If you run a small business or a professional corporation, what's your savviest response to tax reform? It might be to organize as an S corporation -- a way of doing business that could both lower your taxes and simplify your business life.
But after looking, you may decide not to leap. A lot of planners had a brief, passionate love affair with S corporations last year. Now some of them are not so sure.
Any small business should probably operate as a corporation if there's a risk of significant lawsuits. If you don't incorporate, a big judgment against your company could also endanger personal assets, such as your house and savings. With corporate protection, only your business assets are at risk.
In a regular corporation, you're paid a salary. Profits stay in the company's bank account and are taxed at the corporate income-tax rate. Surplus profits are paid to you as dividends, so they're taxed on both your corporate and personal returns.
In an S corporation, on the other hand, there is no corporate tax. All profits (or losses) every year are reported on your personal tax return.
Under the new tax law, the top federal personal income-tax rate for many individuals will be 28 percent in 1988, while the top corporate rate will be 34 percent. That is principally what makes an S look attractive. Revenues switched to your personal returns can be taxed at a lower rate. And there are some ancillary advantages to going S:The accounting is much simpler than in a regular corporation. You avoid the new corporate alternative minimum tax. None of your income from the business is paid out as dividends, which means they escape double taxation. Any closely held company with substantial earnings may be a good candidate for S corporation status, said Samm Starr of Coopers & Lybrand. (But note that about 15 states and cities don't recognize S corporations, and continue to tax them as regular corporations.) S corporation assets are taxed only once -- when you sell the business. Under tax reform, the shareholders of a regular corporation will be taxed twice.
Start-up businesses often like to be S corporations, because losses can be used to shelter the investors' other income from tax. Under tax reform, this plum is now available only to investors active in running the company.
But passive participants can still use the losses to offset income from other passive investments. If the S corporation makes money, passive investors can offset that income with losses from their tax shelters.
Such are the virtues of an S, and to many small business owners, they sound definitive. But as the country judge complained, "How am I going to make up my mind if I have to listen to the other fellow's side of the story?" You may find a regular corporation equally compelling: If your taxable income falls within a certain range (for married people, between $71,900 and $149,250), your personal income-tax rate will be 33 percent in 1988. That's just about the same as the 34 percent top corporate rate, so switching income isn't such a big deal. If, after paying your salary, the business is a low earner, you'd pay lower taxes in a regular corporation, Starr says, because modest profits are taxed at only 15 percent. You can borrow up to $50,000 from your regular pension plan if the documents allow. But in the past you couldn't take loans from an S corporation plan. The tax reform law did add the possibility of borrowing from S corporations for owners who petition the Labor Department and get permission. "I've heard unofficially that the department is going to handle each request separately, and none has been awarded so far," says Peter Elinsky of Peat Marwick. Only in a regular corporation can you can get a deduction for group-term life insurance, company-paid medical insurance and a medical plan allowing you to write off medical bills. You can issue more than one class of stock. In estate planning, this lets you assign current income to yourself while passing the appreciation of the business to your children. You can use a fiscal year rather than a calendar year, which is often helpful in deferring income. Most S corporations have to switch to a calendar year.
What if you're now a regular corporation and want to switch to an S? You face a couple of problems. Any money you have borrowed from your pension plan has to be repaid. And you may owe a tax on your corporate assets (although small businesses get a partial tax break if they convert before 1989).
S corporation status still might be best for certain types of companies. But it's not going to be an easy call.