Academic journal article Journal of Small Business Management

The Impact of Changing Tax Laws on the Subchapter S Corporation

Academic journal article Journal of Small Business Management

The Impact of Changing Tax Laws on the Subchapter S Corporation

Article excerpt

THE IMPACT OF CHANGING TAX LAWS ON THE SUBCHAPTER S CORPORATION

For many years, individual proprietors and partners who engaged in joint business activities were confronted with a difficult dilemma. Although they may have wished to take advantage of operating their businesses under a corporate format, many business people were dissuaded from opting for corporate status due to the inherent disadvantage of double taxation.

Simply put, entities such as partnerships or proprietorships are not subject to income taxation themselves. Instead, all tax-related items automatically flow through to the owners of the entities (this is known as the "conduit' approach to taxation and results in taxation only at the individual level.) For this reason, proprietors' and partners' liability risks extend beyond their investments to include their personal assets, whereas, in theory at least, corporate shareholders' liabilities are restricted to their investments in the corporation.

Corporations, however, are subject to income taxation. In addition, corporate tax provisions can essentially force corporations to distribute their earnings as dividends to their shareholders on a timely basis, and the dividends are taxed as personal income to the recipients.1 Thus, the same income is taxed at both corporate and individual levels, and the overall tax effect is almost certainly greater than would have been the single tax effect of the conduit approach.

1 The accumulated earnings statutes place a prohibitively high surtax on corporate earnings accumulated beyond a corporation's reasonable needs.

Recognizing that the limited liability inherent in the corporate form significantly enhances business stability, the U.S. Congress created an alternative form of business in 1954 that offered taxpayers the advantages of corporate form without subjecting them to double taxation. This form of business (first known as "Subchapter S,' now simply "S corporation') was generally restricted to relatively small businesses that were actively engaged in a trade or business. Thus, many small businesses gained access to the form of business most suited to their needs without undue concern over tax considerations.

S status for corporations has from the start been a very popular form of business (in 1980, over 15 percent of all corporations filing federal tax returns were S corporations). However, operating as an S corporation was quite complex in some ways, and unwary taxpayers could sometimes find themselves in adverse tax situations, usually by inadvertently disqualifying themselves from S status). However, recent changes in the taxation of both individuals and S corporations have reduced the complexities and drawbacks of operating as an S corporation and have made it easier to avoid double taxation.

First, individual tax rates have been reduced by approximately 25 percent in recent years, making it more desirable than ever to be singly taxed under the conduit approach of taxation than doubly taxed as a regular corporation shareholder. And, second, the S statutes have been liberalized so as to increase the number of small businesses eligible for S status and to eliminate (or at least simplify) many of the complications and pitfalls associated with the previous S statutes.

It is the purpose of this article to assess the desirability, from a small business standpoint, of operating as an S corporation. Particular emphasis is placed on how the S statutes have been liberalized in recent years to increase the advantages and expand the number of small businesses eligible for S status. The article includes a discussion of the implications of these changes for small business owner/ managers.

ELIGIBILITY REQUIREMENTS FOR S STATUS

In general, the eligibility requirements are intended to restrict S status to relatively small entities actively engaged in a trade or business. The requirements are relatively straight-forward, so little sophisticated expertise is needed to assess whether a business is eligible for S status. …

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