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Subchapter S Corporations and Why I Hate Them

By Rob Lambert - Email Editor

Date: Feb 02, 2006

I am glad to be back to my series of newsletters on pass through entities. Today I take on my least favorite entity: the subchapter S corporation.

I say this with a bit of a sardonic grin because Asset Protection Corporation is a subchapter S corporation. Why, if I hate them so much, would my “baby” be a subchapter S corporation? The answer is simple. My accountant, like most good accountants, thought it would save me some self-employment tax.

The argument goes as follows: The accountants point out that stock dividends received by subchapter S corporation shareholders are NOT subject to self-employment tax, while, with pass through entities such as LLCs, the member must pay self-employment tax on his share of company profits (this is 15.3 percent of the first $94,200 of income and 2.9 percent thereafter and forever…at least for that year). The accountants believe that by making the small business owner an employee of the subchapter S corporation and setting his salary on the low end of “reasonable,” any dividends in excess of this reasonable compensation level are not subject to self-employment tax. As you can see, the savings can mount up.

Shouldn’t I love subchapter S corporations because they can save on some self-employment tax? Normally, the answer would be "yes". However, I can’t get over two serious hurdles. First, I don’t really understand how subchapter S corporations are taxed. This should be simple; however, after years of teaching subchapter S taxation as an Assistant Professor at the University of Southern California, I can only say that subchapter S corporations are a never-ending mystery to me. Only a few tax folks (like my CPA) who are on the lunatic fringe of tax accounting can even begin to explain critically important subchapter S corporation issues like “inside” versus “outside” basis (this calculation can make a huge difference if you sell or merge your company). Secondly, and most importantly, subchapter S corporations CANNOT be owned by Foreign Trusts. Thus, a subchapter S corporation is a terrible entity if it owns anything that you need to protect from creditors. Does this matter to me? No, because Asset Protection Corporation, like most personal service companies, has little or no value apart from myself.

One important rule: NEVER use a subchapter S corporation for an entity that will hold assets you want to protect.

Here is another interesting side light to subchapter S corporations: Did you know that a plain old LLC can elect to be taxed as a subchapter S corporation? This is done by first having the LLC elect corporate status (Form 8832) and then having it elect subchapter S status (Form 2553).

An LLC is arguably a more difficult entity to pierce. It has a simpler management structure which works via an operating agreement. An LLC does not always need officers and directors. Formalities are simply less important with LLCs. Thus, with a small and simple operation the LLC electing to be taxed as a subchapter S corporation is simpler to operate.

One thing that sets LLCs apart from normal subchapter S corporations for Asset Protection purposes is that LLCs can be formed anonymously. Simply stated, unless and until the predator after you discovers your tax returns, it is difficult or impossible to discover the fact that you own the LLC for tax purposes.

I hope this is helpful. It is just a tidbit…but it gives you something solid to think about until next week.

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