Cream of the Crop 1/Cream of the Crop 1.iso/BUSINESS/SBA62.ARJ/FSBA.EXE/F234.SBE

Text File | 1992-04-30 | 10KB | 195 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 cor-
poration 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 corpora-
tion 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 addi-
tion, 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 cor-
poration within the next 10 years.  Furthermore, if the C corporation
had any accumulated earnings and profits, the S corporation may be
subject to a flat 34% 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
       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 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.

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

    .  An S corporation's income is usually taxed only to its share-
       holders, and thus may be taxed at a lower rate, since the
       maximum tax rate on C corporations (34%, or 39% in the "phase-
       out" range) is higher than on individuals, which is now limited
       to 31%, or slightly over 31%.

    .  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.

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 corpora-
       tions 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 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, until 12-31-91.)

    .  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 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 stocks of other
       companies.

@CODE: NY
           ┌───────────────────────────────────────────────┐
           │      NEW YORK TAXATION OF S CORPORATIONS      │
           └───────────────────────────────────────────────┘

New York has recently enacted a corporate-level tax on S corporations,
which is limited to the difference between the corporate tax computed
on the entire net income of the corporation and the tax computed at
the highest individual tax rate for the year.  The new tax became
effective for tax years beginning in 1990.  An annual New York minimum
tax of $325 is now imposed on S corporations, replacing the former $325
filing fee.

@CODE:OF
@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 elimin-
ating the tax on S corporations, California's franchise tax still im-
poses a 2.5% corporate tax on the corporate taxable income, even though
such income is also fully taxable to the shareholders at their indi-
vidual 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.  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 5560 with the California Franchise Tax
Board.

@CODE:EN

@CODE: CT DC NH NJ TN

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

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

@CODE:EN