How is an S-Corporation taxed by the IRS?

How is an S-Corporation taxed by the Secretary of State of Delaware?

Who may elect “S” Status?

The S-Corporation as an alternative to the C-Corporation

Corporations

A Corporation is a business entity (type of company) which is registered with a state government and entitled to treatment as an artificial person, by which right it may sue or be sued in a court of law with protection for the shareholders and officers from personal claims, unless they commit fraud. This means that, unless a shareholder personally guarantees a debt of the Corporation, or commits fraud, her risk of loss is limited to the amount of money she invested in the Corporation; her personal assets are protected from liability. Corporations and LLC’s are similar in the liability protection offered to owners and officers.

A Corporation which is not a Close Corporation and is not an S-Corporation may be called a C-Corporation or a General Corporation when it is necessary to distinguish it. To distinguish between a for-profit Corporation and a not-for-profit Corporation, a for-profit Corporation may also be called a “Stock Corporation”. The following section will focus on For-Profit C-Corporations.

In smaller companies the owner tends to wear many hats and in Delaware this is perfectly legal; the owner may be a sole shareholder and Director as well as serving as the titular President, Secretary and Treasurer all at the same time! That said, the organization of the Corporation is more rigid than that of the LLC. In the case of a new Corporation, the expected series of events would be as follows:

A person representing a new company that wishes to incorporate contacts DBI. Upon purchasing DBI’s services, DBI becomes the Incorporator. DBI drafts, signs and files the Incorporation documents acting as an agent on behalf of the new Corporation . When the Incorporation is complete, DBI’s services as Incorporator are automatically terminated. The last thing DBI does in its role as Incorporator is officially appoint the Initial Director . The person who will serve as Initial Director will be indicated by the person placing the order for Incorporation services.

The Initial Director is often the founder of the Corporation , although, the Initial Director does not have to be an owner or officer ; the Initial Director could be a manager, CPA or attorney for example. It is the Initial Director’s duty to finish setting up the organization of the new Corporation after it has been Incorporated. The Initial Director has the authority issue stock certificates to the owners to record their ownership share and to call a meeting of the shareholders to elect the Board of Directors. The Initial Director may remain a Director or his services may end after other Directors are appointed. In many cases the Initial Director stays on and becomes the Chairman of the Board of Directors.

Once the Board of Directors is appointed, the Board ratifies the By-Laws and appoints the Officers of the Corporation . Most routine operational oversight is delegated to the Officers, but major policy must be decided by a resolution of the Board which is either approved by a majority of the voting shareholders, or in the case of a Sole Owner/Sole Director by “Unanimous Decision”. A Close Corporation is exempt from formal Board Meeting and Resolutions (see page 40 for more information), as are LLC’s.

A C-Corporation , that is, a Corporation which does not elect “S-Corporation ” status and is not a ”Not-For-Profit”, is taxed as its own “entity”; that is to say, the Corporation is taxed separately from and in addition to the personal income of the Shareholders (owners), and is taxed at a Corporate rate. A C-Corporation must file its own income tax return every year on form 1120. In addition to the income tax the C-Corporation must pay, any distributions made to the stockholders (also known as dividends) are taxed on the personal income tax returns of the shareholders at the shareholders personal income tax rate. This is what is commonly known as “Double Taxation”. Because the Corporation may deduct reasonable salaries before calculating income tax, a large portion of the income paid to Owner-employees is not subject to double federal income tax, however, both the Corporation and the Employee must pay FICA tax on these wages earned. Aside from liability protection, lower corporate rates of income taxation are one of the benefits to Incorporating a Sole Proprietorship or Partnership. Another difference to bear in mind between Corporate taxation and “pass through” taxation is that undistributed profits of a Corporation may be accumulated untaxed if they are related to the reasonable needs of the business.

Caution: ·If the IRS determines that retained earnings are not related to the reasonable needs of the business, those accumulated earnings will be taxed at 39.6%. ·If your Corporation is profitable, but pays no dividends and pays salaries significantly higher than industry standards, the IRS may determine that your Corporation is “disguising” dividends as salaries; and will consequently disallow a portion of eligible salary deductions and apply penalties with interest. ·Personal Service Corporations (those whose employees spend at least 95 percent of their time in the field of Accounting, Actuarial Science, Architecture, Consulting, Engineering, Health, Law or Performing Arts) are taxed at a flat rate of 35 percent of net profits.

