Franchise Tax Board to defer actions on S corporation conformity and check-the-box regulations.

The Small Business Job Protection Act of 1996 made several changes to the Internal Revenue Code regarding S corporations and S shareholders. One of these changes was to increase the maximum number of shareholders from 35 to 75; another permits tax-exempt organizations to be shareholders and certain financial institutions to elect S status

The California Franchise Tax Board (FTB) recently announced, in Notice 96-5, that, until the California legislature enacts conformity legislation, it will not recognize the Federal changes for California taxation purposes. Thus, an S corporation with 40 shareholders will lose its S status for California tax purposes and be taxed as a C corporation, despite the fact that it will be treated as an S corporation for Federal purposes.

In addition, the FTB also announced that the IRS "check-the-box" regulations will not be followed for California tax purposes, until either statutory or regulatory changes are made to California law. As a result, taxpayers and their advisers must continue to analyze whether the proposed entity meets the requirements of, for example, a general partnership or limited liability company. The notice indicates that no action will be taken until the Federal regulations are issued.

Editors note: The California legislature is considering conforming statute to the new Federal S rules. Revenue issues are a concern, but the conformity legislation appears to be moving. Other states will also need to consider conformity legislation, so practitioners will need to carefully check each state in which their client S corporations do business. Similarly, practitioners will need to confirm with their state revenue departments whether or not the state win follow the Federal check-the-box rules.