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1 Vertex Wealth Management LLC Michael Aluotto President Private Wealth Manager 1325 Franklin Ave., Ste. 335 Garden City, NY S Corporation Page 1 of 7, see disclaimer on final page

2 S Corporation What is it? An S corporation is an incorporated business that has formally elected to be taxed as a pass-through entity. Without an S corporation election, the business will be taxed as a C corporation. Though the business may consist of many owners, it is considered a single entity, separate from the owners. Like a C corporation, the S corporation may raise its own money by selling shares of stock to shareholders. Unlike a C corporation, shareholders must meet certain eligibility criteria. The major difference between an S corporation and a C corporation is the tax treatment. When can it be used? Must be a U.S. corporation Your corporation must be incorporated in the United States. All shareholders must consent to S corporation election To be taxed as an S corporation, the business must file an S corporation election on Form 2553 with the tax authorities. All shareholders by the date of the election must consent to the election. Corporation owned by no more than 100 eligible shareholders An S corporation may have as few as one shareholder under IRS regulations (the number could vary under state law) but is limited by law to a maximum of 100 eligible shareholders. Individuals, estates, certain defined trusts, and certain tax-exempt organizations are eligible shareholders. Generally, nonresident aliens, corporations, partnerships, and IRAs are not eligible shareholders. Technical Note: For the purposes of this limit, members of a family will be treated as one shareholder, and the estate of a family member will be treated as a family member. If shares are held in a trust or by a guardian, the beneficiaries will be counted individually. Tip: If you want more than 100 shareholders, you can circumvent the 100-shareholder limitation by forming two S corporations and joining them in a partnership or limited liability company. The 100-shareholder limitation applies to each S corporation. Strengths Offers the limited liability of a corporation Because the entity is a corporation, the shareholders of an S corporation are generally insulated from personal liability. Liability for corporate action is limited to the extent of the shareholders' investments in the corporation (what they paid for their shares). This is referred to as limited liability. Caution: The limited liability feature may be lost if, for example, the corporation acts in bad faith, fails to observe corporate formalities (e.g., organizational meetings), has its assets drained (e.g., unreasonably high salaries paid to shareholder-employees), is inadequately funded, or has its funds commingled with shareholders' funds. A corporation's loss of its limited liability feature is referred to as the piercing of the corporate veil. Tip: Corporate liability insurance can be bought to cover any potential losses if the corporate veil is pierced. However, insurance may not be available for acts of bad faith, fraud, and the like. Page 2 of 7, see disclaimer on final page

3 Has pass-through taxation like a partnership S corporation status offers the company and its shareholders pass-through taxation similar to a partnership. Income, losses, deductions, and tax credits pass through to the individual shareholders in proportion to the level of ownership (more about that in the tax section). This is a major distinction from the double taxation of a C corporation. Note: For tax years beginning prior to January 1, 2003, dividends were taxed as ordinary income. Several pieces of legislation have attempted to mitigate some of the burden of double taxation on a C corporation, by providing that dividends received by an individual shareholder from domestic corporations (and qualified foreign corporations) are taxed at lower long-term capital gains tax rates. Most recently, in general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains. Capital gains and qualified dividends are generally taxed at 0% for taxpayers in the 10% and 15% tax brackets, and at 15% for taxpayers in the 25% to 35% tax brackets. However, starting in 2013, dividends and capital gains are generally taxed at 20% for taxpayers in the new 39.6% tax bracket for high-income taxpayers. Also, as a result of the Affordable Care Act of 2010, beginning in 2013, an additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000. Centralized management Like a C corporation, an S corporation offers centralized management through its board of directors. Shareholders indirectly participate in management by electing the board of directors and by voting on certain corporate issues. Continuity of life An S corporation can "live" forever. The entity itself continues to exist after the death, bankruptcy, retirement, insanity, expulsion, or resignation of an owner. Caution: If the shares of an S corporation shareholder are passed through will or trust to a party that is not an eligible shareholder, S corporation status will be lost for taxation purposes. The business, as a corporate entity will still exist, but will be taxed as a C corporation. Shareholders of an S corporation may want to enter into a shareholders' agreement that prohibits the transfer of S corporation shares to a person or persons if such transfer would make the corporation ineligible for tax treatment as an S corporation. Shareholders deduct losses of corporation S corporation losses pass through to the shareholders and may be deducted (subtracted) from their taxable income. These deductions are taken pro rata (in proportion to stock ownership). Caution: There are several significant restrictions on a shareholder's ability to deduct losses. These restrictions include the passive loss and at-risk rules, and the disallowance of special allocations. For more on this, see Questions and Answers. Tip: Because deductions can be taken by the shareholders, the S corporation may be especially attractive if you anticipate large initial losses. Tradeoffs Limited to one class of stock An S corporation can have only one class of stock. Differences in dividend rights or liquidation proceeds that are allowable in a C corporation through designations of preferred stock and common stock are not allowed in an S corporation. However, the S corporation is allowed to have voting and nonvoting series of common stock without violating the one-class-of-stock rule. Technical Note: A corporation has one class of stock if all of the outstanding shares of stock hold equal rights regarding the distribution of dividends (profits distributed to shareholders) and proceeds Page 3 of 7, see disclaimer on final page