A C-Corporation with no employees, owners, property or operations in the United States, and no US-source income will pay no Federal US Corporate Income Tax. Download Chart: How to Determine if You Have US Source Income for more information.

The annual tax due to the Secretary of State of Delaware for the purpose of maintaining a Delaware Charter is known as the Delaware Franchise Tax. The word “Franchise”, as used in this case, means “a special privilege granted to an individual or group ; especially: the right to be and exercise the powers of a Corporation ” and does not mean “a chain of businesses licensed by the original store and operated per the original store’s pattern under the original store’s trade name”. Delaware Corporations authorizing 5,000 shares or of stock or less may use the Authorized Shares method and will pay the minimum $75 franchise tax regardless of income or activity. The Franchise Tax rates for companies authorizing 5,001 shares or more are discussed below.

It is also necessary for Corporations to file an Annual Report. There is a $50 Annual Report filing fee for Profit-Corporations and a $25 Annual Report Filing Fee for Non-Profits. The Delaware Annual Report is filed online at www.corp.delaware.gov. The following information must be included on the Annual Report:

• The physical location of the headquarters of the Corporation. This address may be anywhere in the US or in the world; it is not required to be a Delaware address. If your Corporation has no headquarters, you may give your home address. You are not permitted give a P.O. Box or the address of a mail forwarding service.

• The phone number of any company representative.

• The names and addresses of all Directors. All Corporations have at least one initial director, if that person has resigned and has not been replaced; a statement that there are no current directors may be given. It is permissible to give a business address or mail forwarding address.

• The name and address of the Officer who is authorizing the filing of the Annual Report. This is usually the President or CEO but other offices are acceptable. If there are no officers currently serving a Sole Director or the Chairman of the Board of Directors may sign. If there are no Officers or Directors please contact an Incorporation Specialist for assistance.

• The signature of the authorizing Officer. This is usually an electronic signature: if you are filing yourself online you will simply type the name, if DBI is filing for you the electronic signature will appear as “/s/FirstName LastName” for example “/s/John Doe”.

The Franchise Tax and Annual Report are due every year before June 1^st. This means payment must be received by the Secretary of State of Delaware no later than the last day of February of any given year. Late Annual Reports and Franchise Tax are penalized $100 and subject to 1.5% interest. DBI offers a tax preparation service for $55 per tax year and also offers an automatic renewal and tax payment program called Good Standing Protection Service. See the forms section in the Appendix for more details or to enroll.

There are two methods of calculating the Franchise Tax. Companies authorizing 5,000 shares of stock or less may use the Authorized Shares method and will pay the minimum $75 franchise tax regardless of income or activity.

Authorized Shares Method

Assumed Par Value Capital Method

Companies authorizing more than 10,000 shares may wish to use the Assumed Par Value Capital Method.

To use this method, you must give figures for all issued shares (including treasury shares). For this purpose it is important to understand the difference between Issued Shares and Authorized Shares. The Authorized Shares are the shares authorized to be issued by the company at the time the Charter was registered or upon amendment of the Charter. This is the number of shares a company may potentially issue. A stock is “Issued” when it is sold, transferred or assigned to an owner, a shareholder . Issued Shares includes Treasury Shares. Treasury Shares are any shares of stock which were previously issued to a shareholder and subsequently bought back from the shareholder by the Corporation itself. While it is not necessary to report income for either method of Franchise Tax calculation, it is necessary to report the Total Gross Assets if you wish to file using the Assumed Par Value Capital Method. Total Gross Assets shall be those "total assets" reported on the U.S. Form 1120, Schedule L (Federal Return) relative to the company's fiscal year ending the calendar year of the report. The tax rate under the Assumed Par Value Capital Method is $350.00 per million or portion of a million. If the assumed par value capital is less than $1,000,000, the tax is calculated by dividing the assumed par value capital by $1,000,000 then multiplying that result by $350.00. If your company has authorized shares at zero par value it will be necessary to contact the Delaware Secretary of State Corporations Division Franchise Tax Department for a calculation of Franchise Tax due if you wish to employ the Assumed Par Value Capital Method.

Regulated Investment Companies Franchise Tax

Regulated Investment Companies pay on a different scale prescribed under Section 503(h), the General Corporation Law of the State of Delaware.

Estimated Franchise Tax

Corporations which pay franchise taxes in excess of $5,000 annually must make quarterly payments, due and payable June 1st, September 1st, December 1st and March 1st.

