Fleets generally choose to operate under either C corporation or S corporation status, but which one is right for your operation? The difference is all in the tax benefits, both now and in the future, according to Russell A. Daniel, senior manager for Grant Thornton LLP specializing in transportation issues. And even if C corporation status was the best choice for your fleet in the past, Daniels believes that recent changes in tax law now make S corporation status a good choice for many companies. Here’s why:
Q: What’s the difference between an S corporation and a C corporation?
A: An S corporation is generally subject to just one level of tax. If your company made $500,000 in 2005, your C corporation paid roughly $200,000 in federal and state taxes. An S corporation instead paid no income taxes and distributed $200,000 to its shareholders, who then paid the taxes and reported the $500,000 of income on their Form 1040 for 2005. The benefit comes when you take a dividend or sell the company. The $300,000 of leftover profits will be taxed as a dividend if paid out by a C corporation, but is tax-free coming out of an S corporation. Even with the dividend federal tax rate at 15%, that’s $45,000 of savings—or almost 10% of your annual profit.
Q: What are the long-term impacts of the decision?
A: Let’s step forward to 2017, when you are ready to retire. Your company has grown in value from $5 million in 2005 to $10 million in 2017, and you have identified a larger company that would love to buy you out. The buyer is going to want to purchase your assets so that they can depreciate or amortize all of the equipment and goodwill they’re buying from you for tax purposes. If you’re a C corporation, you’re looking at taking home about $5.1 million of cash after paying the government $4.9 million—and that’s assuming that federal capital gains rates are still at 15%. Had you made the S election, your tax bill would likely be much lower. That same $10 million could yield $7 million or more after tax, due to the single level of tax on the whole transaction, plus some potential reduction in tax rates.
Q: Are there other benefits to an S corporation?
A: Other benefits of an S election include the ability to retire earlier. It’s easier to pass the business on to the next generation; greater flexibility in estate planning; and other income tax planning opportunities.
Q: There must be some negatives to being an S corporation. What are they?
A: The biggest “cost” of becoming an S corporation is the “built-in gains” (BIG) tax. This tax prevents you from making an S corporation election and then selling your business tomorrow for all of the benefits noted above. For ten years, should you sell property that you owned when you made your S election, you will pay some tax on those sales as if you were still a C corporation, with numerous exceptions. Once ten years pass, this tax is gone and you’re home free. And during the ten-year window, there are a number of ways to plan around this issue. The benefits that are foregone are simply too large. There are other downsides to an S election, and you should consult your tax advisor for details.
Q: How do I become an S corporation?
A: Generally, S corporations are limited to 100 shareholders, with a number of exceptions. It cannot have as a shareholder a nonresident alien, a C corporation, or a partnership. The corporation cannot generally have preferred stock outstanding. Finally, S corporations have very limited ability to use fiscal years, and most follow the calendar year.
Q: Is switching status difficult?
A: The election process is relatively benign—all shareholders must sign an election form that must be submitted to the government by March 15 of the first desired S corporation year. Trustees and other fiduciaries must also consent to the election. In the transportation industry, the benefits usually outweigh the costs by a wide margin, and you don’t want to be the last of your peer group to make the election.
Q: What if the tax rates change?
A: Future increases or other changes in tax rates could change the calculations of tax burdens for some comparable S corporations and C corporations. However, our models and projections still project significant tax savings when you sell the business, and you’ll still save money currently if you’re paying dividends.