By Randolph Smith and Barbara Koosa Ryan
Federal Tax Partners
This Opinion piece appears in the March 7 print edition of Transport Topics. Click here to subscribe today.
What was the most important event that occurred in 1958? The creation of NASA? Perhaps the birth of the King of Pop? For privately owned trucking and logistics companies, there is only one answer: tax legislation permitting S corporations.
An S corporation, while providing for the limited liability benefits of a corporation, provides the benefit of pass-through tax treatment. When a transportation company elects S corporation status, items of income, loss, deductions, etc., are passed through to the shareholders and are reported on their income tax returns, resulting in only one level of tax.
Since 1958, Congress has significantly liberalized the S corporation rules. For example, changes in legislation have increased the allowed number of shareholders to 100, broadened the definition of “shareholder” to allow members of a family to be treated as one shareholder, broadened types of trusts eligible as shareholders (including the creation of the electing small business trust) and allowed the Internal Revenue Service to treat inadvertent invalid S corporation elections as effective. Eligible S corporation shareholders currently include individuals, estates, certain trusts and certain tax-exempt organizations.
Although S corporation status initially was created for small business corporations, because of the significant benefits and the liberalized regulations, many larger transportation businesses qualify and now take advantage of the benefits of being taxed as an S corporation. For example, Swift Transportation, a $3 billion company, was taken private in 2006 as an S corporation.
The most notable tax advantage of an S corporation is the pass-through tax treatment of tax-related items resulting in only one level of taxation. C corporations pay income tax at the company level, and shareholders also pay tax when profits are distributed as dividends. This is referred to as double taxation. However, S corporations generally are not taxed at the company level. All income is passed through to the shareholders, whether distributed or not, and taxed at the shareholder level.
Additional advantages for transportation companies as an S corporation include the following:
• S corporation status is a tax “fiction.” The company’s legal status does not change; therefore, the corporate veil still exists and the limitation of personal liability still applies.
• Corporate losses, if any, are passed through to shareholders and are potentially available to offset other taxable income.
• A significant portion of the gain on a sale of the business assets results in one level of tax at the capital gain rates (a permanent tax savings compared to a sale of C corporation assets).
• Undistributed earnings increase shareholder stock basis.
• Multiple estate-planning options are available that are unique to S corporations.
• If the shareholders plan to sell all or part of the company in the future, some of the significant benefits of S corporations include increased flexibility in structuring a sale and in related estate and gift tax planning. An S corporation is allowed most of the restructuring advantages of a C corporation, while retaining the pass-through advantages of a partnership or sole proprietorship.
• The tax compliance burden is similar to that of C corporations, if handled properly.
Now, let’s refute some myths about the disadvantages of S corporations. There are a series of common questions on management minds when considering electing S corporation status, including:
• “Aren’t individual and trust tax rates increasing and likely to increase further? Why shouldn’t I convert back to C corporation status?”
Individual tax rates may increase in the near future; however, double taxation of a C corporation is still a significant concern. A C corporation will be taxed at the corporate rate, and when profits are distributed, the shareholders will be taxed again at the same potentially higher rates that could apply to shareholders. By remaining (or electing) S corporation status, shareholders will benefit from a single level of taxation.
• “The built-in-gains tax will apply, so why should I convert to an S corporation?”
Built-in-gains tax will apply on the disposition of appreciated assets held at the conversion date for the first 10 post-conversion years. Any gains recognized on the disposal of these assets will be taxed at the corporate level with the net gain flowing through. However, careful tax planning can effectively minimize and possibly eliminate the built-in-gains tax. Recent legislation has reduced the 10-year period for dispositions in 2009 through 2011. While the continuation of this trend cannot be assumed, many observers are hopeful that a shorter holding period will become permanent law.
• “Certain states do not recognize S corporation status.”
The majority of states allow companies to elect S corporation status for state tax purposes. However, careful planning can minimize state tax expense in the states that do not allow S corporation status.
• “The matter of tax reporting and compliance is more complicated, isn’t it?
Though some of the regulations and requirements for S corporations differ from C corporations, the general compliance procedures and burdens are very similar. In addition, companies treated as S corporations are generally not required to prepare and book a tax provision on their financial statements.
• “What about legal liability? We have an elaborate structure to minimize our legal risk.”
S corporations provide the same legal protection as C corporations (consult your attorney). An important aspect of the S corporation conversion process involves detailed analysis of the corporate structure but very rarely requires any restructuring. “Consolidated” tax status has been available for S corporations since the 1997 tax act allowing companies to have subsidiaries such as wholly owned S corporations or single or multimember LLCs.
So, what’s next?
Transportation companies should carefully consider a conversion to or from S corporation status before proceeding. The tax benefits are significant and the analysis is well worth the effort. Contact a tax adviser for more answers to your questions.
Grant Thornton International Ltd., Chicago (U.S. headquarters), is a global audit, tax and advisory firm.