Monster Media 1996 #14/Monster Media No. 14 (April 1996) (Monster Media, Inc.).ISO/business/sba961.zip/F234.SBE

Text File | 1996-01-01 | 11KB | 239 lines

@163 CHAP 2

              ┌───────────────────────────────────┐
              │           S CORPORATIONS          │
              └───────────────────────────────────┘

An "S corporation" is just a regular corporation that has
made an election on Form 2553 for federal tax purposes to
be taxed in a different way than other corporations (C cor-
porations).  Under state law, an S corporation provides the
same degree of limited liability as any other corporation.
In general, an S corporation is simply a corporation that
elects not to be taxed AT ALL. Instead, all of its income
or losses pass through to the individual shareholders, who
include such income and (in most cases) such losses on
their tax returns.

While S corporations are generally not taxable, a corpor-
ation that was previously a C corporation and elects to
change over to an S corporation may find itself immediately
subject to tax if it previously used the LIFO method of ac-
counting for inventories, to the extent of the "LIFO re-
serve" or deferral that it had built up previously.  In
addition, any "built-in" gains on assets that have a value
greater than their tax basis at the time of the changeover
to S corporation status will be subject to a corporate-
level tax if disposed of by the S corporation within the
next 10 years.  Furthermore, if the C corporation had any
accumulated (undistributed) earnings and profits, the S
corporation may be subject to a flat 35% tax on its "ex-
cessive net passive income" if more than 25% of its gross
receipts are from passive investment income (not to be
confused with "income from passive activities" under the
"passive loss" rules).

To qualify as an S corporation, a corporation must meet the
following requirements:

    .  All of the shareholders of the corporation must
       elect, on Form 2553, for the corporation to be
       taxed as an S corporation.  The S corporation
       election must be filed not later than the 15th
       day of the third month of the tax year for which
       it is to go into effect (that is, March 15th, in
       most cases).

    .  It must be incorporated in the United States.

    .  No shareholder can be a non-resident alien indi-
       vidual, another corporation, or a partnership.
       All shareholders must be individuals (or their
       estates), except for certain grantor (revocable)
       trusts and "Qualified Subchapter S Trusts."

    .  The corporation can have only one class of common
       stock, and no preferred stock.  A mere difference
       in voting rights between different common shares
       is disregarded for purposes of this rule.

    .  There cannot be more than 35 shareholders (a hus-
       band and wife are counted as only one shareholder,
       regardless of whether they hold the stock in joint
       ownership of any kind).

    .  The corporation cannot be a member of an "affilia-
       ted group" of corporations.  Thus, for example, if
       it owns 80% of the stock of another corporation,
       it will not be able to qualify under the S corpor-
       ation rules.

S corporations enjoy a number of advantages over regular
("C") corporations:


    .  Where the nature of the business is such is that
       there is no need to accumulate significant prof-
       its in the corporation for expansion or other
       needs, an S corporation election can permit all
       such profits to be paid out to shareholders with-
       out double taxation, since such dividends are
       generally tax-free (since the stockholders are
       taxed on the income whether or not it is distri-
       buted to them).

    .  If a business is operating at a loss, the loss
       can be passed through to the shareholders, and
       generally deducted by them if they are considered
       to "materially participate" in the business (un-
       der the passive loss rules).  No such pass-through
       of losses to shareholders is possible with a C
       corporation.

    .  S corporations are not subject to the accumulated
       earnings tax or the personal holding company tax,
       either of which can be a tax trap for C corpora-
       tions.

    .  S corporations can use the cash method of account-
       ing, if desired, unless engaged in a business in-
       volving the sale of goods, such as wholesale, re-
       tail or manufacturing.

    .  An S corporation's income is usually taxed only
       to its shareholders, and thus may be taxed at a
       lower rate, since there is little possibility
       that it will be double-taxed, as in the case of
       a C corporation.  (On the other hand, however,
       the maximum tax rate on C corporations (generally
       34%, or 39% in the "phase-out" range between $100,000
       and $335,000 of income) is now somewhat lower than on
       individuals, who are now taxed at 36% on income over
       $117,950 (single filing status; $143,600 for joint),
       or at 39.6% on taxable income over $256,500 (1995
       brackets).


Disadvantages of an S corporation election include:

    .  Possible triggering of immediate taxable income,
       if formerly operating as a C corporation and using
       the LIFO method of valuing inventory.

