments account (AAA). As a result of the basis increase, the shareholder could now receive a distribution of the proceeds tax free to the extent of AAA and stock basis. Thus, absent a corporate-level built- in gains tax, the sale and distribution will result in only one level of tax.

The S corporation could also choose to distribute the appreciated property to the shareholder. The rules of subchapter C determine whether and to what extent an S corporation recognizes gain on the distribution of property. Therefore, on almost any current distribution of appreciated property, an S corporation also recognizes gain. The S corporation, however, generally pays no tax on that gain. Corporate- level tax may arise, however, if the gain recognized is subject to the built-in gains tax.

In any event, the shareholders will pay shareholder-level taxes on the recognized gain passed through to them. The shareholder's stock basis and the AAA will increase by the $900,000 gain. Due to the basis increase, the shareholder could receive the property tax-free to the extent of AAA and stock basis. AAA is, however, reduced based on the fair market value of the property distributed. Thus, absent a corporate- level built-in gains tax, the current distribution of appreciated property will also result in only one level of tax.

Returning to the results of a distribution of property by a C corporation, assume the only asset the C corporation holds is the parcel of land. Upon liquidation, the corporation will recognize a $900,000 gain. After IRC Sec. 336(a) has imposed its toll on the corporation, the shareholder will recognize capital gain on the difference between the amount received and his or her stock basis. The result is double taxation on a C corporation's liquidating distribution.

What happens to a corporation that has always been an S corporation? Such a corporation can completely avoid the impact of the TRA '86 repeal of the General Utilities doctrine. The corporation generally recognizes gain or loss on all liquidating sales and distributions. Any corporate gain is not taxed at the corporate level but passes through to the shareholders and increases their stock basis. The increased stock basis generally reduces the shareholder's gain on the receipt of the liquidation proceeds. The net result generally is a single-level tax on all gains. Assuming the corporation has always been an S corporation, IRC Sec. 1374 generally will not impose a corporate level tax on any recognized built-in gains.

Benefit of Stock Basis Increase. Perhaps the most significant benefit available to S corporation shareholders is the long-term stock basis build-up accumulated by S corporation shareholders. The stock-basis build-up benefit becomes invaluable to S corporations that intend to distribute their earnings or have significant sales of assets or stock in the near or mid-term years, i.e., five to 20 years.

Under IRC Sec. 1366, items of S corporation income pass through to shareholders on a per-share, per-day basis. This pass-through occurs without regard to whether the income is, or is not, distributed. IRC Sec. 1367(a)(1) provides for a basis increase equal to the separately and nonseparately stated income that passes through to a shareholder. There is a corresponding increase in the S corporation's AAA.

A shareholder in a C corporation does not obtain the benefit of a stock basis increase for income earned in the C corporation. Assume a C and S corporation are both incorporated and capitalized with $1,000,000 in equity in 1993. Both corporations earn $10,000,000 of taxable income each year for the 10 year period 1993-2002. The S corporation makes annual distributions of $5,000,000 per year to shareholders for them to pay individual income taxes on the S corporation earnings. At the end of each S corporation year, the shareholder's stock basis and the S corporation AAA increases by $5,000,000 annually. At the end of the 10- year period, the C corporation stock basis is $1,000,000 compared to a $51,000,000 stock basis for the S corporation shareholders. Thus, on a sale of stock after 10 years, the S corporation shareholder would recognize a $50,000,000 lower capital gain. This results in a $14,000,000 ($50,000,000 multiplied by a 28% capital gains tax rate) tax savings to the S corporation shareholder.

To complete the analysis, a comparison of the present value (PV) of the stock basis build-up tax benefit available to the S corporation must be compared to the PV of potentially higher current taxes paid by S corporation shareholders based on the 1993 Act's tax rates.

The stock basis build-up benefit available to the S corporation shareholder becomes extremely diluted if the shareholder's have no intent to sell stock or liquidate the business until the "out years" (i.e., stock held until death). IRC Sec. 1014 generally adjusts to fair market value the basis of any stock held by a C or S corporation shareholder at the time of death. This basis adjustment occurs in the hands of the person who acquires the property from the decedent. If a shareholder plans to hold their stock until death, the stock basis of a C and S corporation shareholder could be approximately equal. (This assumes that the increase in value is attributable to the increase in undistributed earnings). Thus, on a subsequent sale of stock by the beneficiary or corporate liquidation, the tax cost at the C or S corporation, corporate, and shareholder level would be approximately equal. It should be noted that in many circumstances, the increase in value will not equal the increase in undistributed earnings. In any event, the beneficiaries of C corporation stock will obtain a significant benefit due to the step-up in basis.

