Chapter 12 - § 12.2 • INCOME TAX — CORPORATIONS

• Jurisdiction: Colorado

§ 12.2 • INCOME TAX — CORPORATIONS

Corporate taxation will be important to LLCs and their owners where the LLC elects to be treated as an association taxable as a corporation. Furthermore, there are potential benefits to corporate tax treatment in connection with the sale of an LLC by its owners if the transaction can be structured as a tax-free corporate reorganization. Finally, clients sometimes will want to have a discussion of the comparative tax treatment before choosing whether to seek corporate or partnership taxation for their business. For these reasons, a brief discussion of corporate taxation is included in this § 12.2.

§ 12.2.1—C Corporations in General

The difference between a C corporation and an S corporation is purely a federal income tax distinction. Under state law (and in Colorado, that means the Colorado Business Corporation Act (CBCA)), there is no difference between a C corporation and an S corporation.²³⁰

Every corporation formed under the CBCA will be a C corporation unless it elects to be taxed as an S corporation.²³¹ A C corporation is a separate taxpayer and will owe tax at corporate rates on its taxable income. See § 12.2.4, "Taxation of Operations — C Corporations." Shareholders receiving dividends will also be paying tax on those dividends. This results in what is generally referred to as "double taxation" — where the corporation first pays taxes on its income, and then distributes a portion of that income to its shareholders, who pay tax on the dividends. Each dollar distributed will have had two different tax assessments against it.

Privately held corporations attempt to avoid this double taxation by reducing income at year end to zero by paying expenses and bonuses to their owner-employees. (Salaries and bonuses are deductible only to the extent they constitute reasonable compensation for services rendered.)²³² This brings up the tension between deductible expenses and non-deductible payments. Where the corporation has to repay a loan, principal payments are non-deductible, but principal payments reduce cash available to pay expenses, which reduces income. Other expenses incurred by a corporation are not deductible on a dollar-for-dollar basis. For example, a corporation may only deduct 50 percent of entertainment expenses.²³³ In many cases, to reduce income to zero (thereby avoiding corporate income tax), the corporation will have to borrow more money to pay expenses to reduce income.

§ 12.2.2—S Corporations in General

A corporation will be an S corporation only if it so elects by filing Form 2553 and all shareholders consent to the election.²³⁴ As discussed in "Numeric Limitation on Number of Shareholders," below, an S corporation cannot have more than 100 shareholders and cannot have shareholders who are nonresident aliens or (with certain exceptions) persons other than individuals.

Numeric Limitation on Number of Shareholders

An S corporation may not have more than 100 shareholders.²³⁵ For purposes of this limitation, a husband and wife (and their estates) and all members of a family (and their estates) are treated as one shareholder.²³⁶ The members of a family include a common ancestor, any lineal descendant of such common ancestor, and any spouse or former spouse of such common ancestor or any such lineal descendant.²³⁷ An individual will not be considered a common ancestor if, on the "applicable date," he or she is more than six generations removed from the youngest generation of shareholders who would (but for this rule) be members of the family.²³⁸ The "applicable date" is the latest of:

• The date the applicable election to be an S corporation was made;
• The earliest date that the common ancestor holds stock in the S corporation; or • October 22, 2004.²³⁹

For purposes of determining the members of a family, an individual's children include a legally adopted child, a child who is lawfully placed with the individual for legal adoption, and a foster child who is placed with the individual by an authorized placement agency or by judgment, decree, or other order of a court of competent jurisdiction.²⁴⁰

Persons Who May Not be Shareholders of S Corporations

LLCs, partnerships, and nonresident alien individuals may not be shareholders of S corporations.²⁴¹ Also, corporations may not be shareholders of S corporations except that an S corporation that has a wholly owned subsidiary may elect to treat the subsidiary as a qualified subchapter S subsidiary.²⁴² If the election is made, the qualified subchapter S subsidiary is not treated as a separate corporation for tax purposes, and all of its income, etc. will be treated as that of its S corporation parent.²⁴³ Otherwise, the only permitted shareholders of S corporations are individuals who are United States citizens or residents or trusts, estates, and other organizations described in "Trusts and Estates as Shareholders of S Corporations" through "Other Permitted Shareholders of S Corporations" of this § 12.2.2.

