Many private business owners elect to operate as (or convert to) an S corporation to lower taxes. When lenders compare C corporations to S corporations, they may not obtain a complete, accurate picture — unless they understand the key differences and potential risks associated with each type of entity.
S and C corporations use many of the same recordkeeping practices. Both types of entities maintain books, records and bank accounts separate from those of their owners. They also follow state rules regarding annual directors meetings, fees and administrative filings. And both must pay and withhold payroll taxes for working owners who are active in the business.
At first glance, it may be hard to tell which borrowers have elected S status. But there are a few telltale signs of S corporations:
S corporation owners pay tax at the personal level on their share of the corporation’s income and gains. If you ignore the fact that an owner still owes federal tax on an S corporation’s income, you might assume that the S corporation is more profitable than an otherwise identical C corporation. However, the combined personal tax obligations of S corporation owners can be significant at higher income levels.
Other financial reporting differences are more subtle. For instance, when C corporations pay dividends, they’re taxed twice: They pay tax at the corporate level when the company files its annual tax return, and the individual owners pay again when dividends and liquidation proceeds are taxed at the personal level.
When S corporations pay distributions — the name for dividends paid by S corporations — the payout is generally not subject to personal-level tax as long as the shares have positive tax “basis”. (S corporation basis is typically a function of capital contributions, earnings and distributions.)
So, in the equity section of an S corporation’s balance sheet, there may be a sizable line item for shareholder distributions. In fact, S corporation distributions are far more common than dividends for privately held C corporations. There are two reasons: S corporation distributions generally aren’t subject to double taxation, so there’s no tax penalty for making distributions. And S corporations often distribute cash to owners to cover their share of the company’s income taxes (although they’re not required to do so).
To further complicate matters, S corporations may use different strategies from year to year to extract cash from the business. For example, the owners might take quarterly distributions in year 1, use shareholder loans in year 2 and pay higher bonuses in year 3. Such variety makes it difficult for lenders to compare an S corporation’s performance over time — or to other borrowers that operate as C corporations.
C corporations may be tempted to pay owners above-market salaries to get cash out of the business and avoid the double taxation that comes with dividends. Conversely, S corporations tend to do the reverse: They may try to maximize tax-free distributions and pay owners below-market salaries to minimize payroll taxes.
The IRS is on the lookout for corporations that compensate owners too much (or too little) for their day-to-day contributions. Regardless of entity type, an owner’s compensation should always be commensurate with their skills, experience and involvement in the business. The IRS will sometimes turn to executive compensation studies to determine what’s reasonable under Internal Revenue Code Section 162.
If the IRS audits an owner’s compensation, it may impair the borrower’s ability to service debt. For example, to the extent that an S corporation shareholder’s compensation doesn’t reflect the market value of the services they provide, the IRS may reclassify a portion of earnings as unpaid wages. Then the company will owe additional employment tax, interest and penalties on the reclassified wages.
Not every private business is eligible to be an S corporation. In order to elect S status, a borrower must:
All shareholders must consent to the S election by signing Form 2553, Election by a Small Business Corporation.
For businesses that qualify, S corporations offer the best of both worlds. Income and gains from an S corporation are generally not taxed at the entity level; similar to earnings from partnerships and other pass-through entities. S corporations also limit shareholders’ legal liability from lawsuits and creditors, similar to a C corporation. Bankers who understand the ins and outs of these types of entities make better-informed corporate lending decisions.
Have questions about the difference between C corporations and S corporations? Or, are you looking for more information on our commercial lender services, including SBA valuation? Contact Mark Abrams at 404-874-6244 or contact us online.
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