As part of future deficit reduction, Congress has hinted at a capital gains tax on death that would apply to the difference between the fair market value and adjusted tax basis of assets held prior to death. If this ever occurred, the S corporation shareholder would always achieve a major tax benefit for stock basis build-up since the C corporation shareholder would be assessed a toll charge on an increase in stock basis to fair market value on date of death. Due to these factors, the basis mechanism available to S corporations should be greatly respected as a major advantage to S corporation status.

No AMT Tax on ACE Adjustments for Pre-1994 Property. C corporations are subject to a separate corporate level AMT. As part of the AMT calculations, C corporations are required to calculate an Adjusted Current Earnings ("ACE") adjustment that generally increases the corporate AMT base. The 1993 Act eliminates the ACE depreciation adjustment for property placed in service after December 31, 1993, but it still applies to property placed in service before January 1, 1994.

All other non-depreciation ACE adjustments still apply for C corporation AMT purposes. Since the ACE adjustment does not apply to S corporations, the additional ACE adjustment cost imposed on C corporations should be quantified.

Pass Through Losses to Shareholders. Often, new businesses operate at a loss in the start up years. S corporation shareholders generally get the benefit of offsetting other sources of income with the operating losses of the S corporation that pass through to them. Such losses are limited to the shareholder's basis in stock or debt. The deductibility of S corporation losses are also subject to the at-risk and passive activity loss limitations. A C corporation's operating losses remain at the corporate level. As such, the benefit of using a C corporation's start- up losses is deferred until the business generates taxable income. Therefore, it may be wise for a new corporation to elect S status so that shareholders get the benefit of offsetting other income with start- up losses rather than deferring the benefit to a later date.

No PHC Tax. A corporation qualifying as a Personal Holding Company (PHC) is subject to a separate PHC tax. To constitute a PHC, a corporation must meet both an income test and a stock-ownership test.

To trigger the PHC designation, at least 60% of a corporation's adjusted ordinary gross income must be PHC income (primarily passive investment income such as interest, dividends, personal service contract income, and certain rents and royalties) and more than 50% of its stock (measured by value) must be owned directly or indirectly, by five or fewer individuals. A PHC is subject to a 39.6% PHC tax on undistributed personal holding company income. The 1993 Act increases the PHC tax rate from 28 to 39.6% effective for tax years beginning after December 31, 1992. An S corporation is exempt from the PHC tax.

An S corporation is subject to a corporate-level tax if the S corporation has former subchapter C earnings and profits at the close of such taxable year, and more than 25% of its gross receipts are passive investment income. To avoid the IRC Sec. 1375 tax, the S corporation may have to distribute all its subchapter C earnings and profits at the close of each year. One should note an S corporation can have an unlimited amount of passive investment income if it has no subchapter C earnings and profits.

Personal Service Corporation Subject to a Flat 35% Tax. A Personal Service Corporation ("PSC"), is a corporation engaged in the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial services, the performing arts, or consulting and substantially all of its stock is owned by employees, retired employees or their estates. A PSC operating as a C corporation is subject to a flat 35% rate and does not receive the benefit of graduated corporate rates.

Use of the Cash Method of Accounting. An S corporation that does not have inventory is not prohibited from using the cash method of accounting. On the other hand, a C corporation is required to use the accrual method of accounting if its average annual gross receipts over the three preceding tax year periods exceed $5 million.

No Environmental Tax. An additional tax that may be imposed on a C corporation is the environmental tax. It is imposed at a rate of .12% on the amount by which its alternative minimum taxable income exceeds $2,000,000. It is imposed whether or not a corporation has to pay AMT. Neither an S corporation nor its shareholders are subject to this tax.

Other. S corporation earnings (in excess of distributions recharacterized as FICA wages, if any) are not subject to self- employment tax. This becomes even more valuable since the 1993 Act eliminates the dollar limit on wages and self-employment income subject to Medicare taxes for wages and other earned income received after December 31, 1993. S corporation capital gains are taxed at an individual 28% capital gains rate vs. a C corporation 34% or 35% capital gains rate.

Bills have been introduced in Congress to amend Subchapter S. The latest bill would include the following:

* Broadening of the eligibility rules;

* Expansion of the capital formation techniques available to S corporations;

* Removal of undesirable tax pitfalls by eliminating complex rules; and

* Help in preserving family owned businesses.

If these provisions were to pass, they would significantly relax many of the traditional restrictions imposed on S corporations.

Advantages of C Status Over S Status

In addition to the five to six percent higher individual tax rates and six to eight percent higher AMT tax rates, the following factors should make a closely held business reevaluate its S status. Once again, the following is by no means a complete list of all factors and one must determine which factors are important in each specific case.