4 from asset liquidation. That means that when the corporation distributes dividends or sells assets, shareholders hold equal rights to receive those distributions (in proportion to their stock ownership). Differences in voting rights do not violate the S corporation one-class-of-stock rule, while differences in dividend rights do. Example(s): Ken and Sue formed an S corporation. Ken and Sue issued voting stock to themselves and nonvoting stock to two other shareholders. At the upcoming shareholders' meeting, only Ken and Sue can vote on the corporate matters that require a shareholder vote (for instance, the election of directors or payment of distributions). When Ken and Sue use their voting rights to declare a dividend distribution, the distribution cannot be restricted to the voting shareholders. The nonvoting shareholders must also receive a distribution proportionate to their share of stock ownership. Special allocation of deductions disallowed Shareholders take deductions pro rata and are therefore not permitted to allocate a disproportionate amount of deductions to shareholders in the highest individual tax bracket. This might make it harder to attract investors (potential shareholders). Tip: If you are in a high tax bracket, consider a partnership or limited liability company (LLC), each of which permits the special allocation of deductions. How to do it* Consult an attorney You may want to consult an attorney experienced in business planning. The attorney should know the laws of your chosen state of incorporation, which will dictate the requirements and fees involved in forming a corporation. Deliver corporate formation documents to secretary of state Generally, to create a corporation, you must deliver articles of incorporation to the secretary of state. State law will dictate what you will need to include in this document. You must also adopt by-laws, elect a board of directors, and hold your first organizational meeting. Make S corporation election You must make an S corporation election. Without this election, the corporation will be taxed as a C corporation. All shareholders must agree to the election of S corporation status. An S corporation election is made by completing and filing a Form 2553 with the IRS. *Checklist is not exhaustive Tax considerations Income Tax Income taxed once at shareholder level Because an S corporation is a pass-through entity, there is generally no entity-level tax. Income is taxed only at the individual shareholder level (and the double taxation of a C corporation is typically avoided). Example(s): As an oversimplified example, assume that shareholder A is in the 35 percent individual tax bracket and is the sole shareholder of XYZ corporation. XYZ is a C corporation in the 34 percent corporate tax bracket. As a C corporation (not a pass-through entity) with $100,000 in profits and assuming no deductions, XYZ's corporate tax would be $34,000 (34 percent of $100,000). The remaining $66,000, if distributed to shareholder A as a dividend, will be taxed again at 15 percent: 0.15 x $66,000 = $9,900 in taxes. When combined, the tax rate for the corporation and the shareholder would equal 43.9 percent for a total of $43,900 in taxes. Page 4 of 7, see disclaimer on final page

5 Example(s): If instead XYZ were an S corporation (a pass-through entity), only the shareholder would be taxed. Shareholder A would pay $35,000 (35 percent of $100,000) in income tax. Total taxes paid on the $100,000 would be $8,900 less than it would be in the scenario above. Caution: Exceptions: An S corporation may be assessed an entity-level tax if it was formerly a C corporation and it has excessive passive investment income, certain capital gains, claimed an investment tax credit, used the last in, first out (LIFO) inventory pricing method in its last year as a C corporation, or has built in gains that arose prior to conversion to an S corporation. Shareholders taxed even if income not distributed Income is taxed directly to the shareholders at their individual rates whether or not such income is actually distributed to the shareholders. Note, though, if income is not distributed, the shareholders' stock basis is increased by the amount of income they would have received had it been distributed. This ensures that the shareholder is not taxed twice: once when the S corporation earns income (that it retains) and again when the shareholder sells his or her shares. Alternatively, as you may have guessed, when income is distributed to a shareholder, a corresponding decrease in his or her basis is effected. Tip: An S corporation--or any other pass-through entity for that matter--that anticipates retaining earnings for business purposes, as opposed to distributing them, should consider distributing enough income so that each shareholder can pay his or her tax liability. Shareholders can be taxed on contribution of appreciated property If a shareholder contributes appreciated property to the S corporation, he or she will be taxed as if the property had been sold unless the requirements of Section 351 are met. Section 351 applies only during the formation of a corporation and requires, among other things, that the shareholders contributing property in exchange for stock must control 80 percent or more of the stock immediately after the exchange. Regarding partnerships, however, control of the business entity is not required. Gain or loss is generally not recognized (either at formation or subsequently) when a partner contributes property to a partnership solely in exchange for a partnership interest. However, there may be later consequences for a partner who contributes appreciated property, including possible recognition of gain. Fringe benefits are taxable to certain shareholder employees An S corporation can deduct the cost of tax-favored fringe benefits provided to employees. With the exception of certain owner-employees, employees don't have to include the value or cost of the fringe benefit in their reported income. However, when fringe benefits are paid by the S corporation on behalf of shareholders who own more than 2 percent of the outstanding stock, the tax code (Section 1372(a)) applies partnership treatment of the fringe benefits to the S corporation and the 2 percent shareholders and fringe benefits are taxable to the 2 percent shareholders. Liquidation of the corporation is a taxable event When an S corporation is liquidated (all of its assets are distributed to shareholders), it is treated as if it sold the assets to the shareholders at fair market value (FMV). Taxes on this supposed sale flow to the shareholders. A partnership or a limited liability company (LLC), by comparison, can generally liquidate (distribute all of its assets to its owners) tax free. However, a partner may recognize gain or loss to the extent money is distributed to the partner in liquidation of the partnership. Liabilities generally do not increase "stock basis" The liabilities incurred by the corporation (except your personal loans to the corporation) do not increase your stock basis. Your stock basis in the shares of an S corporation will generally equal the price you paid for your shares when you purchased them plus, among other things, the amount of all of your personal loans to the corporation. Your tax basis affects the amount of losses you are able to deduct. Tip: If your business will be funded primarily with third-party debt, you may wish to consider a limited liability company (LLC) or a partnership, each of which will allow you to increase your basis by your share of the entity's debt. Page 5 of 7, see disclaimer on final page

