Software of the Month Club 1997 March/Software of the Month Club 1997 March.iso/pc/dos/lg/sba/f308.sbe

Text File | 1996-08-23 | 16.2 KB | 474 lines

@Q01

    IS MY COMPANY ELIGIBLE TO ELECT S CORPORATION STATUS?

An "S corporation" is merely 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, its income or losses
pass through to the individual shareholders, who include such
income and (in most cases) such losses on their tax returns.
As such, an S corporation can, in many situations, save a
great deal in income taxes, as compared to a C corporation.
However, there are a number of technical requirements that
must be met to elect "S" status.

  QUESTION:  Is your corporation incorporated in the United
             States? (Or will it be, if your business is not
             now incorporated?)
@YN
01\Q03
02\Q02

@Q02

CONCLUSION:  It appears that your corporation will not
qualify to be an S corporation.  The requirements are
quite strict.

@BR\02

@Q03

INELIGIBLE TYPES OF SHAREHOLDERS:  In general, the stock in
an S corporation can only be held by individual persons or
their estates.

An S corporation cannot have any shareholders that are
corporations or partnerships.  If even one share of its
stock is owned by a partnership or another corporation, or
any other kind of entity other than a natural person (with
certain exceptions for trusts, or the estate of a deceased
person or an estate in bankruptcy), a corporation will not
be eligible to become an S corporation.  Or, an existing S
corporation will lose its "S" status if such an entity
becomes a shareholder.

QUESTION:  Will any of the stock of your corporation be
          owned by a partnership, another corporation, or
          by any other kind of entity (such as a pension
          fund), other than trusts, estates, or individuals?

@YN
01\Q02
02\Q04

@Q04

TRUSTS AS SHAREHOLDERS:  Trusts generally are not permitted
as shareholders of an S corporation, although there are a
few limited exceptions to this general rule.

  QUESTION:  Is any of the stock of your company held by
             a trust?

@YN
01\Q05
02\Q06

@Q05

TRUSTS PERMITTED AS SHAREHOLDERS:  While having a trust as a
holder of its stock will usually disqualify a corporation
from becoming or being an S corporation, there are several
exceptions, as follows:
  . Qualified Subchapter S Trusts.  A special kind of trust
    that makes an election to become such a trust and which
    must meet a number of technical requirements, to hold S
    corporation shares.
  . Grantor trusts or other trusts whose property is treated
    as owned by an individual for tax purposes, such as the
    grantor.  (Also often called "revocable trusts.")
  . Voting trusts, set up to hold stock of a corporation,
    primarily to control the exercise of its voting rights.
  . Testamentary trusts, which receive the stock of an S
    corporation under someone's will.  (But only for the 60
    days after the stock is received.)

QUESTION:  Does the trust that owns stock in your corporation
    come within one of the allowable exceptions listed above?
@YN
01\Q06
02\Q02

@Q06

  QUESTION:  Is any shareholder of your corporation a
             NONRESIDENT alien individual?

@YN
01\Q02
02\Q07

@Q07

AFFILIATED GROUPS OF CORPORATIONS:  An S corporation can't
be a member of an "affiliated group" of corporations, with
a few limited exceptions.

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, don't count stock it owns in
a dormant corporation that has not yet begun business and
has no gross income -- That's O.K.)  But a new law enacted
in 1996 now permits an S corporation to own 100% of certain
"qualified Subchapter S subsidiary" corporations.

  QUESTION:  Is your corporation a member of a group of
             "affiliated corporations"?

@YN
01\Q02
02\Q08

@Q08

PRIOR REVOCATION OF S CORPORATION STATUS:  If your
corporation was previously an S corporation and had its S
corporation election terminated (voluntarily or otherwise),
it may not make another election to become an S corporation
again until it has been a C corporation for five consecutive
taxable years (unless the IRS grants special permission).

  QUESTION:  Has your corporation previously been an S
             corporation, during any of its last 5 taxable
             years?

@YN
01\Q02
02\Q09

@Q09

NUMBER OF SHAREHOLDERS:  An S corporation cannot have more
than 75 shareholders at any given time.  If any of its
shares are held by joint tenants, or by tenants in common,
each such joint owner is counted as a separate shareholder.
However, each husband and wife pair who owns stock in the
corporation, regardless of whether they hold it jointly or
separately (or both), are counted as only one shareholder.
(Thus there could actually be up to 150 stockholders in an
S corporation, if its stock were owned by 75 married
couples.)