Foreign Corporations Franchise Tax

Corporations Chartered in another state that are qualified in Delaware as Foreign Corporations must file an annual report before the 30^th day of June each year; the annual report filing fee for Foreign Corporations is $125. If the annual report is not filed before the due date a penalty of $125 is assessed.

Caution: ·Franchise tax is pro-rated ONLY in the case of I. An amendment being filed within that tax year which increases or decreases the number of Authorized Shares or II. A Corporation, which owes more than the minimum franchise tax, dissolves, transfers out of state or country, or converts to a different entity type. If your Corporation owes the minimum Franchise Tax, your annual tax will not be pro-rated for any reason. ·Franchise tax is due regardless of whether your company was actively transacting business. ·Your Delaware Franchise Tax and Annual Report are due every year before June 1st. Although DBI will send you a notice each year, like Federal Income tax, this tax is due every year at the same time and you are responsible for filing on time regardless of circumstances. We strongly suggest you mark your calendar accordingly. It is not necessary to have a copy of your tax notice to pay your Delaware Franchise Tax or to file your Delaware Annual report, but if you have not received your notice, or have lost your notice, you may contact DBI before June 1st for a replacement. It is very important that you notify DBI if your address or contact information changes. ·If your company fails to pay Delaware Franchise Tax for two consecutive years, your company Charter will be declared VOID for failure to pay taxes. This means that your company Charter is invalid and you do not have the right to transact business as a Corporation. ·Note that, under Delaware law, the shares of any person in any Corporation with all the rights thereto belonging or any person’s option to acquire the shares or his/her right or interest in the shares may be attached for debt or other demands. So many of the shares, or so much of the option, right or interest therein may be sold at public sale to the highest bidder as shall be sufficient to satisfy the debt or other demand, interest and costs, upon an order issued therefore by the court from which the attachment process issued, and after such notice as is required for sales upon execution process. While your personal liability is limited to your investment in the company; you can lose your investment in the company.

Other Delaware State Taxes

Many entrepreneurs and Investors are already aware of the many tax benefits of a Delaware LLC or a Delaware Corporation . Following are some facts regarding taxes on Delaware C-Corporations:

Delaware State Taxes you will not owe:

• No Delaware State Personal Income Tax for shareholders who reside outside the state.
• No State Sales Tax on goods and services purchased inside the state
• No Delaware State Corporate Income Tax for Delaware Corporations headquarted and operating outside Delaware

Delaware State Taxes you may owe:

If you have a physical office, store, factory or other center of operations located within Delaware, you may owe Delaware State Corporate Income Tax. As a rule of thumb, if your Corporation produces a product or service within the state of Delaware, you may owe Delaware Corporate Income Tax on those revenues, even if they are sold out of state. If you have operations in Delaware you may also owe Delaware Corporate Income Tax on revenue from products and servicessold within the state of Delaware, even if those products and services were produced outside the state.

Delaware evaluates three types of activity in determining what portion of income tax will be subject to Delaware Corporate Income Tax:

1. Corporate sales attributable to Delaware
2. Property located in Delaware and
3. Payroll incurred in Delaware

Stock Corporations and Not-for-Profit Corporations will be created by filing the Certificate of Incorporation. This document is sometimes called the Articles of Incorporation. DBI will draft this document for you. Any information needed from you will be obtained from your internet order or order form.

The following information will be included on the Certificate of Incorporation of a General Stock Corporation

1. The name of the Corporation
2. The name and complete address of the Delaware Registered Agent
3. The General Purpose of the proposed Corporation
4. A statement regarding the Authorized Shares, stating the number of shares authorized and par value or stating no par value.
5. The name and address of the Incorporator and the name and address of the Initial Director, unless the Certificate is to be Anonymous, in which case the fifth article will only feature the name and address of the Incorporator.
6. A statement affording the Directors of the company the broadest liability protection allowable under Delaware law.
7. The signature of the Incorporator

DBI will be your Incorporator. An Incorporator has the power to represent the company as an agent during the process of creation. The Incorporator has the authority to prepare, sign and file the Certificate of Incorporation and any other needed documents. The Incorporator’s authority ends when the Corporation is registered and the Initial Director is appointed. An Incorporator is not an owner or officer .

