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Text File | 1996-11-06 | 12KB | 263 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
corporations).  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 corporation
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 accounting for
inventories, to the extent of the "LIFO reserve" 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 "excessive 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
       individual, 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 husband
       and wife are counted as only one shareholder,
       regardless of whether they hold the stock in joint
       ownership of any kind).  (The new tax law enacted
       on August 20, 1996 has increased the allowable number
       of shareholders to 75.)

    .  The corporation cannot be a member of an "affiliated
       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 corporation rules.
       (However, the new tax law enacted August 20, 1996 will
       allow an S corporation to own 100% of a "qualified
       Subchapter S subsidiary" corporation.)

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 profits
       in the corporation for expansion or other needs, an
       S corporation election can permit all such profits
       to be paid out to shareholders without double
       taxation, since such dividends are generally tax-free
       (since the stockholders are taxed on the income
       whether or not it is distributed 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 (under
       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 corporations.

    .  S corporations can use the cash method of accounting,
       if desired, unless engaged in a business involving
       the sale of goods, such as wholesale, retail 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
       $121,300 (single filing status; $147,700 for joint),
       or at 39.6% on taxable income over $263,750 (1996
       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 present.
       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 retain
       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
       double taxation of certain "unrealized receivables"
       (receivables of a cash basis taxpayer, for instance).
       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 Revenue Reconciliation Act of 1993 now allows
       a more-than-2% shareholder to deduct 30% 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
       employees 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.  Some limited borrowing by participants is
       permitted in the case of a pension or profit sharing
       plan of a C corporation, by contrast.

    .  The tax treatment of S corporations is inordinately
       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 corporation.

    .  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.
However, 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
shareholders 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
filing 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
corporation converts to C corporation status in mid-year,
the corporation 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
corporations (7.5% or 9%) over the maximum personal income
tax rate.
@CODE:OF
@CODE: VT
However, effective January 1, 1997, S corporations, LLCs,
and partnerships will all become pass-through entities for
state income tax purposes in Vermont.

However, the pass-through entity will be subject to a $150
minimum tax and required to withhold tax from distributions
to shareholders, members or partners at the highest marginal
individual tax rate.  This tax may be credited against the
owner's individual Vermont income tax liability.

Nonresident owners of such pass-through entities are
subject to Vermont income tax on their share of income
from S corporations, LLCs or partnerships operating in
Vermont.
@CODE:OF
@CODE: CT
Certain "separately stated" income is currently taxed to
shareholders in Connecticut, however.  But under 1996 tax
legislation, Connecticut will phase out the entity-level tax
on S corporations by the year 2000.
@CODE:OF