Introduction Tax Information Becoming an S Corporation on ...

1 Publication 589 ContentsCat. No. an S theRequirements of an STreasuryTax 2553 Electing S Corporationon Corporation Income and NonseparatelyStated Items That Affect SFor use in preparingCorporation Income ReturnsS Corporation on Excess Net on Capital on Built-In from Recomputing a Prior-YearInvestment Recapture Form Shareholder on Shareholder s Losses to Corporation with No Earnings Corporation with Earnings S Corporation S Corporation To the Passive Termination Changes for1995 Caution. As this publication was being pre-pared for print, Congress was considering taxlaw changes that could affect your 1995 taxreturn and 1996 estimated taxes.

2 This in-cludes changes to capital gains and Publication 553, Highlights of 1995 TaxChanges, for further developments. Informa-tion on these changes will also be availableelectronically through our bulletin board or viathe Internet (see page 34 of the Form 1040 Instructions).Health insurance for self-employed per-sons. The 25% deduction for health insur-ance costs for self-employed persons hasbeen reinstated for tax years beginning afterOrdering publications and forms. To order1) A member of an affiliated group of publications and forms, call 1 800 TAX rations. Generally, an affiliated groupThe deduction increases to 30% for taxFORM (1 800 829 3676). You can also writemeans one or more chains of corpora-years beginning after 1994.

3 See Health andto the IRS Forms Distribution Center nearesttions connected through stock ownershipaccident insurance under Figuring Share-you. Check your income tax package for thewith a common parent Corporation that isholder Taxable part of the group where:If you have access to a personal computera) The common parent directly ownsand a modem, you can also get many formsstock that possesses at least 80% ofand publications electronically. See How Tothe total voting power of the stock of atIntroductionGet Forms and Publications in your income taxleast one of the corporations,package for eligible domestic Corporation can avoidb) The stock the common parent ownsdouble taxation (once to the Corporation andhas a value equal to at least 80% of theTelephone help.

4 You can call the IRS withagain to the shareholders) by electing to betotal value of the stock of that sameyour tax question Monday through Friday dur-treated as an S Corporation under the rules ofcorporation, anding regular business hours. Check your tele-Subchapter S of the Internal Revenue book for the local number or you canc) One or more of the other corporationsIn this way, the S Corporation passes its itemscall 1 800 829 the group directly owns at least 80%of income, loss, deduction, and creditsof the total voting power of the stockthrough to its shareholders to be included onTelephone help for hearing-impaired per-and at least 80% of the total value oftheir separate returns. Individual shareholderssons.

5 If you have access to TDD equipment,the stock in each of the other corpora-may benefit from a reduction in their taxableyou can call 1 800 829 4059 with your taxtions (except the common parent) inincome during the first years of the corpora-question or to order forms and s existence when it may be operating at aSee your tax package for the hours ofSee Subsidiaries, later, for exceptions to For purposes of determining whether aThis publication discusses how to becomecorporation is a member of an affiliated group,an S Corporation , how an S Corporation maycertain preferred stock is not taken intobe taxed, how income is distributed to , and how to terminate an ) A DISC (Domestic International Salesan S Corporation Corporation ) or former ItemsA Corporation can become an S Corporation if:3) A Corporation that takes the Puerto RicoYou may want to see:and possessions tax credit for doing busi-1) It meets the requirements of S corpora-ness in a United States status,Publication4) A financial institution that is a bank, in-2) All its shareholders consent to S corpora- 15 Circular E, Employer s Tax Guidecluding mutual savings banks, coopera-tion status, 334 Tax Guide for Small Businesstive banks, and domestic building and3) It uses a permitted tax year, or elects toloan associations.

6 535 Business Expensesuse a tax year other than a permitted tax5) An insurance company taxed under Sub- 538 Accounting Periods and Methodsyear, explained later, andchapter L of the Internal Revenue Code. 542 Tax Information on Corporations4) It files Form 2553 to indicate it chooses Scorporation status. 544 Sales and Other Dispositions ofAssetsOne Class of Stock 550 Investment Income and ExpensesFor tax years beginning before May 28, 1992,Requirements of anan S Corporation had more than one class of 551 Basis of Assetsstock if the rights in the profits and assets ofS Corporation 583 Starting a Business and Keepingthe Corporation were not identical for all hold-To qualify for S Corporation status, a corpora-Recordsers of the outstanding stock.

7 Differences intion must meet all the following requirements: 908 Tax Information on Bankruptcyvoting rights were ) It must be a domestic Corporation that isThe one-class-of-stock rules discussed 925 Passive Activity and At-Risk Ruleseither organized in the United States orhere apply to corporate tax years beginning af-organized under federal or state law. Theter May 27, 1992. However, an S corporationForm (and Instructions)term Corporation includes joint-stockand its shareholders can apply these rules tocompanies, insurance companies, and Corporation Income Taxprior years. For more Information , see date, later in this ) It must have only one class of stock. See Income Tax Return for an SA Corporation that has more than one classOne Class of Stock, stock does not qualify as an S Corporation is treated as having only one3) It must have no more than 35 sharehold- 1128 Application To Adopt, Change, orclass of stock if all outstanding shares of stockers.

8 See Counting Shareholders, a Tax Yearof the Corporation confer identical rights to dis-4) It must have as shareholders only individ- 2553 Election by a Small Businesstribution and liquidation proceeds. Stock canuals, estates (including estates of individ-Corporationhave differences in voting rights and still beuals in bankruptcy), and certain one class of stock. For example, a 6251 Alternative Minimum Tax See Trusts, later. Partnerships and corpo- Corporation can have voting and nonvotingIndividualsrations cannot be shareholders in an Scommon stock, a class of stock that can vote 8082 Notice of Inconsistent on certain issues, irrevocable proxyor Amended Return (Administrative5) It must have no nonresident alienagreements, or groups of shares that differAdjustment Request (AAR)) respect to rights to elect members of the 8716 Election To Have a Tax Yearboard of Than a Required Tax YearCertain domestic corporations ineligible.

9 8752 Required Payment or RefundCertain domestic corporations are ineligible toIdentical rights to distribution and liquida-Under Section 7519elect S Corporation status. They are:tion proceeds. Generally, the determinationPage 2of whether stock has identical rights to distri-debt of the Corporation is not prevented frominclude in income the fair market value of thestock at the time of the transfer minus thebution and liquidation proceeds is made basedqualifying as straight paid for the stock. Whether thaton the governing provisions of the corporateStraight debt modified or stock is treated as a second classcharter, articles of incorporation, bylaws, ap-An obligation that originally qualifies asof stock depends on the facts andplicable state law, and binding agreements re-straight debt ceases to qualify to distribution and liquidation ) The obligation is materially modified soDeferred compensation plans.

10 An in-A commercial contractual agreement,that it no longer satisfies the definition ofstrument, obligation, or arrangement is notsuch as a lease or loan agreement, is not astraight debt, ortreated as outstanding stock if:binding agreement relating to distribution andliquidation proceeds, and is not a governing2) It is transferred to a third party who is not1) It does not convey the right to vote,provision unless a principal purpose of thean eligible shareholder in the Sagreement is to get around this ) It is an unfunded and unsecured promisestock provision. Although a Corporation is notto pay money or property in the future,treated as having more than one class ofSecond class of stock.