S-Corps: Not A Silver Bullet, But Potentially Useful (Just Don’t Ever Put Real Estate in One)

When it comes to setting up a business, one of the most common questions I hear from entrepreneurs is whether or not they should elect their LLC be taxed as an S-Corporation (S-Corp) as opposed to being taxed as a partnership (or, heaven forbid, a C-Corporation). On the surface, it seems like a no-brainer, as electing S-Corp status can greatly reduce self-employment taxes for business owners who take a salary out of their business while preserving pass-through entity status. After all, who doesn’t like saving on taxes?

In practice, however, electing S-Corp status comes with additional costs, responsibilities, and potential drawbacks that are often overlooked when considering the tax savings. We’ll discuss the most significant those benefits and potential pitfalls below.

Reduced Self Employment Tax

As mentioned above, the primary benefit of S-Corporation tax treatment is that shareholders who also work for the company can avoid some self-employment taxes. While they must still receive a reasonable salary, the remaining profits can be distributed as dividends, potentially saving on Social Security and Medicare taxes.

Herein lies one of the most significant and potentially onerous drawbacks to S-Corp status, however: the challenge of defining reasonable compensation.

The IRS requires S-Corporation owners who actively participate in the business to receive "reasonable compensation" for their services. Determining what is considered reasonable can be subjective and may lead to scrutiny during audits. Not paying yourself an adequate salary could result in penalties and additional taxes.

Increased Complexity and Administrative Burden

S-Corporations require strict adherence to corporate formalities, such as regular meetings, record-keeping, and filing annual reports. This additional administrative burden can be time-consuming and may require professional assistance, increasing operational costs.

A further result of electing S-Corporation status is that you can no longer file your entity tax return on a Schedule C as part of your 1040. Instead, a form 1120S must be filed for your S-Corp and you’ll be issued a K-1 which will drive activity on your 1040. This may result in increased tax preparation costs over an entity structure that can file via a Schedule C.

Additionally, if you fail to comply with the requirements of being an S-Corporation as described above, you can have your S-Corporation status revoked.  Once the IRS revokes your S-Corp status, your tax status defaults to that of a C-Corp, meaning you are subject to double-taxation on income. This has the potential to create tax liability dating back to the time of election.

Limited Ownership Structure

S-Corporations have restrictions on ownership, limiting the number and types of shareholders. This structure may not be suitable for businesses planning to attract a large number of investors or issue multiple classes of stock.

Owners of S-Corps must be US citizens/resident aliens, trusts, estates, or non-profits. Corporations, partnerships, business trusts, and IRAs cannot hold ownership in S-Corps, limiting their utility for entities without closely-held ownership interests.

Transaction Consequences

Transactions involving the sale of an S-Corporation may have different tax consequences compared to other business structures. S-Corporations may be subject to the Built-In Gains Tax if certain assets are sold within a specified period. This tax is designed to prevent the conversion from being used solely for tax avoidance.

Additionally, various actions within an S-Corporation, such as contributing property, selling or liquidating shareholder interests, and distributing profits, all initiate taxable events. If a shareholder, holding less than 80% of the corporation's majority vote and value post-transfer, contributes appreciated property, it incurs tax implications. Additionally, taxable events arise when S-Corporations distribute profits to shareholders or when shareholders engage in the sale of their stock.

Issues with Real Estate

Finally, the simplest piece of advice we can provide is that you should NEVER own real estate in an entity taxed as an S-Corp. S-Corporation assets are not allowed a step-up in tax basis when an owner passes away. In the event of a shareholder's death or the sale of their interest to third parties, beneficiaries or buyers experience a "step-up" in the basis of their inherited or purchased S-Corporation stock. This step-up entails the reassessment of the asset's value to the fair market value at the time of death or sale, effectively minimizing or eliminating future capital gains taxes for the new owners.

Unlike Partnerships or LLCs, S-Corporations' assets, particularly real estate, do not benefit from the step-up treatment. This limitation becomes especially noteworthy for those planning to retain rental properties long-term and pass them down through generations.

Finally, one of the most tax-attractive reasons to invest in real estate is the reduction in earnings (often to the point of taxable loses) from depreciation which can substantially lower your tax burden when deployed correctly. S-Corps, however, are subject to basis rules which can result in suspended losses for tax purposes, i.e. a handicapping of the depreciation benefits of real estate. Pass through entities treated as partnerships for tax purposes often do not face these same basis limitation issues and are often able to much more easily utilize losses generated by tax depreciation to minimize tax.

Summary

While the S-Corporation structure offers significant benefits, the concept of reasonable compensation and transaction consequences must be carefully navigated. S-Corporations can be a great vehicle for single-owner businesses making six-figure income from services revenue (freelance/1099 professional service companies come to mind), but can represent significant challenges for other business types. Business owners should consult with tax professionals and legal advisors to ensure compliance with regulations and make informed decisions that align with their specific business goals and circumstances.