    .  S corporations are allowed to elect a fiscal tax
       year only in certain special situations at pres-
       ent.  Even pre-existing S corporations that were
       on fiscal years were required by the Tax Reform
       Act of 1986 to change over to calendar years in
       1987, unless they made a special election to re-
       tain their fiscal year (on Form 8716) by August
       25, 1988.  New S corporations may not generally
       make this special election, unless they elect a
       deferral period of no more than 3 months (that
       is, a fiscal year that ends in either September,
       October, or November).

    .  Possible tax traps such as, for example, the dou-
       ble taxation of certain "unrealized receivables"
       (receivables of a cash basis taxpayer, for in-
       stance).  Collection of such receivables will not
       only result in taxable income which passes through
       to the shareholders, but may also give rise to a
       corporate-level tax as "built-in gains," where
       such receivables were earned by the corporation
       while it was still a C corporation.

    .  Taxability of fringe benefits provided for 2% (or
       greater) shareholders.  Thus, premiums paid for
       medical, disability or group term life insurance
       that would be tax-free to employee-shareholders
       of a C corporation are taxable to them in the case
       of an S corporation except for those employees who
       are not shareholders (or 2% or lesser shareholders).
       (The 1990 Revenue Reconciliation Act now allows a
       more-than-2% shareholder to deduct 25% of medical
       insurance, the same as for a self-employed person.
       Note that under an IRS ruling (Announcement 92-16),
       such medical premiums may NOT be taxable for FICA
       (social security and Medicare tax) purposes if the
       payments are made under a plan or system for emplo-
       yees of the company generally (but will still be
       taxable for INCOME tax purposes to the more-than-2%
       shareholders for whom the premiums are paid).

    .  Employee-owners of an S corporation may not borrow
       at all from a pension or profit sharing plan set
       up by the S corporation.  Any such loan is subject
       to a "prohibited transactions" excise tax of 5% or
       more.  Limited borrowing by participants is per-
       mitted in the case of a pension or profit sharing
       plan of a C corporation, by contrast.

    .  The tax treatment of S corporations is inordinate-
       ly complex!  Thus, just to comply with the tax law
       and avoid falling into various tax traps, you will
       probably need to incur extra professional fees for
       top-flight tax advisors, if you have an S corpora-
       tion.

    .  An S corporation is not eligible for the 70% (or
       80%) "dividends received" deduction that other
       corporations are allowed on the dividend income
       they receive from investing in the stock of other
       companies.
@CODE: CA

        ┌───────────────────────────────────────────────┐
        │     CALIFORNIA TAXATION OF S CORPORATIONS     │
        └───────────────────────────────────────────────┘

After many years of not following the federal tax treatment
of S corporations, California finally conformed, generally,
in 1987, to the federal treatment of S corporations.  How-
ever, instead of eliminating the tax on S corporations,
California's franchise tax still imposes a 2.5% corporate
tax (1.5%, starting in 1994) on corporate taxable income,
even though such income is also fully taxable to the share-
holders at their individual tax rates.  The minimum annual
franchise tax for corporations subject to tax in California
is $800.  It applies to S corporations as well as regular
corporations (and limited partnerships).  S corporations
are required to make estimated tax payments of California
franchise tax.

A corporation that is an S corporation need not necessarily
be an S corporation for California purposes also, unless so
desired.  If your company is an S corporation for federal,
but not state purposes, and you wish to elect S status for
California purposes also, you must make an election by fil-
ing Form 3560 with the California Franchise Tax Board.  The
same form is used to terminate a California S corporation
election.

Note that the FTB takes the position that, if an S corpora-
tion converts to C corporation status in mid-year, the cor-
poration must file two short-period tax returns, and thus is
required to pay the annual minimum franchise tax TWICE for
that year (once for each of the two short taxable years).

@CODE:OF

@CODE: CT DC NH NJ NY TN VT

        ┌───────────────────────────────────────────────┐
        │        STATE TAXATION OF S CORPORATIONS       │
        └───────────────────────────────────────────────┘

While most states recognize S corporations in some fashion
similar to the federal tax treatment, no special treatment
or exemption from tax is accorded to S corporations in
@STATE, generally.

@CODE:OF
@CODE: NJ
However, the New Jersey tax on S corporations is set at a
low rate, equal to the excess of the tax rate on C corpora-
tions (7.5% or 9%) over the maximum personal income tax rate.
@CODE:OF