More Flexibility. An S corporation is a domestic corporation that is not an ineligible corporation, does not have more than 35 shareholders, does not have as a shareholder a person (other than an estate and certain trusts) who is not an individual, have a nonresident alien as a shareholder and have more than one class of stock. An S corporation also cannot be a member of an affiliated group as determined under IRC Sec. 1504. Due to these restrictions, a C corporation has much more flexibility and more financing alternatives and opportunities.

More Than One Class of Stock. As previously stated, S corporations cannot have more than one class of stock. Unlike C corporations, all outstanding shares generally must "confer identical rights to distributions and liquidation proceeds." Thus preferred stock is prohibited in an S corporation.

Qualified Small Business Stock Eligible for 50% LTCG Exclusion. The 1993 Act creates a 50% long-term capital gains ("LTCG") exclusion for non- corporate taxpayer's who hold qualified small business stock for more than five years issued after August 10, 1993. If qualified, certain C corporation shareholders can enjoy a 50% LTCG exclusion on certain sales of stock subject to per-issuer limitations. The newly enacted capital gains incentive for investment in certain small businesses does not apply to investments in S corporations.

Utilization of NOL Carryover. A taxpayer having net-operating-loss carryovers (NOL) may want to remain a C corporation to utilize such loss carryovers. An S corporation generally cannot use such C corporation carryovers in a taxable year governed by Subchapter S except against the built-in gains tax. Also, each year under subchapter S will count as one year in the 15-year loss carryover period. Therefore, C corporations should maintain their C status until their NOL carryovers have been utilized.

Active 80% Subsidiaries. A C corporation can be a member of an affiliated group and join in the filing of a Federal consolidated tax return. As such, losses of members are available to offset other members' profits. An S corporation cannot be a member of an affiliated group without losing its S status.

AMT Rate Remains at 20%. AMT is determined at the shareholder level for an S corporation and at the corporate level for a C corporation. Currently, the AMT rates for individuals range from 26% to 28% while the corporate rate is only 20%. The potential additional individual AMT tax based on higher rates should be quantified after taking into consideration the additional C corporation AMT base due to the inclusion of ACE adjustments.

Other. Certain dividend income eligible for a 70% dividend received deduction is available to C but not S corporations. A C corporation also has more favorable exclusions for certain employee benefits (e.g., exclusion of health insurance benefits) that are restricted under IRC Sec. 1372 for two percent or more S corporation shareholders.

Which Way to Go?

The examples illustrate some of the points raised. In Example 1, where there are no dividends paid, the higher individual tax rates will lead to higher taxes for shareholders making an S election. However, in Example 2, the benefit of the stock basis build up will ultimately make the election pay off. In the third example, the introduction of a dividend payout makes the S corporation election pay off immediately. These examples assume that everything else is equal. That normally is not the case. Many middle-market companies find their S corporation is still the choice of entity. However, the increased tax rates must be received along with the company's and shareholder's long-term business plan and objectives. There are many factors involved in making and continuing an S corporation election and they must all be considered in arriving at a final decision.

EXAMPLE1-NODIVIDENDSPAID

Scenario:

