1975, December, Pg. 2463. Electing Subchapter S? Be Careful!.

4 Colo.Law. 2463

Colorado Lawyer

1975.

1975, December, Pg. 2463.

Electing Subchapter S? Be Careful!

2463Vol. 4, No. 12, Pg. 2463Electing Subchapter S? Be Careful!A Subchapter S election, under §§ 1371 through 1378 of the Internal Revenue Code, like most tax-saving devices is no panacea. In enacting §§ 1371 through 1378, Congress clearly had in mind aiding the small businessman by allowing the small businessman to obtain the benefits of incorporation without incurring the imposition of income taxes on earnings at the corporate level. Through the provisions of the referred-to sections, a qualifying corporation can elect not to be taxed as a corporation but, rather, have the earnings taxed, whether or not distributed, at the shareholder level. Thus, the income is taxed only once, or seemingly so. While the following discussion is not intended to be exhaustive of the problems which must be considered in making a Subchapter S election, practitioners advising small businessmen on whether to seek such an election should at least consider the following and discuss them with their clients.

Checklist

1. Be sure that the corporation is one contemplated by the Act; for example, § 1371 provides that there may be no more than 10 shareholders (note that stock held by a husband and wife, as community property, joint property or as tenants in common or by the entirety, is considered to be the stock of one shareholder for purposes of the Act); that shareholders must be individuals or estates; that nonresident aliens are not eligible to be shareholders and that there may be only one class of stock (more than one class is acceptable, provided the only distinction between the classes of stock is the voting rights in electing directors of the corporation).

   In addition, § 1372(e)(5) provides that no more than 20 percent of the corporation's income may be passive in origin. Passive income is construed to be income from royalties, rents, dividends, interest, annuities and sales or exchange of stock or securities. Note, however, that the inclusion of rent in the definition of passive income does not include hotel and motel room rental charges where significant services are rendered to the occupant. Therefore, the business of operating a hotel or motel could qualify for Subchapter S treatment. Moreover, the passive income limitation does not apply...