NEW YORK, NY--(Marketwire - Mar 19, 2013) - The American Tax Relief Act, passed by Congress to avoid the "fiscal cliff," raises tax rates for some high-income individuals. It also probably has some owners of growing, successful businesses thinking their company should be a C corporation rather than an S corporation, whose shareholders are subject to personal income tax based on the company's earnings.
"The smart move will be to avoid that immediate, knee-jerk reaction. You may think you're lowering your tax obligations by being a C corporation and the company pays the taxes, at a lower rate. The reality is you'll still probably save by remaining or becoming a flow-through entity such as an S corporation," said John Evans, CPA, partner in the Tax Group at New York accounting firm Marks Paneth & Shron LLP. "With the new law, the federal tax rate for the highest income individuals is 39.6% plus an additional 3.8% on investment income; for corporations the highest rate is 35%. Before the law, the highest rates for both individuals and corporations were 35%."
There are a number of reasons why the owners of a growing company should retain its S designation, Mr. Evans said. For instance -- consider a corporation ("Company") in an active trade or business, in which all the shareholders materially participate and are taxed at the highest effective federal tax rate:
- Revenue/income deferral. S corporations generally allow for cash-method accounting, while C corporations generally require the accrual method. A good example is a Company that provides services. If the Company is growing, the cash method allows for an almost "permanent" deferral of revenues -- the Company doesn't need to report receivables as income -- and can accelerate the payment of its expenses. That can lower flow-through income and thus taxes.
- Avoiding double taxation.
- From normal operations: Say an accrual basis Company earns $1,000,000 in profit. If it's a C corporation, it pays $350,000 in income taxes. Its shareholders also pay a 23.8% tax on the retained earnings when they are distributed, so there are two levels of tax that reduce the shareholders' net cash distribution to $495,000. If the Company is an S corporation, the income flows through to the owners, who pay as little as $396,000 in income tax. The S corporation owners are left with $604,000 or $109,000 more than the C corporation owners.
- If the business is sold: Double taxation comes into play again. Say a Company finds a buyer for all its assets and one of the assets to be sold is self-created goodwill with a fair market value of $5 million and no tax basis. If it's a C corporation, it is subject to $1.75 million in corporate taxes. The remainder is distributed to the owners who must then pay $774,000 in capital gains tax on that amount. If it's an S corporation, the $5 million flows through to the shareholders as a capital gain and they pay $1.0 million in taxes. The S corporation owners are left with $4.0 million after taxes, while the C corporation owners are left with approximately $2.5 million -- a saving of $1.5 million in taxes as a result of operating as an S corporation.
"In short, simply looking at new tax rates is NOT the best way to evaluate whether to become, or remain, an S corporation or a C corporation," Mr. Evans said.
For more information, or to schedule an interview, contact Katarina Wenk-Bodenmiller of Sommerfield Communications at (212) 255-8386 or firstname.lastname@example.org.
About John Evans
John N. Evans, CPA, is a Partner in the Tax Group at Marks Paneth & Shron LLP. He specializes in tax issues affecting closely held businesses and their owners. He has worked on tax matters relating to the conversions of large, multinational C corporations into S corporations including planning to minimize the tax on subsequent dividend distributions. He has also reorganized S corporations and limited liability companies (LLCs) so they could go public and has helped take public companies private.
About Marks Paneth & Shron
Marks Paneth & Shron LLP is an accounting firm with over 500 people, of whom nearly 65 are partners and principals. The firm provides public and private businesses with a full range of auditing, accounting, tax, consulting, bankruptcy and restructuring services as well as litigation and corporate financial advisory services to domestic and international clients. The firm also specializes in providing tax advisory and consulting for high-net-worth individuals and their families, as well as a wide range of services for international, real estate, media, entertainment, nonprofit, professional and financial services, and energy clients. The firm has a strong track record supporting emerging growth companies, entrepreneurs, business owners and investors as they navigate the business life cycle.
The firm's subsidiary, Tailored Technologies, LLC, provides information technology consulting services. In addition, its membership in Morison International, a leading international association for independent business advisers, financial consulting and accounting firms, facilitates service delivery to clients throughout the United States and around the world. Marks Paneth & Shron LLP, whose origins date back to 1907, is the 32nd largest accounting firm in the nation and the 16th largest in the New York area. In addition, readers of the New York Law Journal rank MP&S as one of the area's top forensic accounting firms for the third year in a row.
Its headquarters are in Manhattan. Additional offices are in Westchester, Long Island and the Cayman Islands. For more information, please visit www.markspaneth.com.