Electing to establish an S corporation could unlock the tax benefits enjoyed by millions of small business owners — as long as financial advisors and clients avoid some pitfalls.
Those include the ramifications of filing for deductions on the pass-through entity’s so-called qualified business income, the requirement of one single class of stock for the company’s equity and the implications of the S corp holding real estate, according to Tal Binder, CEO of
The caveats of S corp classification
For advisors and their clients, the S corp entity classification — named after Subchapter S of the Internal Revenue Code as a “Subchapter S corporation” or a “Small Business Corporation” — represents an opportunity with some tradeoffs.
“Instead of thinking about it as just a tax structure, think about it as a tool — it’s a tool in the toolbox when you’re doing tax planning or tax strategy,” Binder said in an interview. “The S corp has a lot of tax benefits. It just becomes more complicated as you dig into the specifics and the numbers.”
Business owners and their advisors have likely run into those challenges in any number of situations — Binder noted that professional services firms such as a small wealth management company usually make the best candidates to be S corporations. The entity classifications of registered investment advisory firms
Most service-based businesses do elect to be S corporations, according to Miklos Ringbauer, the founder of Los Angeles-based tax firm
“You have to understand the state rules first — before you look at tax structure,” Ringbauer said in an interview. “Where we shine as tax professionals is providing that value, that guidance to the taxpayers, the investors to make the right choices, to help them to decide what is the best, optimized tax structure for their operation.”
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History to of S corporations
And tax pros have been doing so for decades.
Almost 70 years ago, small business owners gained the exemption from double taxation on corporate income flowing to their personal returns to
“How significant was the creation of subchapter S?” it asked. “Consider that in 1958, the top income tax rate was 52% for corporations and 91% for individuals. That means dividends paid by a C-corporation to a high-income shareholder faced an effective tax rate of 96% Even a shareholder with median family income faced an effective federal tax of more than 60%.”
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Potential downsides to S corp entities
The savings to the owners of S corporations add up in the right circumstances, but laws and individual tax implications could call for a sole proprietorship, partnership, limited liability company or a C corporation as a better fit.
In the case of a pass-through business tapping into the deduction
As another caveat to the S corporation, certain RIAs launch when advisors team up, but one of the advisors may bring a much more substantial base of clients to the business. That would suggest that one of the owners should have more control of the firm than the other, even if they each own half of the RIA, Binder said. They couldn’t set up the business that way as an S corporation that can only have one class of stock, though.
“It doesn’t make sense, because you started it and built it for many, many years,” he said. “That might disqualify the S corp, so it’s not best in those cases.”
He brought up the additional problematic use of the structure with the idea of an S corporation RIA holding the building housing the business in the same entity, which is “the right approach” from the perspective of the general tax savings for real estate assets but “in the vast majority of cases not beneficial to you,” Binder said. The real estate could bring higher payments to Uncle Sam for an S corporation, based on the rules for tax basis and mortgage financing.
An LLC or LLP structure also provides more flexibility than an S corporation for transferring the real estate asset out of the business and into the client’s personal holdings without generating a taxable event, Ringbauer noted. From the perspective of a startup company that must take out heavy loans for capital expenses while incurring business losses in the first few years after launch, the S corporation could further cap the level of deductions — far below the amount available to an LLC or LLP, he said.
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Don’t go it alone on business-entity decisions
Unfortunately, many business owners attempt to choose their entity based on a simple online search or even a question to a public chatbot, according to Ringbauer.
“There’s a lot of incorrect information out there, which would result in incorrect guidance on how to treat stuff,” he said. “It’s a personal preference, but if it is properly guided, then the individuals who are starting the business will be able to make the right choice.”
In that vein, advisors who might otherwise avoid any mention of tax-related topics that fall
“I’d highly recommend the wealth manager to partner with a competent tax professional or CPA firm,” he said.
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