The economic downturn, coupled with proposals to make the Research and Development Credit permanent, the potential repeal of LIFO, and higher individual tax rates under the Obama administration, could significantly reshape the landscape of S corps over the next several years."For planning purposes, the proposal to make the R&D Credit permanent has significance because it will affect what types of investments companies will make," explained Rick Klahsen, managing director at RSM McGladrey's national tax department. "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. It will cause them to take a look at the types of inventory investments they might make."
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.
"LIFO cuts both ways," observed Rick Thompson, a tax partner at Sikich LLP. "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. Of course, you have to use the same LIFO for financial statements as you do 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."
Potentially the most significant impact will be felt from the higher individual tax rates expected under the new administration, Klahsen said. "Today, the highest rate for both individuals and corporations is 35 percent, so there's parity," he said. "It allows an easy comparison of the possible benefits of S corporation status."
S corporations are generally not taxed at the corporate level; income, losses, deductions and credits are passed through to individual shareholders. "Since losses flow through to the shareholders, they can offset income from other sources," explained Thompson. "And while a partner has to pay self-employment tax on partnership net earnings, S corporation shareholders are not subject to self-employment tax on their share of income."
Although much of the discussion about the proposed rate increase has centered on the fact that it would only affect 2 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 said. "Most of the small businesses they say would not be affected are sole proprietorships. The larger businesses that are S corps 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, noted Klahsen.
"The proposals talk about expanding or extending the carryback provision, but there's not a lot of detail," he said. "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."
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.
THE S ELECTION
Two general rules are often true in making an S election decision, according to Jerry Jonckheere, tax partner at Plante & Moran. "First, the S election may result in more current tax, due to different corporate and state rates that result in higher individual rates than corporate rates, and second, the S election will generally result in significant tax savings if the company is sold," he said.
"With the election of President Obama, we're looking at two possible avenues in which rates will change," opined Jonckheere. "It's expected that individual tax rates for 'wealthy' individuals will increase to 36 percent and 39.6 percent. First, these rates will put the federal individual income tax rate significantly above the corporate tax rates of 34 percent for companies with taxable income below $10 million. Second, there was discussion by both Democrats and Republicans of reducing the corporate tax rate to 30 percent to better align U.S. rates with falling corporate rates overseas. The difference in rates would be a negative factor in analyzing the S election."
On the other hand, the economic downturn may make an S election more valuable, according to Sikich's Thompson: "With values being relatively low in the marketplace, it's an ideal time for C corporations to consider making an S corporation election. ... Today's lower values will ensure that a corporation that makes an S election will have a relatively low built-in gain, and will have minimized its exposure to a potential future built-in gain tax."
Many S corporations are faced with losses, which can flow through to the shareholders and reduce their taxable income, Thompson explained. "However, they have to have basis - you can have all the losses you want, but if you don't have basis you can't have the deduction," he said.
The shareholder can increase basis by putting money into the company in a number of ways, he noted: "Capital contributions in exchange for stock, or accumulating and not distributing profits add to basis. Also, a shareholder loan to the corporation increases basis as well."
"In order to get the basis," he said, "we recommend that the shareholder go to the financial institution and personally borrow the funds, and loan the money to the corporation. The corporation takes the money from the shareholder and pays back the loan. This creates basis for the shareholder."
However, documentation of the loan is critical, according to Thompson. "We recommend that actual checks get written so that the individual steps in the transaction will be respected by the IRS," he said.
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