@163 CHAP 2 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� � S CORPORATIONS � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� 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 34% 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: . An S corporation's income is usually taxed only to its shareholders, and thus may be taxed at a lower rate, since the maximum tax rate on C cor- porations (34%, or 39% in the "phase-out" range) is higher than on individuals, which is now lim- ited to 31%, or slightly over 31%. . 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. 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 a 1992 IRS ruling (Announcement 92-16), such medical premiums may NOT be taxable for FICA (social security and Medicare tax) purpo- ses if 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. 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: NY 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� � NEW YORK TAXATION OF S CORPORATIONS � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� New York has enacted a corporate-level tax on S corpora- tions, which is limited to the difference between the cor- porate tax computed on the entire net income of the corpor- ation 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 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� � CALIFORNIA TAXATION OF S CORPORATIONS � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� 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 on the corporate taxable income, even though such in- come is also fully taxable to the shareholders at their in- dividual tax rates. The minimum annual franchise tax for corporations subject to tax in California is $800. It ap- plies 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 fil- ing Form 3560 with the California Franchise Tax Board. The same form is used to terminate a California S corporation election. @CODE:EN @CODE: CT DC NH NJ TN 旼컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� � STATE TAXATION OF S CORPORATIONS � 읕컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴컴� 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