Taxes and Business Decisions 317This election is recommended in a number of circumstances. One exam-
ple 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
for ward” 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 substan-
tially 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 capital gain tax on the growth in the value of its assets from
their acquisition to the time of sale, 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 sta-
tus, 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 a 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 75 or fewer stockholders holding only one
class of stock, 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 lim-
ited liability companies (LLCs). Unfortunately for Morris, however, a few
states require LLCs to have more than one owner.
Under subchapter S, Morris can pay himself and Lisa a reasonable salary
and then take the rest of the money either as salary or dividend without fear of
challenge. He can then distribute that additional money between Lisa and Vic-
tor, to support their individual lifestyles. Thus, it appears that the effective use
of a strategic taxation tool has solved an other wise costly problem.
Gif t 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 any strategy he adopts, the
gifts of surplus cash he makes to his children may subject him to a federal gift