S-Corporations: Getting rid of the C-Corporation Monkey

By Adam Thaine, CPA

If you look hard enough, every storm cloud has a silver lining.  For 2010, dividends are taxed federally at a 15% tax rate.  Numerous tax cuts originating from the Bush era (including 15% dividend tax rate) are set to expire at the end of 2010.  While both the Republicans and Democrats have expressed a desire to create new tax cuts (legislation unlikely to occur prior to November elections) it is likely that dividends will be taxed at a rate higher than 15%.  While the probable tax rate increases are not good news in of themselves, it creates unique planning opportunities for the vigilant business owner.  One such example would be S-Corporations that previously existed as a C-Corporation.

S-Corporations that had earnings during their C-Corporation years have a proverbial monkey on their back.  One of the benefits to S-Corporations is that earnings they make can be distributed to their owners tax-free, unlike C-Corporations where distributions are dividend income to shareholders.  C-Corporation earnings not distributed at the time of the S-Election are still taxable to the shareholders.  There are two common ways in which these earnings are taxed.  The first is if the S-Corporation makes distributions to owners in excess of their S-Corporation earnings, this excess is treated as a dividend of C-Corporation earnings.  The second is once the corporation is liquidated this gain is effectively part of the liquidation capital gain recognized by the shareholders.

Since every S-Corporation's C-Corporation earnings must be recognized at some point in time, it may be beneficial to recognize this gain in 2010 at 15% federal rates utilizing dividend strategies rather than at a future point in time when tax rates will likely be higher.

C-Corporation earnings can be recognized by making dividend distributions to the shareholders in an amount equal to these earnings and electing on the corporate tax return to distribute C-Corporation earnings before S-Corporation earnings for the current year.  If the corporation does not have enough cash or such distribution would deplete cash below a level needed there are two alternatives.  The first is either in combination of cash or instead of, the corporation can issue notes to the shareholders.  The second is that the corporation can make an election to have a "deemed distribution".  This election, for the amount desired, treats the company as making a dividend distribution of C-Corporation earnings to the shareholders and the shareholders contributing that money back into the corporation. 

Given that recognition of C-Corporation earnings may not happen for many years, this strategy may not make sense for many S-Corporations.  The benefit of the lower rates may be lost due to the time value of the money that would be taken out of the S-Corporation to recognize C-Corporation earnings and/or distributed to the shareholders to pay taxes on the resulting dividend income.  It is worth pointing out that the current worst case scenario of a possible future tax rate of 39% instead of the 2010 rate of 15% on C-Corporation earnings creates a large gap. 

Ultimately each S-Corporation owner and their accountants should examine the future to determine when C-Corporation earnings are likely to be recognized and ask if they might be better off recognizing this income during 2010.

Questions about your S-Corporation? Give us a call at 1-800-487-7624.