The Bottom Line: New Rules for S Corporations Offer Flexibility with Profit Taxes
The Protecting Americans from Tax Hikes Act (PATH Act) permanently shortened the S Corporation “built-in gain holding period,” making it more attractive for corporations to elect status as an S Corporation and the treatment that such a status incurs. This gives mold shops more flexibility as to how they are taxed on their profits and the eventual sale or transition of their businesses.
The Protecting Americans from Tax Hikes Act (“PATH Act”), which Congress passed in December 2015, permanently shortened the S Corporation “built-in gain holding period,” making it more attractive for corporations to elect status as an S Corporation and the treatment that such a status incurs. In order to be treated as an S Corporation, a company must file Form 2553 with the IRS with the full consent of all shareholders. Someone authorized to sign the S Corporation’s tax return must sign the form.
What does this mean for mold shops? Let’s back up a bit and review some basics. When a company elects to be treated as an S Corporation, the company must determine the fair market value of each asset and determine the amount by which the fair market value exceeds the tax basis in the asset. This amount is the built-in gain. At this point, the built-in gain on each asset is calculated but not paid.
The built-in gain tax is paid if the company sells or otherwise disposes of an asset within the recognition period, which the PATH Act shortened from 10 years to five years.
The built-in gain tax is paid if the company sells or otherwise disposes of an asset within the recognition period, which the PATH Act shortened from 10 years to five years. For example, if a tool shop owned a piece of equipment that had a fair market value of $100,000 at the time that the tool shop elected to be an S Corporation, but the piece of equipment was fully depreciated (and therefore had a $0 tax basis), the built-in gain would be equal to $100,000. If the piece of equipment was sold during that five-year recognition period, the company would pay a built-in gains tax of $35,000. That figure is calculable by taking the fair market value ($100,000) and multiplying it by 35 percent, which is the rate at which S Corporations are taxed.
S Corporations are generally not subject to income tax. Instead, items of income, gain, loss and credits are passed to the shareholders of the S Corporation, who pay income tax on their pro-rata share of those items of income and loss. For instance, if an individual owns 50 percent of an S Corporation, the individual must pay tax on 50 percent of the ordinary income and other items of income and loss that the S Corporation reports.
When a C Corporation elects to become an S Corporation, it must pay tax at the highest corporate rate, which, again, is currently 35 percent. The S Corporation must pay tax on all gains that were built-in at the time of filing Form 2553 if the asset with the built-in gain is sold or otherwise disposed of during the recognition period. For example, a C Corporation mold shop elects to become an S Corporation on January 1, 2016, and has one asset in which the fair market value exceeds its basis in the asset. If the shop sells or otherwise disposes of the asset before December 31, 2020, it must pay the built-in gain tax in the tax year in which the asset was sold. However, if the shop sells or disposes of the asset after January 1, 2021, the shareholders do not pay a built-in gain and instead pay any gains on the sale of the asset.
When applicable, the built-in gain tax is paid at the S Corporation level (35 percent of the built-in gain). The shareholders do not pay the built-in gain tax. In addition, if the company has net operating losses (NOLs) or general business tax credit carryforwards, it may use those tax assets to offset the built-in gain.
S Corporation Requirements
Companies interested in filing as an S Corporation must meet all of the following requirements:
Limited number of shareholders. The company may not have more than 100 shareholders (the number of people who are shareholders at any given time throughout the tax year). However, the company can have more than 100 shareholders throughout the taxable year, as long as there are no more than 100 shareholders at one time. All family members and their estates are treated as a single shareholder.
Domestic corporations only. The company must be a domestic corporation, created or organized in the United States. Years ago, the IRS allowed companies to “check the box” as a means of determining how the company would be taxed. “Check the box” refers to the Entity Classification Election part of Form 8832, which allows companies to elect their classification for Federal income tax purposes. This election has allowed some Limited Liability Companies (LLCs) to become S Corporations. That is, they may “check the box” to be a C Corporation, then timely file Form 2553 to become an S Corporation. However, to do this, the LLC operating agreement must be compliant with the S Corporation rules.
Eligible corporations only. The company may not be a financial institution, insurance company, domestic international sales corporation (DISCs) or taxable mortgage pool.
Eligible shareholders only. Nonresident aliens may not be shareholders. Only individuals, decedents’ estates, estates of individuals in bankruptcy and certain trusts can be shareholders of an S Corporation. Corporations, partnerships and numerous types of trusts cannot be shareholders either. One exception is that S Corporations may own qualified Subchapter S subsidiaries (QSubs) if the proper filings occur.
In this case, both S Corporations would be treated as one entity for Federal income tax purposes.
One class of stock. A company may have only one class of stock and is treated as having only one class of stock if all of the outstanding shares grant identical rights to distribution and liquidation proceeds. That is, each shareholder must receive their pro rata share of any distributions and their pro rata share of assets should the company liquidate.
It is also noteworthy that S Corporations exercise a distinct set of voting rights, which is helpful to family-owned mold shops. For example, mom, dad or both can retain all of the voting shares, which enables them to retain control of the company and enables the kids to purchase or receive gifts of non-voting shares. Many times, this is done for estate planning purposes or as a means of succession planning.
Many shops prefer S Corporations over partnerships because the ordinary income of an S Corporation is not subject to self-employment tax. And, owners of an S Corporation can be employees and receive wages, while partners must receive compensation through guaranteed payments or distributions of income.
C Corporations Selling Their Business
Shop owners looking to sell their business should weigh the pros and cons of an S Corporation. For example, many buyers wish to buy assets, rather than stock, because then they can amortize or depreciate the purchase price of the assets.
When a C Corporation sells its assets, it will be subject to the tax that the C Corporation pays and to the tax that the shareholders pay upon liquidation. However, when an S Corporation sells its assets, the shareholders pay tax on the gain on the sale of assets, but they do not pay tax at the corporate level unless a built-in gain exists and the sale of the assets occurs during the recognition period. Any appreciation that occurs after the S Corporation files avoids this “double tax.”
For C Corporations that are considering a sale in five years, the shortened built-in gain recognition period provides some relief. For a mold shop looking to sell within five years, a late S Corporation filing is possible if the company follows
All of this means that mold shops now have more flexibility in the way that they are taxed on their profits and in the eventual sale or transition of their businesses.
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