6 Gift and Estate Tax Gift and estate taxes may apply to the transfer of S corporation shares by way of gift, will, or trust. Generally, these taxes will not be applicable at the time the S corporation is formed. Questions & Answers Are there any restrictions on the deductibility of losses in an S corporation? Yes, there are three restrictions on the deductibility of losses in an S corporation in addition to the requirement that losses cannot be deducted in excess of basis. They are the passive loss limitation, at-risk rules, and the disallowance of special allocations: Passive loss limitation rules: These rules apply to shareholders who do not "materially participate" (substantial, regular, continuous participation) in the management of the S corporation. The rules characterize any income or loss with regard to such a nonparticipating shareholder as passive activity income or loss. The rules dictate that such a shareholder cannot deduct corporate losses unless, and to the extent, the shareholder has income from some other passive activity. At-risk rules: If a shareholder's share of losses in a particular corporate activity exceeds his or her contribution to that activity (or third-party loans that were guaranteed by the shareholder), then the excess cannot be deducted until the shareholder's amount at risk increases in a future year. Example(s): XYZ Corporation acquired an office building through funds borrowed from all shareholders except Ken. The additional space in the office building could not be rented out as anticipated, so the corporation sold the building at a loss. At the end of the year, Ken's share of corporate losses was $5,000, half of which represented the loss from the sale of the office building. If Ken did not have other basis, he cannot deduct the $2,500 loss from the sale, since he is not at risk with respect to the corporation's investment in the building. Special Allocations Disallowed: Because deductions are distributed pro rata, an S corporation shareholder in the highest tax bracket cannot be allocated a larger share of deductions, which, if allowed, will allow the shareholder to save taxes. Contrast this with a partnership. Example(s): Ken is a 25 percent partner in a partnership. The partnership agreement allocates 50 percent of all losses to him so as to save him some money in taxes. The partnership has had $50,000 in losses this year alone. Ken can deduct 50 percent of this $50,000 ($25,000) on his personal tax return. If instead Ken were an S corporation shareholder, his deduction would be limited to his percentage of ownership in the corporation--25 percent (his pro rata share). How can you be sure that shareholder loans will not be characterized by the IRS as a second class of stock--a violation of the one-class-of-stock-rule? You should consult your tax attorney or accountant. Generally, to ensure that debt will not be characterized by the IRS as a second class of stock (equity), the debt should fall within one of the following safe harbors: Unwritten shareholder advances from a shareholder totaling no more than $10,000 at any time during the year that are expected to be repaid within a reasonable time Debt held by an individual or entity that (1) would be considered an eligible S corporation shareholder, (2) the repayment of which does not depend on the profits or discretion of the corporation, and (3) cannot be converted into equity Page 6 of 7, see disclaimer on final page

7 Securities offered through First Allied Securities, Inc. A Registered Broker/Dealer Member FINRA/SIPC Advisory Services offered through First Allied Advisory Services, Inc. A Registered Investment Adviser Vertex Wealth Management LLC Michael Aluotto President Private Wealth Manager 1325 Franklin Ave., Ste. 335 Garden City, NY Page 7 of 7 Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2013

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