This article is a story about an out-of-state friend and the poor advice and poor service she received from multiple CPAs. The story is told with my friend’s permission with the hope others will heed the warning. Be sure to tell your professional advisors (lawyer, accountant, insurance representative, financial advisor) all of your goals.
My friend (jet’s call her “Nancy”) CPA failed to timely file her “S” Election. For those who do not know, an S Election is a tax election whereby an eligible entity with one class of stock and not more than 100 shareholders, among other requirements, can elect under Subchapter S of Chapter 1 of the Internal Revenue Code (Sections 1361 through 1379) tax treatment similar to that of partnerships, namely, that income passes through to the shareholders of the corporation and is not taxed at the corporate level.
Nancy’s business had previously been formed as an LLC and was taxed as a disregarded entity, as it had just one owner (member). For some reason, her second CPA chose not to change the tax election but instead had her form a new corporation. The S election was then made untimely. Instead of appealing that late filing, the CPA said not to worry about it and they could fix it next year. (There are limited time windows in which to elect “S” status annually.)
The problem with this advice is that Nancy is now trying to sell her business and there is a BIG penalty upon conversion of a C Corp to an S Corp as it relates to appreciated assets. The “built-in gain” (“BIG”) tax rate is 35% on appreciated property sold within ten years of conversion. (This has been scaled back by the American Recovery and Reinvestment Act of 2009 to a seven-year period if the seven-year period preceded 2009 or 2010 and by the Small Business Jobs Act of 2010, to five years, as further set forth in the acts.)
What is the lesson? It is that tax elections have significant consequence and should be considered not only in light of current taxes due, but also in light of taxes due upon disposition.
By Guest Blogger Mary J. Drury, Esq.