Taxableincomeafterdeductionforofficer'scompensation$5,000,000

Officer'ssalaries$2,000,000

Ccorporationdividends$0

TAXCONSEQUENCESASACCORPORATION

Corporate-levelTaxesDue

Taxableincome$5,000,000

NYCcorporatetax:Regular$442,500

Alternativetax185,452

Greateroftwomethods442,500$442,500

Subtotal4,557,500

NYSfranchisetax541,431541,431

Federaltaxableincome$4,016,069

Federalincometax1,365,463

Totalcorporate-leveltaxes2,349,394

ShareholderLevel

Salary$2,000,000

Dividend0

Taxableincome2,000,000

NYSTax(80%Federalitemized

deductionlimitations)126,000$157,500

NYCTax(80%Federalitemized

deductionlimitations)71,36089,200

Federaltaxableincome$1,802,640

Federalincometax713,845

Totalshareholderleveltaxes960,545

TotaltaxesasaCCorporation$3,309,939

TAXCONSEQUENCESASASCORPORATION

Corporate-level$5,000,000

Taxableincome

NYCCorporatetax:Regular$442,500

Alternativetax185,452

Greateroftwomethods442,500$442,500

Subtotal4,557,500

NYSfranchisetax112,798112,798

Federaltaxableincome$4,444,702

Federal-levelScorporationtaxes0

Totalcorporate-leveltaxes555,298

Shareholderlevel

DistributiveshareofScorporation

Income$4,444,702

Salary2,000,000

Taxableincome6,444,702

NYSTax(80%Federalitemized

deductionlimitation)406,016507,520

NYCTax(80%Federalitemized

deductionlimitation)229,947287,434

Federaltaxableincome$5,808,739

Federalincometax2,300,261

Totalshareholder-leveltaxes3,095,215

TotalTaxesasaSCorporation$3,650,513

TotalScorporationtaxes$3,650,513

TotalCcorporationtaxes3,309,939

Difference$340,574

Basedsolelyoncurrenttaxobligations,Ccorporationstatuswouldresultin

a$340,574annualtaxsavings.Otherfactorsmustbeconsidered(i.e.double

taxation,AETorPHCTax,unreasonablecompensationexposure,andthebenefit

ofanScorporation'sstockbasisbuild-up)beforereachingacomprehensive

conclusion.

EXAMPLE2:STOCKBASISBUILD-UPANALYSIS--CCORPORATIONVS.SCORPORATION

STATUS

Scorporation

Taxableincome$5,000,000

Less:SCorpdistributionstopay

individualincometaxes(SeeExample1)3,095,215

Stockbasisbuild-up(annualincreasetoAAA)$1,904,785

Assumestocksoldatendof10years

Federalindividualcapitalgainstaxrate(.28)

NYSindividualrate.07875

NYCindividualrate.0446

.12335

Less:BenefitofFederalitemizeddeduction

(subjectto80%limitation).12335x.80=.09868

.28(1-.09868)=.25237+.12335=.37572Effectivecapitalgainstaxrate

Taxavoided

$19,047,850($1,904,785x10years)x.37572=$7,156,658

i=6%

n=10

PVtablefactor.55839

Stockbasisbuild-up

(PVbenefitoftaxsavings)$3,996,206

Presentvalueofstockbasisbuild-up(taxbenefit)$3,996,206

PresentvalueofadditionalScorporationtaxes

(2,506,655)

PresentvalueofScorporationsavings$1,489,551

ThepresentvalueofthetaxbenefitoftheScorporationstockbasisbuild-up

is$3,996,206.Aspreviouslyillustrated,Ccorporationstatusresultsinan

annual$340,574taxsavings.Overthecourseofa10-yearperiodthepresent

valueofthisbenefitequals$2,506,655.Evenwithhigherannualtaxburdens,

theScorporationprovestobemoreadvantageous.Thisassumesastocksale

within10years.Thebenefitmaybegreaterorlessafteracarefulreviewof

thecompany'sandshareholder'slong-termbusinessplanandobjectives(i.e.,

stockmaybeheldformorethan10years).

EXAMPLE3

CCORPORATIONVSSCORPORATIONANALYSIS--WITHDIVIDEND

ASSUMESAMEASEXAMPLE1,BUTWITH$1,000,000CCORPORATIONDIVIDEND

TaxConsequencesasaCCorporationTaxesDue

Totalcorporate-leveltaxes(sameasExample1)$2,349,394

Shareholderlevel

Salary$2,000,000

Dividend1,000,000

Taxableincome3,000,000

NYSTax(80%Federalitemized

deductionlimitations)189,000236,250

NYCTax(80%Federalitemized

deductionlimitations)107,040133,800

Federaltaxableincome$2,703,960

Federalincometax1,070,768

Totalshareholder-leveltaxes1,440,818

TotaltaxesasaCcorporation$3,790,212

TaxConsequencesasaSCorporationTaxesDue

Totalcorporate-leveltaxes(Sameasexample1)$555,298

Shareholderlevel

DistributiveshareofScorporation

Income$4,444,702

Salary2,000,000

Taxableincome6,444,702

NYSTax(80%Federalitemized

deductionlimitation)406,016$507,520

NYCTax(80%Federalitemized

deductionlimitation)229,947287,434

Federaltaxableincome$5,808,739

Federalincometax2,300,261

Totalshareholder-leveltaxes3,095,215

TotaltaxesasaScorporation$3,650,513

TotalCcorporationtaxes$3,790,212

TotalScorporationtaxes3,650,513

Difference$139,699

OnceaCcorporationisrequiredto,ormakesadistribution,thecostof

doubletaxationmayquicklyoutweighthelowercorporatetaxrates.Basedon

theabove,Scorporationstatuswillresultinanannual$139,699tax

savings.Inaddition,theScorporationshouldbenefitfromthetaxsavings

fromthestockbasisbuild-up.

Alan T. Frankel, CPA, is a Senior Tax Manager in Ernst & Young's New York Office Entrepreneurial Services Group. Jacob Weichholz, CPA, is Director of Tax of the New York Office Entrepreneurial Services Group. Both are members of the NYSSCPA's Closely Held and S Corporation Committee.