@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 flat 34% 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 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