The Importance of Converting Equity to Capital

Guy Baker By
Guy Baker

MBA, MSFS

 

  1. Introduction
  2. The Beginning
  3. Why have a business entity
  4. To Pass Through or not
  5. Closed Entities and Pass through entities
  6. The benefits of owning a closed entity
  7. The Three Circles of Wealth – The Common Denominator
  8. The Three Big Questions
  9. I. Creating and Retaining Value
  10. II. Keeping Superkeepers
  11. III. Exit Strategies
  12. Additional strategies to build and retain wealth
  13. Conclusion

 

Closed Entities And Pass Through Entities

So, which is better? Since the real issue is how the income of the entity is going to be taxed, the IRS has established the bar for this question. It is called “unreasonable compensation.” Essentially, the IRS has established a principle for all shareholders. Regardless of whether the shareholders are employees or not, they are entitled to earn a fair rate of return on their invested capital. If the executive/shareholder extracts too much compensation from the entity, they are cheating other shareholders of a fair rate of return. Therefore, the IRS places a restriction on how much compensation can be taken – an amount that is deemed to be reasonable. Any amount above that level of compensation will not be deductible as compensation and if distributed, will be considered a dividend and double taxed.

This restriction primarily affects a C corporation. The corporation is forced to pay tax at the corporate level and the shareholder now must pay another tax. The penalty for not following this rule is simple. The IRS caps the compensation and reclassifies the excess as a dividend. It then adds penalties and interest. Some CPAs worry about this problem, others don’t.

How do you avoid this problem? Two ways. One, be aware of the limitation but continue to accumulate earnings in the corporation. (You must be aware of the accumulated earnings tax for excess accumulations. This is a whole other issue). The other way is to convert your entity to a pass-through. If you become an S Corp, then your strategy changes. Instead of taking as much compensation as possible (subjecting all of it to payroll taxes), the shareholder/executive usually tries to suppress their compensation to minimize the payroll taxes and takes excess income as a K-1 distribution. Employing this approach, avoids any excess accumulation problems or unreasonable compensation concerns. All of the income is taxed at the personal level.

Note, personal tax brackets are usually higher than the closed entity tax brackets, but this strategy does avoid the onerous double tax.

Even though the shareholders are proportionately responsible for the tax on 100% of the net income of the S Corp entity, distributions may be limited to only the tax. Why? Primarily so they can leave working capital in the company. Money left in a S Corp is called their AAA account (accumulated adjustment account). Unlike retained earnings in a C Corp (which will always be subject to a second level of tax when distributed), the AAA account has already been taxed, so when it is distributed, it is tax free.

It is possible for a C Corp to convert to an S Corp . But there are a few restrictions which may be of concern. There is a limitation on the number of shareholders, and benefits for shareholder employees have limitations. There are also accounting issues if a C converts to an S, because all trapped gains must stay trapped for 10 years even though the entity becomes a pass through entity. To avoid dealing with this trapped gains problem, you might consider starting a new S Corp from inception and leave the gains alone to avoid increasing them in the future.

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