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S Corporation Taxes: Worst Case Scenarios For Small Business Corporations

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Author: Stephen Nelson

Most of the time, an S corporation does not pay federal income taxes. Rather, shareholders pay the taxes on their proportional shares of the S corporation's income. An S corporation that previously operated as a C corporation, however, may end up paying tax on its income in three situations.

S Corporation Tax #1 - Built-in Gains Taxes

When an S corporation that formerly operated as a C corporation realizes built-in gains stemming from the period the corporation operated as a C corporation, a built-in gains, or BIG, tax may be levied.

To explain how the BIG tax gets calculated, suppose your C corporation owns an office building. Further suppose that building was purchased by the corporation many years ago for $100,000 but is now worth $1,000,000.

If the C corporation sells this building, the $900,000 of profit will be taxed at the C corporation tax rates (roughly 34%). That means an initial $306,000 of corporate income taxes. If the leftover amount (roughly $600,000) is distributed to shareholders as a dividend, that $600,000 is subject to another tax that will run at least $90,000 and may, by the time you read this, run $234,000 if the Bush tax cuts have expired.

Out of the $900,000 profit, then, the C corporation taxes and shareholder dividend taxes take at least $400,000 of the $900,000 profit for taxes. And if you're reading this article after the Bush tax cuts have expired in 2011, more than $500,000 of the $900,000 of profit could be confiscated for corporate and shareholder dividend taxes.

But what if the C corporation in this example immediately prior to selling the $1,000,000 building elects to be treated as an S corporation? If an S corp enjoyed a $900,000 capital gain like the one described in this article, the profit would be subjected only to one, 15% capital gains tax equal to $135,000.

An S corporation, in other words, might seem to reduce the taxes paid on the building appreciation by $265,000 (if the Bush tax cuts are still in place) or by roughly $400,000 (if the Bush tax cuts have expired).

Unfortunately, there's a fly in the soup. In a situation like I've just described, the built-in gain tax kicks in. And, essentially, the S corporation is forced to pay the "C corporation" taxes the shareholders would hope to sidestep via a ninth-inning S election.

Caution: The BIG tax calculations are more complicated than I've described here. For example, you actually net built-in gains from appreciation in asset values with net built-in losses from depreciation in asset values. The calculations also require paying the built-in gain tax on some surprising items. What all this complexity and convolution means is probably apparent: The complexities of the BIG tax calculations mean you want an experienced tax practitioner to make these calculations for you. Built-in gain S corporation taxes are not something you deal with on your own using, for example, TaxCut or TurboTax.

One other tidbit to know about the built-in gain tax. The BIG tax only comes into play during the first few (either the first seven or the first ten) years of an S corporation's life. In other words, if an S corporation sells assets with all sorts of built-in gains--but more than ten years after converting to S corporation status--the BIG tax doesn't get levied.

S Corporation Tax #2 - LIFO Recapture Taxes

Most small businesses won't use LIFO inventory accounting--popular small business accounting programs like QuickBooks and Microsoft Small Business Accounting don't even support the LIFO system. But LIFO can save a business taxes. In an inflationary environment, LIFO lets a business slightly overstate its cost of goods sold each year and then slightly understate its ending inventory by a corresponding amount.

Unfortunately, another, BIG-like tax potentially gets levied when an S corporation previously operated as a C corporation and uses the last-in, first-out inventory accounting method. If an S corporation used to be a C corporation and uses the LIFO inventory accounting method, a LIFO recapture tax gets applied to the tax benefits that accrue from using LIFO accounting.

If you're in a situation where the LIFO recapture tax might apply, you should confer with a knowledgeable tax practitioner. I will tell you that often time the LIFO recapture tax means that converting your C corporation to an S corporation is not financially feasible.

S Corporation Tax #3 - Excessive Passive Income Taxes

One other category of S corporation taxes can get levied when an S corporation that previously operated as a C corporation has net passive income (dividends, interest, capital gains, rental income and so on) and, has also retained some of the profits from its old "C corporation years."

In the situation, if the S corporation's net passive income exceeds 25% of its gross receipts for the year, the S corporation pays the highest corporate income tax rate on the net passive income. Furthermore, if an S corporation suffers from the excessive passive income tax three years in a row, the S corporation "S corp status" automatically terminates.

About the author: Tax CPA and bestselling business author Stephen L. Nelson regular writes about S corporation taxes at his website, . Nelson is also the author of QuickBooks 2010 for Dummies.

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