Trusts and Estates as Shareholders of S Corporations

I.R.C. § 1361(c)(2) permits certain trusts to be shareholders of an S corporation and provides who will be treated as shareholders in these cases:

• A trust all of which is treated under the grantor trust rules²⁴⁴ as owned by an individual who is a citizen or resident of the United States, and the deemed owner is treated as the shareholder; if such a trust continues in existence after the death of the deemed owner, it will continue to be a permitted shareholder, and the estate of the deemed owner will be treated as the shareholder, but only for the two-year period beginning on the date of death of the deemed owner;
• A trust with respect to stock transferred to it by will, and the estate of the testator will be treated as the shareholder, but only for the two-year period beginning on the date such stock is transferred to the trust;
• A trust created primarily to exercise the voting power of stock transferred to it, and each beneficiary of the trust will be treated as a shareholder;
• An electing small business trust, and each potential current beneficiary will be treated as a shareholder; provided, if for any period there is no potential current beneficiary, the trust will be treated as the shareholder; and
• In the case of a corporation that is a bank or a depository institution holding company, a trust that constitutes an IRA or Roth IRA, but only with respect to such stock held by such trust in such bank or company on the date of enactment of § 1361(c)(2)(A)(vi), and the individual for whose benefit the trust was created will be treated as the shareholder.

Section 1361(c)(2)(A) does not apply to any foreign trust.

Electing Small Business Trust

Section 1361(e)(1)(A) defines an electing small business trust as any trust if:

• The trust does not have as a beneficiary any person other than:

◦ An individual;
◦ An estate;
◦ An exempt organization described in § 170(c)(2), (3), (4), or (5); or
◦ An organization described in § 170(c)(1),²⁴⁵ if the organization holds a contingent interest and is not a potential current beneficiary;

• No interest in the trust was acquired by purchase; and
• An election under § 1361(e) applies to the trust.

The following trusts may not elect to be an electing small business trust:

• A qualified subchapter S trust;
• A trust that is exempt from federal income taxes; or
• A trust that is a charitable remainder annuity trust or a charitable remainder unitrust (as defined in § 664(d)).

The election to be an electing small business trust must be made by the trustee of the trust within the 16-day-and-two-month period beginning on the date the stock of an S corporation is transferred to the trust.²⁴⁶

Qualified Subchapter S Trust

Section 1361(d) provides permitted shareholder status to a qualified subchapter S trust if the beneficiary elects pursuant to § 1361(d)(2) that the trust be so treated. A qualified subchapter S trust is a trust, the terms of which require that

• During the life of the current income beneficiary, there shall be only one income beneficiary of the trust;
• Any corpus distributed during the life of the current income beneficiary may be distributed only to such beneficiary;
• The income interest of the current income beneficiary shall terminate on the earlier of the beneficiary's death or the termination of the trust; and
• Upon the termination of the trust during the current income beneficiary's lifetime, all of the assets of the trust will be distributed to the beneficiary.

If a trust fails to meet any of the foregoing four requirements, it will cease to be a qualified subchapter S trust on the date it fails to meet any of such requirements.²⁴⁷

• All of the income of which is distributed (or required to be distributed) currently to one individual who is a citizen or resident of the United States.

If a trust fails to meet this requirement but continues to meet the four requirements first listed above, it will cease to be a qualified subchapter S trust as of the first day of the first taxable year beginning after the first taxable year in which it failed to meet the requirement that all of its income is distributed (or required to be distributed) currently to one individual who is a citizen or resident of the United States.²⁴⁸

I.R.C. § 1361(d)(3) provides that for purposes of the electing small business trust rules and the qualified subchapter S trust rules, a substantially separate and independent share of a trust within the meaning of § 663(c) will be treated as a separate trust. The federal income tax rules for the taxation of trusts provide that for certain purposes, "[i]f a single trust (or estate) has more than one beneficiary, and if different beneficiaries have substantially separate and independent shares, their shares are treated as separate trusts (or es-tates)."²⁴⁹ Although the term "substantially separate and independent shares" is not expressly defined, the term appears to require that the trustee may...