Software of the Month Club 1996 May/Software of the Month Club 1996 May.iso/mac/ISO9660/ZIPFILES/SBA962.ZIP/F308.SBE

Text File | 1996-02-15 | 16.0 KB | 467 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 corpora-
tions).  Under state law, an S corporation provides the same
degree of limited liability as any other corporation. In gen-
eral, 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 in-
come 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 qual-
ify 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 cor-
porations 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 cer-
tain exceptions for trusts, or the estate of a deceased per-
son or an estate in bankruptcy), a corporation will not be
eligible to become an S corporation.  Or, an existing S cor-
poration 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 cannot
be a member of an "affiliated group" of corporations.  Thus,
for example, if it owns 80% of the stock of another corpora-
tion, it will not be able to qualify under the S corporation
rules.   (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.)

  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 corpora-
tion was previously an S corporation and had its S corpora-
tion 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 tax-
able 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 35 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 70 stockholders in an
S corporation, if its stock were owned by 35 married
couples.)

  QUESTION:  Are there more than 35 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 cred-
    it 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 corpora-
tion 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 character-
ized 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 incor-
porated, may be able to elect S corporation status, since it
appears to meet all of the applicable requirements.  (How-
ever, 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 try-
ing to elect to become an S corporation.)

To actually elect S corporation status, all of the corpora-
tion'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

Good.  Then you will not have to worry about a great many
complex problems that can arise upon changing a C corpora-
tion 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 di-
rectly 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 busi-
ness.  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 cor-
porations, 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 cor-
    poration that was previously a C corporation and elects
    to change over to an S corporation may find itself im-
    mediately 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 great-
    er 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 re-
    ceipts 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 corpora-
    tion for fringe benefits for all shareholders owning 2%
    of more of the stock (for medical, group-term life in-
    surance, and disability insurance coverage).

 .  Possible tax traps such as, for example, the double
    taxation of certain "unrealized receivables" (receiva-
    bles of a cash basis taxpayer, for instance).  Collec-
    tion of such receivables will not only result in tax-
    able 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 share-
holders, 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
disqualify a corporation from becoming or remaining an S
corporation (although 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 as-
sets, within 30 days of acquisition).

@RD\08
Having had a previous S corporation election makes your cor-
poration 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 35 shareholders will prevent your corporation
from electing S corporation status.  However, this is a
problem that can often be overcome, if the number of share-
holders is only slightly over 35, by buying out some of the
smaller shareholders, and placing restrictions on the stock
of the remaining stockholders, thereby limiting their abil-
ity 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, fin-
ancial institutions, some kinds of insurance companies, and
corporations electing the Section 936 credit, are not al-
lowed to become S corporations.

@RD\11
A corporation is not allowed to become or remain an S cor-
poration 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 in-
dividual 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 (non-U.S. citizen) stock-
holders, but only if they are RESIDENTS
of the  United States,  and thus  fully
subject to the U.S. income tax system.

@H\07

Also, it is permissible for an S corpor-
ation to  acquire and  briefly hold  the
stock of another corporation in order to
get its assets, if the subsidiary is li-
quidated within 30 days  after being ac-
quired.   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 of the follow-
ing 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 cor-
   poration.
@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, unless
your corporation  is one that  has made
an election to be taxed as an S corpor-
ation,  it is an C corporation.  There-
fore,  answer this  question "N" ("NO")
only if your  company is an  S corpora-
tion, or is not a corporation at all.

@END