Although most Delaware Corporations prefer to follow the minimum provisions model, it is possible to include additional provisions on the Certificate of Incorporation. If you want additional provisions included on your Certificate, please supply the exact language of the additional articles to be included. Following are the additional provisions which can be included on the Certificate of Incorporation:

8. The period of its duration, which is usually stated as “perpetual.”
9. Whether or not cumulative voting of shares is authorized.
10. Provisions regarding By-Laws.
11. Provisions regarding the sale or purchase of the Corporation’s stock.
12. Provisions specifying special voting rights and preferences.
13. Provisions limiting or denying to shareholders the preemptive right to acquire additional or treasury shares of the Corporation.
14. Provisions for the regulation of the internal affairs of the Corporation.
15. Any other provisions required to define or place parameters on the internal or external organization, financial structure or activities of the Corporation.

Caution: If you are drafting your own Certificate of Incorporation and wish for DBI to serve as your Delaware Registered Agent you must contact us before the Certificate of Incorporation is filed.

The By-Laws are a document which sets forth the rules adopted by the Directors for the operation, organization and conduct of the Corporation . By-Laws specify how the Corporation will conduct its meetings, how Directors and Officers will be elected or appointed, how it will handle resignations, and will elaborate on the duties of officers and the voting rights of shareholders, amongst other information. The By-Laws of a Corporation are not registered or filed with the State of Delaware; they should be properly maintained by the Corporation and filed safely with the Corporation’s other private Corporate records such as the Shares Transfer Register. Your Corporation’s By-Laws may someday be crucial to resolving unforeseen problems such as absentee Officers or Directors; to resolving shareholder disputes; defending or applying for tax status ; and bringing, settling or defending lawsuits. DBI offers model By-Laws templates or fill-in-the-blank forms as part of the Corporate Kit available separately or as part of your purchase of a New Company Registration Package.

The following topics are addressed in the By-Laws template available with the purchase of your New Company Registration Package:

1. Meeting of Shareholders
2. Board of Directors
3. Officers
4. Shares of Stock
5. Dividends
6. Fiscal Year
7. Corporate Seal
8. Amendments
9. Waiver of Notice
10. Interested Directors
11. Form of Records

If you wish to include additional provisions please indicate that you want the Word .doc or Word Perfect .wpd template. You are free to alter, add or delete any material you wish. Please contact a qualified tax professional and/or attorney if you have questions regarding these provisions. DBI does not alter, add or delete provisions from the standard template, if you wish to alter the template and you do not feel competent to do so without assistance, please consult an attorney; you may contact an Incorporation Specialist if you would like a referral.

A Close Corporation is a Corporation which sets certain limitations on the sale, holding and transfer of its shares of stock . In Delaware, a Close Corporation is limited to thirty shareholders. Two common reasons to form a Close Corporation are to seek and maintain “S-Corporation ” tax status from the IRS and/or to ease administration for a small business, frequently a family business. Restrictions on the transfer of stock are frequently employed as a way of maintaining S-Corporation tax status; for example: A typical restriction prohibits the transfer of restricted securities to non-resident aliens. (See page 42 for more about S-Corporations). Another typical restriction, known as “First Refusal” requires a potential seller to offer the stock shares to the Corporation and its existing shareholders before offering the stock shares for sale to anyone else. First Refusal can potentially protect shares of a family business from being sold to someone outside the family or shares of an S-Corporation from being sold to a party that would cause the Corporation to loose its “S” status.

Close Corporations are not required to hold an annual meeting of the Board of Directors; decisions effecting shareholders can be governed by a “Shareholder Agreement” rather than a Board of Directors. A Shareholder Agreement is similar to an Operating Agreement or a Limited Partnership Agreement and defines the specifics of the regulation of the of the company’s business.

The following information will be included on the Certificate of Incorporation of a Close Corporation :

1. The name of the Corporation
2. The name and complete address of the Delaware Registered Agent
3. The General Purpose of the proposed Corporation
4. A statement regarding the Authorized Shares, stating the number of shares authorized with or without par value.
5. The name and address of the Incorporator and the name and address of the Initial Director, unless the Certificate is to be Anonymous, in which case the fifth article will only feature the name and address of the Incorporator.
6. A statement limiting the number of shareholders to 30
7. A statement that the shares of stock are subject to one or more restrictions on the transfer of stock
8. A statement that the Corporation will not make public stock offerings.
9. The signature of the Incorporator

The specific limitations on the transfer of stock may be made in the By-Laws . (See page 37 for more information on the By-Laws.)

