One of the concepts least understood by many business owners, and even others in the business community, are “S” Corporations.  Although I’ll cover a few of the issues surrounding this entity type, my main goal here is to highlight why, in the vast majority of cases, it makes sense to be treated as an S Corporation for tax purposes.  It’s a decision that all business owners should have already addressed or should be addressing.  Over the years I’ve met business owners who have said that no one in their trusted advisor circle ever raised the issue for consideration.  That’s truly a shame but it’s never too late to consider whether making the election to be treated as an S Corporation for tax purposes makes sense.  I do not plan on getting into the details of who can qualify for “S” status as most contractors will be able to do so.  Further, it always makes sense to consult with the company’s advisors to decide whether “S” status makes sense as certain circumstances may be present (unused NOL carry forwards as one example) whereby it would make sense to retain the C Corporation status.

The S Corporation is a tax concept, it does not affect the liability protection afforded by being incorporated or the accounting and reporting for the business (aside for accounting for income taxes).  I’ve often been asked whether liability protection is diminished and I always give this same answer along with the suggestion that they speak with their corporate legal counsel to gain additional peace of mind.  As “S” status is a tax concept, it affects how tax is assessed and who is responsible for the payment of tax.  An S Corporation is not an income tax paying entity.  The shareholders are responsible for paying the income tax to the government.  The income tax is calculated, and reported, on the shareholders personal tax returns.  The money to satisfy the tax obligation usually comes from the S Corporation itself in the form of a distribution.  As the S Corporation is not an income tax paying entity, any deferred income taxes (including those arising from the use of a tax exempt method such as cash or completed contract basis) will not be the responsibility of the S Corporation and therefore not recorded on the corporate balance sheet as a liability.  Most CPA firms will provide a footnote in S Corporation financial reports stating what the amount of the estimated personal deferred income tax liability is for the shareholders resulting from the S Corporation.  One quick way to calculate this deferred tax amount is to, as long as the balance sheet in the tax return is reported on the tax exempt method (e.g. cash basis), take the difference between percentage of completion based retained earnings in the financial report and retained earnings reported in the tax return and multiply the difference by 40%.  That should provide a reasonable estimate of the deferred tax liability to be paid by the shareholders in the future.

Next time I’ll take you through an illustrative example highlighting the tax differences between selling your construction business as an S Corporation versus a C Corporation via an asset sale, the most likely sale of your business to an outside buyer…