Community Banking Advisor: Do You “Speak” Both S Corporation and C Corporation?

You likely have a constant stream of customer financial statements passing over your desk (virtual or otherwise) for an evaluation of the borrowers’ creditworthiness. But do you possess enough knowledge about different types of business structures to shine the right spotlight on their diverse financial statements?

Both “Languages” Have Similarities

Both S and C corporations maintain books, records and bank accounts separately from those of their owners and follow state rules about annual directors’ meetings, fees and administrative filings. And both must pay and withhold payroll taxes for working owners in the business.

At first glance, it may be hard to tell which borrowers have elected S status. But there are a few telltale signs. Importantly, S corporations don’t incur corporate-level tax, so they can forgo reporting federal (and possibly state) income tax expense on their income statements. Also, S corporations generally don’t report prepaid income taxes, income taxes payable, or deferred income tax assets and liabilities on their balance sheets. Instead, S corporation owners pay tax at the personal level on their share of the corporation’s income and gains.

The Reporting of Dividends vs. Distributions

Other financial reporting differences are more subtle. For instance, when C corporations pay dividends, they’re taxed twice: They pay tax at the corporate level when the company files its annual tax return, and the individual owners pay again when dividends and liquidation proceeds are taxed at the personal level.

When S corporations pay distributions — the name for dividends paid by S corporations — the payout is generally not subject to personal-level tax as long as the shares have positive tax “basis.” (S corporation basis is typically a function of capital contributions, earnings and distributions.)

So, in the equity section of an S corporation’s balance sheet, there may be a sizable negative line item for shareholder distributions. In fact, S corporation distributions are far more common than dividends for privately held C corporations.

There are two reasons for this: S corporation distributions aren’t subject to double taxation, so there’s no tax penalty for making distributions. And S corporations often distribute cash to owners to cover the owners’ shares of the personal income taxes attributable to the company’s income (although they’re not required to do so).

To further complicate matters, S corporations may use different strategies from year to year to extract cash from the business. For example, the owners might use shareholder loans in year 1, pay higher bonuses in year 2, and take quarterly distributions in year 3. Such variety makes it difficult for lenders to compare an S corporation’s performance over time — or to that of borrowers that operate as C corporations.

Owner Motivation Varies When Setting Salaries

C corporations may be tempted to pay owners above-market salaries to get cash out of the business and avoid the double taxation that comes with dividends. Conversely, S corporations tend to do the reverse: They may try to maximize tax-free distributions and pay owners below-market salaries to minimize payroll taxes.

The IRS is on the lookout for corporations that compensate owners too much (or too little) for their day-to-day contributions. Regardless of entity type, an owner’s compensation should be commensurate with his or her skills, experience and involvement in the business.

If the IRS audits an owner’s compensation, it might impair the borrower’s ability to service debt. For example, to the extent that an S corporation shareholder’s compensation doesn’t reflect the market value of the services he or she provides, the IRS may reclassify a portion of earnings as unpaid wages. Then the company will owe additional employment tax, interest and penalties on the reclassified wages.

Understanding the Ins and Outs

Both S and C corporation business structures offer certain advantages and shortcomings for their owners. It’s your job to make sure you know the nuances of both entity types before you give their loan requests your stamp of approval.