  QUESTION:  Are there more than 75 shareholders in your
             corporation, counted as described above?

@YN
01\Q02
02\Q10

@Q10

INELIGIBLE CORPORATIONS:  Certain types of corporations are
ineligible to become S corporations. Ineligible corporations
include:

  . Financial institutions (such as banks);

  . Insurance companies--this would mainly include life
    insurance companies--some casualty insurance companies
    would qualify;

  . DISCs or former DISCs (Domestic International Sales
    Corporations); and

  . Certain corporations that have elected to be Sec. 936
    corporations, that is, elected to be allowed a tax credit
    on income from Puerto Rico and from U.S. possessions.

QUESTION:  Is your corporation an "ineligible corporation,"
         as described in any of the categories listed above?
@YN
01\Q02
02\Q11

@Q11

SECOND CLASS OF STOCK:  A corporation cannot be an S
corporation if it has more than one class of stock
outstanding.  An example would be a corporation that issues
both common stock and preferred stock.  However, just
because the common stock has differences in its voting
rights, such differences won't be considered to result in a
second class of stock, if all the shares of stock are equal
as to rights in the income and assets of the corporation.

Note that debt issued by the corporation, particularly if
the corporation is "thinly capitalized," may be characterized
by the IRS as a second class of stock, if it has "equity"
characteristics.  However, "straight debt" will not be
treated as stock for this purpose.

  QUESTION:  Does your corporation have more than one
             class of stock?

@YN
01\Q02
02\Q12

@Q12

CONCLUSION:  It appears that your business, once it is
incorporated, may be able to elect S corporation status,
since it appears to meet all of the applicable requirements.
(However, many of the rules we have described in this
question-and-answer session are much more complex and
technical than you might suspect -- so consult a good tax
adviser before trying to elect to become an S corporation.)

To elect S corporation status, all of the corporation's
shareholders must consent by signing the election form, IRS
Form 2553.  The S corporation election form 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).  Some states may also require a separate
state filing in order to become an S corporation for state
income or franchise tax purposes.

  QUESTION:  Is your business already incorporated, as a
             C corporation?
@YN
01\Q14
02\Q13

@Q13

That is fortunate.  Then you will not have to worry about a
great many complex problems that can arise upon changing a
C corporation over to S corporation status, provided that
when you do incorporate, you elect S corporation status on
a timely basis for your corporation's first taxable year.

The possible tax problems you will be avoiding by going
directly from unincorporated status to S corporation status
include, among others, a large tax bite if you are currently
using "LIFO" inventories in your business, and potential tax
traps if a C corporation has any "built-in gains" on assets,
or if it generates "passive income" that might be subject
to a tax at the corporate level (despite the S corporation
election).

Fortunately, those problems should not apply to you if
you elect S status immediately after you incorporate your
business.  Nevertheless, S corporations are very complex
beasts, and you need to consult a good tax adviser before
you decide to incorporate and make any S corporation
election.

@STOP

@Q14

FURTHER ADVICE:  Then we STRONGLY advise you to seek the
help of a competent tax adviser who is familiar with S
corporations, before you make an S corporation election.
There are a number of possible tax traps and problems that
may arise when an existing C corporation is converted to an
S corporation.  These would include, among others:

  . Being forced to change from a fiscal tax year to a
    different tax year (the calendar year in many cases).

  . 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 while using LIFO accounting.

  . 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 may be subject to a corporate-level
    tax if disposed of by the S corporation within the next
    10 years.

  . If the C corporation has any "accumulated earnings and
    profits" at the time it becomes an S corporation, the
    S corporation may be subject to a tax on its "excess
    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.  Simple, isn't this?)

 .  Conversion from C corporation to S corporation status
    may result in taxability of amounts paid by the
    corporation for fringe benefits for all shareholders
    owning 2% of more of the stock (for medical, group-term
    life insurance, and disability insurance coverage).

 .  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 could 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.

Electing S corporation status may make great good sense in
many cases, but as the above items hint, the changeover from
C corporation to S corporation is fraught with complexity
and possible booby traps for the unwary (or poorly advised)
taxpayer.

