Switching from S to C can be short-sighted

CEOs of growing firms see a major tax advantage in C corp status. But some may regret the switch.to come.

By Jayne A. Pearl

When congress passed increases in personal income tax rates in 1993, many family companies faced a complicated new tax equation. With the personal rate now higher than the corporate rate, business owners wondered whether it was time to switch from Subchapter S companies to C corporations. No stampede to C corp status has yet occurred. But it appears that some CEOs of fast-growing companies have switched or are seriously considering the switch.

Coopers & Lybrand recently surveyed chief executives of 410 companies with revenues from $1 million to $50 million that had grown by at least 20 percent a year for five years. A total of 11 percent of these CEOs reported they had already switched from S to C status or were planning to do so by 1995. Another 33 percent said they were planning to discuss a change with their tax advisors in the next three months. Of those who switched or were considering it, 70 percent said that it was because of the 1993 tax increase on the income of S corp shareholders.

The income of C corps is subject to double taxation, once at the corporate level and again when distributed as dividends. Most state corporate taxes are higher than individual rates, moreover. Why then would growing companies be tempted to assume C corp status?

The earnings of S corps accrue to shareholders and are taxed as personal income, whether distributed or not, but the business pays no tax. Small companies,notably startups, find S status attractive because it allows distributions to flow through to investors without the double tax, but also because it enables them to deduct losses on their personal income tax.

Of course, C corps also enjoy certain advantages. They tend to have greater flexibility in raising capital, and enjoy favorable rules on treatment of fringe benefits. But the rate inversion is very likely the big magnet at the moment for CEOs in the Coopers & Lybrand survey (many of whom are no doubt leaders of family businesses, although not identified as such in the survey).

C status becomes more enticing when companies begin to turn a profit and plow back earnings into future growth. They plan to pay no dividends and therefore expect to be taxed only at the corporate level. The CEOs who were contemplating a switch from S to C corp status said they were planning to commit 21.6 percent of revenues in that period to new capital investments—nearly twice the average of all survey respondents.

However, C corps that retain substantial earnings instead of distributing them will have to make a case to the IRS. Samuel P. Starr, a tax partner in the Washington, D.C, office of Coopers & Lybrand, notes that a company is not permitted to retain unlimited amounts in earnings. "It has to be able to demonstrate to the IRS that it is retaining them for reasonable business needs," he says. Otherwise, it will be subject to a 39.6 percent accumulated earnings tax—the same as the top personal income tax rate. The penalty is designed to encourage C corps to distribute earnings to shareholders. To avoid it, Starr says, "companies have to produce contracts or board resolutions to show that the company is trying to use this money to purchase new properties or companies or to expand. Companies that can't prove that do not want to terminate the S status."

Starr adds, "If you're a high-growth but maturing company that can't reinvest all retained earnings, and you have to invest them in securities or other assets, you run the risk of being subject to the accumulated earnings tax."

C corps unable to reinvest, or whose owners need cash, may be tempted to distribute all or part of earnings as bonuses to executives, which are generally deductible on the corporate income tax. This practice could backfire. The IRS might consider the bonuses a hidden dividend, which is not deductible. "It doesn't change the liability of the shareholders," Starr cautions, "but it can seriously affect them at the corporate level. The company would end up paying a tax of 34 or 35 percent on that bonus."

What is considered unreasonable compensation? William Dunn, manager of Coopers & Lybrand's National Tax Consulting Group in Washington, D.C., says: "If the average executive at your level in your industry earns $500,000 and you're taking $600,000, you're probably okay. But if you're drawing $1.1 million, you're taking too much."

Companies that opt for C status may thus be caught in a bind if they can't legitimately invest earnings in growth but don't want to pay out taxable dividends. Keeping too much in the business may raise one red flag. Doling out bonuses may raise another. There's no shortage of tax-court cases involving companies that have been sucked into one vortex or another. No formulas have emerged to determine how much working capital a company can accumulate and how much it can pay executives before the IRS blinks.

State taxes must also be considered. As a result of the 1993 inversion, the top personal rate is now 4.5 percent higher than the 35 percent corporate rate for companies with more than $10 million in revenues. If a company is in a state that has a higher corporate rate than individual rate, however, that may cancel out the benefit from the federal rate. In addition, Starr says, "If you're in a state that recognizes S corporations [more than 40 do], that may be a reason to retain S status. But if you're in a state that already taxes S corporations, that may push you over the top to switch."

A number of other pitfalls await the family company that decides to switch. A company that changes to C status in anticipation of investing in growth may find shareholders smart ing from the loss of regular distri butions. William Dunn points out that financially viable companies that have operated as S corps get addicted to the steady stream of cushy distributions. Says Dunn: "We go in [to C status] with the best of intentions—that cash will stay in the business and fund growth. But, lo and behold, we realize we need to get cash out."

Once a company changes from S to C, it cannot switch back for five years. This is a decided disadvantage if the owners suddenly decide to sell. They could end up being double-taxed on asset sales, paying capital gains tax at both the corporate and shareholder levels. Under S status, they would face only a single shareholder tax. "A CEO might take four or five cents on the dollar every year [in savings on personal income taxes] and forget that an offer can come along that's too good to be true," says Samuel Starr.

It is probably unwise for companies to base structure on tax considerations alone. Congress could well pass new legislation that again changes relative corporate and personal rates. It will be costly if a company decides after five years to switch back to S status. The business would have to be revalued, and it would be subject to capital gains taxes on any appreciation.

S corp status may look more appealing if Congress passes legislation first proposed in 1993 to liberalize Subchapter S provisions. Although the health care debate last year elbowed out any chance for a tax bill, Starr, who helped draft the legislation, expects there will be a bill this year. "We have a good shot at getting our proposals attached to that tax bill," he says.

Starr was surprised by the results of the Coopers & Lybrand survey. The survey provides clues to what CEOs of high-growth companies are thinking about, but not necessarily to what they will do, he believes. "In my client base, 1 out of 100 may terminate their S status. In a higher-growth population, maybe 1 out of 10 will switch."

Given the current playing field, Starr warns, all businesses should be careful about making a change in entity, even with the apparently higher tax rate for S corp shareholders. "In general, the only ones that might benefit are fast-growing companies that want to reinvest substantial profits in future growth and are confident they don't want to sell the company within five years."

Jayne A. Pearl, a former senior editor of Family Business, is now a freelance business writer and editor.