Determining the corporate form of a business can have multiple legal, tax, and financial implications. Consideration must be given to the operational characteristics of the company, the number of shareholders, the distribution policy, potential liability, and many other factors. All of these factors are subject to change over time and, fortunately, the form of a corporation can be changed as well. A common change in corporate form is from a C corporation to an S corporation due to the beneficial tax attributes afforded to the individual shareholders.
An S corporation election can be made as long as a corporation is eligible and all shareholders consent to the election. Certain C corporations may find it advantageous to elect S corporation status. C corporations are subject to corporate-level income taxes at the entity level, while its shareholders are additionally subject to income taxes on both dividends and equity capital gains, often referred to as “double taxation.” Conversely, S corporations are not subject to income taxes at the corporate level. Instead, the S corporation’s income and deductions are “passed through” to the personal income tax returns of its shareholders based on their pro-rata ownership interest.
A common misconception with an S corporation election is that an S election will result in the avoidance of corporate income taxes. While this is technically true in form, it is not true in substance; shareholders of S corporations essentially pay corporate income taxes at ordinary personal income tax rates. Based solely on this one attribute, and given the similarities in the current top marginal corporate and ordinary personal income tax rates, a shareholder of a C corporation would be in a similar position if the corporation had made an S corporation election. However, the primary benefit for shareholders electing an S corporation status is that they do not pay taxes on distributions. Furthermore, any retained income of an S corporation increases the tax basis of its shares, allowing the shareholders to avoid capital gains taxes on any stock appreciation upon a sale.
Eligibility Requirements and Limitations
Given the benefits of making an S election, many corporations choose to be treated as an S corporation for federal income tax purposes. However, in order to elect S corporation status, the corporation must meet the following requirements:
- It is a domestic corporation, or a domestic entity eligible to elect to be treated as a corporation, that timely files Form 2553.
- It has no more than 100 shareholders. A husband and wife and all members of a family and their estates can be treated as one shareholder for this test. All others are treated as separate shareholders.
- Its only shareholders are individuals, estates, exempt organizations, or certain trusts.
- It has no nonresident alien shareholders.
- It has only one class of stock (disregarding differences in voting rights). Generally, a corporation is treated as having only one class of stock if all outstanding shares of the corporation’s stock confer identical rights to distribution and liquidation proceeds.
- It is not one of certain defined ineligible corporations, including certain banks and thrift institutions, certain insurance companies, a possessions corporation, or a domestic international sales corporation.
- It has or will adopt or change to certain stipulated tax years as defined in the Internal Revenue Code (the “Code”).
If the previous requirements are met, the shareholders of a corporation must all consent to the S corporation election as well. For corporations with multi-tiered entities, special consideration should be given to the structure of associated entities.
For example, partnerships1 and C corporations are not eligible to hold stock in an S corporation. Shareholders considering an S election should also consider that certain deductions are not afforded to S corporations that are available to C corporations.2 Additionally, certain states do not recognize an S election. S corporations in some of these states are simply taxed in the same manner as C corporations.
In addition to the eligibility requirements previously mentioned, shareholders should also consider the following limitations after an S election is made:
- S corporations are not eligible to file for an initial public offering.
- If an S corporation does not make distributions sufficient to pay shareholders’ income tax obligations, the shareholders would still remain responsible for payment.
- S corporation shareholders are subject to changes in ordinary personal income tax rates.
Before an S election is made, shareholders should be aware that the corporation may remain liable for the tax imposed on certain items such as excess net passive income, the recapture of a prior year’s investment credit, and last-in, first-out (“LIFO”) recapture tax amounts.3 Notably, certain C corporations that have maintained inventory using the LIFO method are required to recognize a LIFO recapture amount as income when it elects S corporation status. The LIFO recapture amount is the amount by which the value of inventory using the first-in, first-out inventory method exceeds the value of inventory using the LIFO method. The tax liability due as a result of LIFO recapture is payable by the corporation in four equal installments. The first payment is due in the last tax year the corporation maintains C status, and the remaining payments are due in the three subsequent years after the S corporation election. Given LIFO recapture tax applicable to certain corporations electing S status, careful consideration should be given to the benefits and detriments of an S election.
Tax Liability Resulting from Built-In Gains
As previously outlined, there are many valuation issues to consider and explore with legal and tax advisors when making an S corporation election. One of the most prevalent areas to explore from a valuation perspective centers on the probability of any future sales of assets, divisions, or subsidiaries. The potential tax liability associated with the net unrealized built-in gains (“BIG”) of S corporations not only applies to the corporation as a whole, but all assets held by the corporation as well.