Also known as: “Non-Profit”, “Non-Stock Corporation ” or “501(c)3”

When we use the term “Not-for-Profit Corporation ” we are typically referring to a Chartered Charitable or Religious Organization. A Not-for-Profit Corporation is not “tax-exempt” until it has been granted Tax Exempt status by the IRS after filing form 1023. To be Tax Exempt, the Corporation must meet specific requirements:

2. Typically, the Corporation does not authorize or issue shares of stock.
3. The Corporation is organized and operated exclusively for Religious, Educational, Charitable, Scientific or Literary purposes, or for Testing for Public Safety, to Foster National or International Amateur Sports Competition, or for the Prevention of Cruelty to Children or Animals
4. No part of the net earnings of a section 501(c)(3) organization may, by practice or custom, benefit a person having a personal and private interest in the activities of the organization, such as the creator of the Corporation or the creator's family.
5. The organization is restricted in how much political and legislative (lobbying) activities they may conduct. Political Organizations usually file under an exemption other than 501(c)3.

DBI will draft your Certificate of Incorporation with the appropriate language (see below) and file your Certificate of Incorporation in the same manner that a For-Profit Stock Corporation is filed. After the Not-for-Profit Corporation is registered by us, you will then need to apply to the IRS for Tax Exempt Status. Contact an Incorporation Specialist if you would like a referral to a qualified tax professional. For more information about Tax Exempt Status see the IRS publication “Tax Exempt Status for Your Organization” at http://www.irs.gov/pub/irs-pdf/p557.pdf.

The managers of a Not-for-Profit Corporation are typically known as the Board of Trustees. The powers and responsibilities of the Board of Trustees are outlined in the Not-for-Profit Corporation’s By-Laws together with specifications on how the Trustees will be elected and how long they will serve. The duties of the Trustees will typically include overseeing the operation of the organization to ensure that the purpose of the Charitable Organization is upheld; managing the receipt of donations; investment and management of assets and operating funds; budgeting; and project planning.

Not-for-Profit Corporations are exempt from paying Delaware Franchise Tax and pay a reduced annual report filing fee of $25. Annual Reports are due before March 1^st of each year and are filed online at www.corp.delaware.gov.

The following information will be included on the Certificate of Incorporation of a Not-for-Profit Corporation :

1. The name of the Corporation
2. The name and complete address of the Delaware Registered Agent
3. The Purpose Statement setting forth purposes in keeping with those listed as eligible by 501(c)3 and barring those activities or practices restricted under 501(c)3
4. A statement that the Corporation shall have no shares of stock
5. The name and address of the Incorporator and the name and address of the Initial Director. Not-for-Profit Corporations are not permitted to file an Anonymous Certificate of Incorporation.
6. The signature of the Incorporator

1. The Corporation or LLC must be Chartered in a US State of Territory, such as Delaware.

2. The Corporation or LLC must file Form 2553 on time. (For more information about the filing deadlines see IRS Publication i2553 “Instructions Filing Form 2553” at http://www.irs.ustreas.gov/pub/irs-pdf/i2553.pdf)

3. All of its shareholders must either be natural persons or estates of deceased persons in the process of administration. Other Corporations and partnerships are not permitted to be shareholders unless they are exempt under provisions such as 501(c)3 for Charitable Organizations; or unless they are an S-Corporation holding a 100% share of a subsidiary S-Corporation.

4. All of its shareholders must either be US Citizens or US-Resident Aliens. US-Resident Aliens must reside in a US state; Aliens resident in a US territory are not eligible. A non-resident alien cannot be a shareholder of an S-Corporation. An “alien” is also known as a “foreign national” or “non-citizen”.

5. The Corporation must have only one class of stock, although that class may be divided into Voting and Non-Voting shares. In the case of an LLC, all owner-members must have identical rights to distribution and liquidation proceeds.

6. The Corporation must not be a Section 585 bank, a subchapter L insurance company, a section 936 possession S-Corporation, nor a Domestic International SaleS-Corporation or former DISC.

7. The Corporation must follow a calendar tax year unless it can justify a reason to do otherwise, such as seasonal business.

8. Each shareholder must consent to the S-Status election.

9. The Corporation must have less than 100 shareholders or LLC Members. In this case, a married couple who hold stock as “Tenants in Common”, “Joint Tenants”, or “Community Property” are counted as one shareholder; unless both spouses also hold shares of stock individually in addition to jointly, in which case they are counted as two shareholders; if only one spouse holds additional shares individually they are only counted as one shareholder. Two unmarried shareholders holding stock jointly are counted as two shareholders.