–guest post by Tom Tillery, Vice President and co-founder of Paraklete® Financial, Inc.
Tom, I have often heard you say, regarding the S-election for a corporation, that “S stands for sad.” I have a client considering an S-election. What would be some of the financial planning downsides from choosing this option?
This is a great question and I welcome the opportunity to put into writing the financial planning issues which an S-election creates. Let’s begin by defining an S-corporation, which is a corporation that is treated, for tax purposes, as a pass-through entity. In a pass-through entity, all items of income and expense “pass through” to the shareholder. This is the genesis of the problems in planning with an S-corporation.
I want to acknowledge that from a planning perspective, S-corporations do fit in a limited set of facts and circumstances that include the need for a corporate veil to provide asset protection and the “pass through” of losses to the shareholder’s form 1040. Frankly, in 20 years no one has said to me “I really need some pass-through losses on my 1040.”
Distributions, also called pass-through income, from an S-corporation have been under IRS scrutiny for several years. Why is this? S-corporation pass-through income enjoys an employment tax advantage. This advantage was created in Revenue Ruling 59-221, which held that a shareholder’s undistributed share of S-corporation income is not treated as self-employment income.
In recent years as employment tax rates have climbed, this singular advantage of operating as an S-corporation has become magnified. Because S-corporation income is not subject to self-employment tax, there is tremendous motivation for shareholder-employees to minimize their salary in favor of distributions, which are not subject to payroll or self-employment tax. This abuse by taxpayers has drawn the ire of the IRS and generated increased surveillance of S-corporations. I do not understand why so many advisers do not disclose this increased surveillance (certainly a material fact) when they recommended the S-election.
In making an S-election, many financial planning opportunities are removed from consideration. By limiting these opportunities, the client is placed at a disadvantage. The planner’s palette is reduced from dozens of colors to only a few. There are many opportunities removed from the financial plan by making an S-election. I will present a few for consideration. They are not placed in order of priority.
Qualified plan design: Qualified plans provide asset protection, tax deferred growth and tax deductible contributions. Distributions are not wages. As such, they are not considered in the qualified plan design (yet another material fact). If an owner has $75,000 of wages and $100,000 of distributions, only the $75,000 of wages is factored in to the plan design.
De minimis fringe benefits: Granted, the cumulative total of tax savings from de minimis fringe benefits is small, but they are still a benefit. And to put things into perspective, I would rather pay for the occasional sporting event or stage play using before tax dollars than after tax dollars.
Estate planning: There is no way to describe estate planning with an S-corporation other than a traffic accident. If a trust that holds stock of an S-corporation does not meet all the applicable S-corporation trust rules, not only will the trust be ineligible to hold S-stock but the corporation’s S-election will terminate. So, if a client wants to make an S-election, it should be disclosed that their estate planning will be more complicated and costly (and yes, this is a material fact).
Income follows equity: This one is my favorite. There is much less flexibility in allocating income and loss in an S-corporation. An S-corporation is only allowed one class of stock. As a result it cannot easily allocate losses or income to specific shareholders. The allocation of income and loss is governed by stock ownership, unlike a partnership or LLC where the allocation can be set in the operating agreement.
Should you have questions about whether an S-election is right for you and your business or are curious about the implications, I highly recommend you reach out to a qualified professional who can help guide you through those decisions.
Paraklete® Financial, Inc., an Atlanta-based firm with offices throughout the United States, designs and implements integrated financial planning strategies without asset management or product placement. The primary focus for their clients is financial education. Paraklete® Financial, Inc. coordinates its client’s investment, legal, tax and insurance advisers. Tom Tillery, Vice President and co-founder of Paraklete® Financial, Inc., has more than 30 years of experience in financial planning, insurance, investments, philanthropy and tax planning. He provides these services to businesses, individuals and families of substantial wealth. He is a CERTIFIED FINANCIAL PLANNERTM, Chartered Life Underwriter®, Chartered Financial Consultant®, Life Underwriter Training Council Fellow, and Chartered Retirement Planning Counselor®.