To convert to S corporation, a corporation conducts an election which has to be conducted after the consent of all the share holders (Traum & Traum, 2008). These elections are held under certain rules and requirements. S corporation is a creation of Congress, which was effected in 1958. S corporation has undergone a transformation in 1982, changing from Subchapter S Corporation to S corporation (Schlesinger, 2007). S corporation has been fine-tuned by the law which has become a vehicle for good business conduct in the United States and further abroad (Schlesinger, 2007). In recent time S Corporation, which is a federal tax hybrid entity has become comparable to limited liability Company which is a state tax hybrid entity. Their operation and concepts resemble each other in spite of few distinctive differences. There are many possibilities that are not available in LLCs, which is not the case in S corporations. S corporation require only one taxpayer to operate. S corporations have a favorable tax treatment as compared to LLC (Schlesinger, 2007).
Personal Service Corporations which meet the qualifications of being S corporations can make S elections such as the ones that have been conducted by Scuba View Inc and The Lost and Found Corporation (Jamison, 2008). However, even after making an S election and becoming an S corporation, the corporation can choose to retain its status as personal service corporations.
An S corporation will be ideal for Scuba View Inc, since it will mean that the Company`s ordinary income and loss will not be taxed at the Company`s level rather, it will have to be approved by the shareholders as in the case of partnerships. For Scuba view Inc, this will not be the only benefit of choosing an S corporation in addition there are other benefits that will accrue to this. Share holders will to approve other things such as Scuba`s foreign income and loss, charitable contributions, passive incomes, and tax-exempt interest. One-level taxation which is associated with the S corporation has made this option a desirable choice for many corporations, where they avoid the technicalities associated with of “regular Form 1120 corporations` (C corporations). Scuba will escape tax on surpluses that accumulate over a period of time, other forms of taxation such as personal holding company taxation, and disguised dividends.
There are many advantages that Scuba will enjoy for choosing to go the S corporation way. For instance, taxpayers will contribute assets to Scuba View Inc tax free. This will be made possible if the Corporation meets some certain requirements. For example, if a certain taxpayer contributes a real estate to Scuba View Inc in exchange for 40 percent of its stock. If the taxpayer`s tax basis for her real estate stands at $200,000 its fair market value is $300,000. If the real estate is encumbered by $250,000 mortgage, it is clear that the mortgage exceeds the taxpayer`s basis in the property. Therefore, the taxpayer must recognize a $50,000 gain upon the transfer of his property to Scuba View Inc. Here, the character of the gain depends on the nature of the property which is the real estate prior to its transfer. Let`s take that it was a capital asset. The nature of the gain will be capital.
Another benefit that will accrue to Scuba is that, in case the Corporation has debts it will have only to meet the statutory worldwide creditor protection requirement. This requires the corporation to be Domestic Corporation, and observe the company`s formalities such as observing annual general meetings for its shareholders (Schlesinger, 2007). Apparently, this is the only body where the corporations are protected, and this has made S corporation a business vehicle of choice.
The federal law requires the corporations to be double taxed. However, if Scuba View Inc adopts the S corporation way, it will avoid double taxation because it will convert to a corporation which will be taxed at the shareholders level. This is not usually the case in C corporations where income is taxed twice. Re-characterization of items is not applied on S corporations. For instance, If Scuba View Inc was an S corporation it`s charitable contributions of $10,633 would avoid a 10 percent limitation that is usually imposed on the C corporations (Schlesinger, 2007). Scuba View Inc will avoid the re-characterization of these pass-through items.
In case Scuba experiences heavy start-up losses at the beginning of a financial year, these losses will be deductible in that year. A benefit of not paying alternative tax will accrue to Scuba if it chooses S corporation. Schelinger (2007) states that `S corporation shareholders include in their alternative minimum tax calculation the pass through of preference items to determine if they are liable for any alternative minimum tax`. If S corporation does not have C corporation profits, it will comfortably engage in total passive investments without being taxed adversely or having additional tax liabilities. Therefore, Scuba View Inc will be able to engage in other passive investment activities regardless of the number of its shareholders and the amount of its passive investment income of its dollar without the fear of extra tax impositions.
Under S corporation, if Scuba View Inc it will comfortably conduct foreign operations directly. It will operate directly because currently there is no restriction on the amount of foreign income that an S corporation can earn. Scuba can also `conduct business indirectly through a foreign branch` (Traum & Traum, 2008). The benefits that accrue to conducting business outside the United States are the same as the ones that accrue in conducting business in United States. In both cases the income and losses, credits, and deductions are passed to the shareholders (Traum & Traum, 2008). Traum & Traum (2008), states that being an S corporation that conducts business outside the United States, the corporation will enjoy the elimination of corporate taxes and also the elimination of Sec. 884 branch-profits on income effectively that is usually connected to the United States trade.
Adoption of S corporation status will make Scuba View Inc shareholders pay their taxes at the shareholders level only. The operation within an S corporation status produces significant tax savings. The express requirement under Radtke Court is that shareholders should be paid reasonable salaries. However, this requirement of leaving the decision of `reasonable salary` open and having not been defined leaves it free from Federal Insurance Contributions Act (FICA) (Schlesinger, 2007). However, the shareholders` aggressiveness has increased, with the shareholders pursuing distribution of salaries. They are pursuing FICA tax rate which currently stands at 15 percent (Schlesinger, 2007). Distribution is the payment of shareholder`s interests in property other than unrealized receivables and goodwill (Schenk, 1985).
In S corporations, shareholders stand to gain on their part. Capital gains are created at the end of each tax year. This shields the taxpayer from carrying forward the capital losses subject to limited deductibility of $3,000 per year (Schlesinger, 2007). In case of cash-tightness, The Lost and Found Corporation can borrow money to create the distribution. The Lost and Found can not effect such a thing in a partnership or in LLC because that debt will raise the basis of the partner.
Although Scuba View Inc and Lost and Found Corporation will derive lots of benefits from converting to S corporation, there are few disadvantages related to S corporations. The shareholders are often subjected to rigid election procedures and there may be mixed feelings from the shareholders due to its elections nuisance provisions and the shareholders may choose to forego the S corporation status (Jamison, 2008). These corporations may have to cut the number of shareholders because there is a requirement for S corporations to have a limited number of shareholders. The ability of Scuba and Lost and Found Corp to shelter certain fringe benefits on behalf of shareholders and employees may be limited. They will loose their right to exemption from the alternative minimum tax which is provided to C corporations which have a limited taxable income not exceeding $5 million (Jamison, 2008).
Finally, Scuba View Inc and Lost and Found Corporation charters will have to have one class of stock. In a case where their corporate charter may provide for two classes of stock, the shareholders will have to use bylaws or other agreements to override the provisions of the charter. In a case where they might have provided one class of stock, the shareholders can create a second class by a binding agreement (Jamison, 2008).
Traum. E. & Traum. J. (2008). The S Corporation Answer Book, Book 2009. Aspen Publishers Online.
Jamison, R. (2008). S Corporation Taxation 2009. Chicago: CCH.
Schenk, D. (1985). Federal Taxation of S Corporation. New York: Law Journal Press.
Schlesinger, M. (2007). Practical Guide to S Corporations (4th Ed). Chicago: CCH.