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usiness corporation for all purposes other than taxation (retaining its ability to grant limited liability
to its stockholders, for example). The corporation elects to forgo taxation at the corporate level and to
be taxed similarly to a partnership. This means that a corporation that has elected subchapter S status
will escape any taxation at the corporate level, but its stockholders will be taxed on their pro rata share
of the corporation‟s profits, regardless of whether these profits are distributed to them. Under this
election, Morris‟s corporation would pay no corporate tax, but Morris would pay income tax on all the
corporation‟s profits, even those retained for operations.
This election is recommended in a number of circumstances. One example is the corporation that
expects to incur losses, at least in its start-up phase. In the absence of a subchapter S election, such
losses would simply collect at the corporate level, awaiting a time in the future when they could be
carried forward to offset future profits (should there ever be any). If the election is made, the losses
would pass through to the stockholders in the current year, and might offset other income of these
stockholders, such as interest, dividends from investments, and salaries.
Another such circumstance is when a corporation expects to sell substantially all its assets sometime
in the future in an acquisition transaction. Since the repeal of the so-called General Utilities doctrine,
such a corporation would incur a substantial income tax on the difference between the value of its
assets at the time of sale and their depreciated basis on the corporation‟s books, in addition to the
capital gain tax incurred by its stockholders when the proceeds of such sale are distributed to them.
The subchapter S election (if made early enough) again eliminates tax at the corporate level, leaving
only the tax on the stockholders.
The circumstance most relevant to Morris is the corporation with too much profit to distribute as
reasonable salary and bonuses. Instead of fighting the battle of reasonableness with the IRS, Morris
could elect subchapter S status, thus rendering the controversy moot. It will not matter that the amount
paid to him is too large to be anything but a nondeductible dividend, because it is no longer necessary
to be concerned about the corporation‟s ability to deduct the expense. Not all corporations are eligible
to elect subchapter S status. However, contrary to common misconception, eligibility has nothing to
do with being a small business. In simplified form, to qualify for a subchapter S election, the
corporation must have only one class of stock, held by 100 or fewer stockholders, all of whom must be
individuals who are either U.S. citizens or resident aliens. Plant Supply qualifies on all these counts.
Alternatively, many companies have accomplished the same tax results, while avoiding the
eligibility limitations of subchapter S, by operating as limited liability companies (LLCs).
Under subchapter S or as a LLC, Morris can pay himself and Lisa a reasonable salary and then take
the rest of the money either as salary or as a dividend without fear of challenge. He can then distribute
that additional money between Lisa and Victor, to support their individual lifestyles. Thus, it appears
that the effective use of a strategic taxation tool has solved an otherwise costly problem.
Gift Tax
Unfortunately, like most tax strategies, the preceding solution may not be cost free. It is always
necessary to consider whether the solution of one tax problem may create others, sometimes
emanating from taxes other than the income tax. To begin with, Morris needs to be aware that under