Based on §1374 of the Code, if an S corporation sells or distributes assets after an S election is made, that corporation will be subject to a corporate level tax (at the highest corporate income tax rate) on any asset appreciation that arose prior to the S election (i.e., asset appreciation while the corporation was a C corporation). This tax treatment is applicable for a 10-year period beginning with the first day of the first taxable year for which the corporation was an S corporation and is also known as the “recognition period”.4 §1374 of the Code was enacted to prevent C corporations with highly appreciated assets from electing S corporation status for tax purposes and immediately thereafter distributing assets to avoid BIG taxes.
An S corporation’s tax liability can be minimized for the recognition period if it establishes the Fair Market Value5 of assets less the adjusted basis of the assets. As such, at the date of S election, it is important to have a well-documented and supportable valuation of any assets or entities that may be sold within the recognition period. In addition, assets acquired after the corporation elects S status are not subject to BIG taxes.
Scope of Valuation
A valuation solely of the corporation as a whole may be sufficient only in the event that a sale of the assets on an individual basis is not anticipated. Conversely, for corporations with multiple subsidiaries or divisions considering an S corporation election, establishing the Fair Market Value of the corporation on a consolidated basis may not provide the necessary disclosure to facilitate effective tax planning if shareholders decide to sell a specific division or certain assets within the recognition period. If this scenario is possible, establishing the Fair Market Value of each asset owned by the corporation electing S corporation status, including both tangible and intangible assets, may be necessary. In addition, per §1374 of the Code, the valuation establishing the Fair Market Value of the company’s assets should reflect attributes of the subject company with an effective valuation date as of the beginning of the first taxable year the subject company elected S corporation status. Furthermore, if the corporation electing S corporation status holds a significant amount of non-operating assets that may be sold within the recognition period, such as real estate or excess machinery, it is important that a valuation establishes the Fair Market Value of each of those assets.
In such situations, it is appropriate to effectively conduct a purchase price allocation under the premise of a hypothetical sale of the company at the date of election, since BIG taxes are applied on an asset-by-asset basis. A purchase price allocation would establish the Fair Market Value of all of the corporation’s assets (e.g., real estate, machinery and equipment, identifiable intangible assets, and potentially even individual divisions of the corporation). This would mitigate any risk in determining the Fair Market Value of specific assets at a later date within the recognition period.
Premise of Valuation
When valuing a corporation’s tangible assets or specific divisions independently of the enterprise as a whole, one key issue to consider relates to the concept of highest and best use. In broad terms, highest and best use is determined based on the use of the asset by a market participant that maximizes the value of such asset, even if the intended use of the asset by the subject company is different than a market participant. For example, a division of a company that is underutilized or poorly managed may be worth considerably more on a stand-alone basis. Further, the valuation of a business requires an investigation into “the possibility that the business enterprise may have a higher value by liquidation of all or part of the business than by continued operation as is.”6 In situations where a corporation, division of a corporation, or individual asset is not generating a sufficient return or that has historically benefitted from improper transfer pricing among divisions, a hypothetical orderly liquidation value may be a more appropriate premise of value as compared to a going-concern premise of value.
Treatment of Tax Carryforwards
In the instance certain assets are sold within the recognition period, all is not lost. Based on §1374(b)(1) and §1374(b)(2) of the Code, net operating loss (“NOL”) carryforwards and capital loss carryforwards arising in a taxable year for which the corporation was a C corporation shall be allowed as a deduction against the net recognized built-in gain used in the calculation of the corporation’s tax liability. As such, if an NOL carryforward balance is being used to offset a BIG tax during the recognition period, the value of the assets used to calculate the BIG tax liability should not incorporate the benefit of any NOL carryforwards. Furthermore, based on §1374(b)(3)(B) of the Code, any business credit carryforwards arising in a taxable year for which the corporation was a C corporation shall be allowed as a credit against the BIG tax due upon the sale of assets within the recognition period.
Ultimately, the financial benefits of tax savings associated with an S corporation election can be compelling. In order to ensure that the potential benefits are fully realized, an S corporation election requires careful planning with respect to legal, tax and accounting, and valuation matters.
1 It should be noted that a limited liability company with a single, individual member that is taxed as a disregarded entity is eligible to hold stock in an S corporation. See IRS Letter Ruling 200107025.
2 See IRC §1363(b).
3 See IRC §1374, §1375, §1363(d).
4 No tax shall be imposed on the net recognized built-in gain of an S corporation, in the case of any taxable year beginning in 2009 or 2010, if the seventh taxable year in the recognition period preceded such taxable year, or in the case of any taxable year beginning in 2011, if the fifth year in the recognition period preceded such taxable year. IRC §1374(d)(7)(B).
5 “Fair Market Value” is defined as the price at which property would change hands between a hypothetical willing buyer and a hypothetical willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts (Rev. Rul. 59-60, 1959-1 C.B. 237; Treas. Regs. §20.2031-1(b) and §25.2512-1).
6 Uniform Standards of Professional Appraisal Practice 2012-2013 Edition. The Appraisal Foundation. Standards Rule 9-3.