To Avoid Tax, Set Up as S-Corp or C-Corp?

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What's involved in terminating the S-corp election? Is it a costly, complicated process?

Not too much. There is some additional income tax reporting work by the shareholders and the accountants. If you do it in the middle of the year, you'll effectively have to file two different tax returns.

The larger picture is that if you lose your S-election, there's a rule that says you can't go back to being an S-corp for five years, though there are some exceptions. But if you do it and later realize that being a C-corp is less beneficial than you thought, you can't just say: "Well, I'll go back tomorrow."

One of the downsides of the C-corp is the issue of double taxation. How does that work?

Let's say your C-corporation earns $100 and is taxed at the highest corporate tax rate of 35%. That leaves $65 after taxes are paid. Let's say the business owner needs that $65, so it comes out of the corporation as a dividend and the owner reports it and is taxed at 20%, which is the anticipated dividend tax rate. So another $13 in tax is paid and the business owner nets $52.

With an S-corp that earns $100, it's reported on the business owner's individual tax return and if he's in the highest bracket it's taxed at 40% and the owner nets $60. There are a whole bunch of other taxes, including state taxes and self-employment taxes, that may shift those numbers but that gives you a simple example of how the double tax could still be higher at the anticipated future tax rates.

What are some of the other details you're considering when it comes to S-corporations versus C-corporations?

State taxes are very important because in some states there is no personal state income tax but there is a state corporate tax. Also the nature of the assets inside the S-corporation and the type of income that comes out is important.

And the other thing is that the federal corporate tax rate now starts off at 15% and at the higher income levels you're looking at about 35%. But what we don't know is whether we'll have higher tax rates for corporations in the future. We may make a decision now based on today's rates but in the long term if corporate tax rates change then we could find out we've actually done something that will have a negative impact.

This is why I say that small business owners who are concerned about the potential for higher tax rates should run the numbers with their advisers and go through alternate scenarios that look at the long-term health of the business and the individual owners.

Karen E. Klein is a Los Angeles-based writer who covers entrepreneurship and small-business issues.

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