@STOP

@Q15

@STOP

@RD\01
A corporation that is incorporated outside the United States
cannot elect to be an S corporation.  The way to get around
this particular problem would be to re-incorporate your firm
in the United States, if that is feasible.

@RD\03
Ownership of a corporation's stock by certain types of
shareholders, such as corporations, partnerships, most kinds
of trusts, or by non-resident alien individuals will make
that corporation ineligible for S corporation status.

@RD\07
Being a member of an affiliated group of corporations
will gemerally disqualify a corporation from becoming or
remaining an S corporation.  However, there are some
limited exceptions, such as an S corporation holding the
stock of an acquired subsidiary, if the subsidiary is
liquidated to get its assets, within 30 days of acquisition,
or under new tax laws enacted in 1996, the ownership of
100% of a "qualified Subchapter S subsidiary" corporation
by an S corporation is now allowable.

@RD\08
Having had a previous S corporation election makes your
corporation ineligible to elect S corporation status again,
for a period of five taxable years.  However, if you do not
wish to wait this long, you may apply to the Internal Revenue
Service, requesting that they waive this restriction.  You
will need some good reasons to obtain such a waiver, however.

@RD\09
Having over 75 shareholders will prevent your corporation
from electing S corporation status.  However, this is
a problem that can often be overcome, if the number of
shareholders is only slightly over 75, by buying out some
of the smaller shareholders, and placing restrictions on
the stock of the remaining stockholders, thereby limiting
their ability to sell their stock in the future, if such a
sale or other disposition would jeopardize the S corporation
election.

@RD\10
"Ineligible corporations," such as DISCs, former DISCs,
financial institutions, some kinds of insurance companies,
and corporations electing the Section 936 credit, are not
allowed to become S corporations.

@RD\11
A corporation is not allowed to become or remain an S
corporation if it has more than one class of stock.

@HELP

@H\01

Enter "Y" ("YES") if your corporation is
incorporated (or will be) under the laws
of any of the 50 states.  Enter "N" (for
"NO") if it is (or will be) incorporated
in a foreign country.

@H\03

Answer "Y" if any  stock will be held by
another corporation, by a partnership, a
tax-exempt entity of  any kind,  or by a
pension or profit sharing plan.

Answer "N" ("NO") if all of the stock of
the  corporation  will be  held only  by
individual persons or else by estates or
trusts (other than pension plan trusts).

@H\05
A "Qualified Subchapter S Trust" is one
that has all of these characteristics:

 .  Only one current income beneficiary
    at any given time;
 .  All principal distributed must go
    to income beneficiary during term
    of the trust;
 .  Current income beneficiary of the
    trust will have his/her interest
    terminate on earlier of death or
    the termination of the trust, and
    if terminated during his/her life,
    all assets must go to him/her.
@H\06

Note that it is OK for an S corporation
to have alien (i.e., non-U.S. citizen)
stockholders, but only if they are
RESIDENTS of the United States, and
thus fully subject to the pleasantries
of the U.S. income tax system.

@H\07

Also, it is permissible for an S
corporation to acquire and briefly hold
the stock of another corporation in
order to get its assets, if the
subsidiary is liquidated within 30 days
after being acquired.  In that case, the
subsidiary will not be considered an
"affiliate" of the S corporation.

@H\10

"Insurance companies" are companies that
actually issue the insurance;  companies
that merely  SELL (or broker)  insurance
would  not  be  considered  "ineligible"
under  this  definition  of  "ineligible
corporations."

@H\11
"Straight debt"  is debt  issued by the
corporation that has all the  following
characteristics:

 . Evidenced by a written unconditional
   promise to pay a fixed amount on
   demand or at a specified date;
 . Interest rate and payment dates are
   not contingent on profits or on any
   similar factors;
 . Debt is not convertible into stock;
 . The creditor holding the note is an
   individual, estate, etc., that is
   eligible to hold stock in an S
   corporation.
@H\12

A "C corporation" is  a technical term,
but, fortunately,  is a relatively easy
one to understand.  A C corporation is,
quite  simply,  any corporation  (other
than a  not-for-profit  one) OTHER THAN
an "S corporation" (formerly known as a
Subchapter S corporation). Thus if your
business is incorporated,  unless it is
a corporation that has made an election
to be taxed as an S corporation,  it is
considered to be a "C corporation."

@END