The economic downturn, coupled with recent legislation and budget proposals, could impact a company's decision to elect or maintain its status as an S corporation. Proposals to make the R&D Credit permanent, the potential repeal of LIFO, and higher individual tax rates under the Obama administration could also shape the landscape of S corps over the next several years.

"The proposal to make the Research and Development Credit permanent has significance because it will affect what types of investments companies will make," explains Rick Klahsen, managing director at RSM McGladrey's national tax department in Minneapolis. "However, the proposed repeal of the LIFO inventory method would have a tremendous negative impact on S corporations. Many S corporations are manufacturers, and the loss of the LIFO method will cost them in terms of additional taxable income."

'Cuts Both Ways'

The Obama administration's proposed budget includes a "line item" (with no discussion) repeal of LIFO that it projects as a $61 billion offset to the federal deficit through 2019.

Notes Rick Thompson, a tax partner at Sikich in Aurora, Ill. "It lowers income by increasing the cost of goods sold in inflationary times, and it can be a good option for clients because it can be elected after the end of the year. You have to use the same LIFO for financial statements as on the tax return. If there's less income to show the government, that's good, but if there's less to show banks for borrowing purposes, that's bad."

The most significant impact could be felt from higher individual tax rates. Says Klahsen, "Today, the highest rate for both individuals and corporations is 35 percent, so there's parity. It allows an easy comparison of the possible benefits of S corporation status."

S corporations are generally not taxed at the corporate level, but income, losses, deductions, and credits are passed through to individual shareholders, explains Thompson.

Hidden Impact?

Although much of the discussion about the proposed rate increase has centered on it only potentially affecting two percent of taxpayers, it fails to consider the impact this might have in the marketplace, according to Klahsen. "These are companies that employ the most people," he says. "Most of the small businesses they say would not be affected are sole proprietorships. The larger businesses that are S corporations would be affected by the impact on net cash flow. To the extent that there will be less available cash, it will impact decisions on employment, inventory, investments in business and capital assets."

The recommendation in the recent budget proposal to expand the five-year 2008 NOL carryback provision for qualified small businesses would be very favorable to many S corporations, notes Klahsen. "The proposals talk about expanding or extending the carryback provision, but there's not a lot of detail," he says. "The initial Senate and House provisions actually allowed far more businesses to take advantage of that carryback, but the provision was pared down in conference committee. It's hard to tell from the budget language what the proposed extensions will be. They could extend the applicable NOL from 2008 to 2009 and 2010, or they could apply the provision to more businesses." Currently, the extended NOL is permitted only for businesses that average $15 million in gross revenue for the three-tax-year period ending with the tax year in which the loss arose.

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