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Recent legislation boosts appeal of S corporations

The recently passed Small Business Job Protection Act of 1996 made significant changes to the rules affecting S corporations. These changes will make S corporations easier to use and less susceptible to disqualification.
Let me first briefly review the attraction of S corporations. Regular, or C, corporations are taxed twice on their income: first at the corporate level and again when that income is paid out to the shareholders as a dividend. The corporation gets no tax deduction for the distribution. This double layer of tax can be quite onerous and a serious impediment to using the corporate form of doing business.
There are several possible responses to this double tax. One is to use compensation deductions and other strategies to minimize the double tax imposed on C corporations. Another is to adopt a different form of entity altogether, such as a limited liability company. However, a third and very popular option is to make the S election.
This election enables a corporation to enjoy many of the benefits of “pass-through” taxation: The income of the corporation is taxed directly to its shareholders on their individual tax returns, and in most circumstances no federal income tax is imposed at the corporate level.
Historically, there have been many restrictions on the ability of a corporation to make the S election, or to continue to qualify for S status. These restrictions have prevented some corporations from making the election, or have caused corporations to lose their S status and become subject to the double tax. The recent act makes S corporations more attractive with several major and minor technical changes to these restrictions. Let me focus on just a few of the more important changes that were made.
First, corporations historically have been entitled to make and retain the S status only if they have 35 or fewer shareholders. While this requirement may not be an impediment to the initial election, as a corporation grows, its 35-shareholder limitation is often a problem. Corporations might wish to provide their employees with stock; founding shareholders might die and leave the stock to a variety of family members; or the corporation could desire to raise funds using a private placement of stock to a small group of investors. Any of these events, or a combination of them, might cause the corporation to bump up against the 35-shareholder limit and create significant tax problems.
The new act solves many of these problems by simply extending the limitation from 35 shareholders to 75 shareholders. By more than doubling the number of permitted shareholders, the new act greatly expands the number of corporations that qualify for the S election.
A second historic restriction on S corporations is a prohibition of subsidiaries. Any corporation that owned 80 percent or more of the stock of another corporation was ineligible to be an S corporation. Obviously, this requirement created serious difficulties when an S corporation desired to acquire another corporation, or to form a subsidiary to isolate or expand a particular aspect of its business.
This restriction on corporate subsidiaries has been removed. S corporations now can have two kinds of subsidiaries: An S corporation may own any percentage of the stock of a C corporation (which still would be subject to a double tax), and it may own 100 percent (not less) of the stock of a qualified subchapter S subsidiary (QSSS).
If an S corporation owns 100 percent of the stock of a QSSS, for tax purposes the QSSS is simply disregarded. From a tax perspective, the two corporations are treated as a single entity, and the parent S corporation is treated as owning all of the assets of the QSSS directly.
This new form of QSSS will be particularly useful for an S corporation desiring to isolate the liabilities of a portion of its business from the assets of the main business. It now can put those assets into a QSSS with no change to the passthrough tax treatment for the entity as a whole.
However, there are serious restrictions on the QSSS form; because the S corporation must maintain 100 percent ownership of the QSSS, it will be unable to share ownership. Now say a corporation separately incorporates a particular branch or location for business reasons. It might wish to provide the manager of that branch with a stock interest in that particular branch. But this will not be possible with a QSSS because of that total-ownership requirement. While the corporation could provide cash or other compensation measured by the performance of the subsidiary, it could not directly provide subsidiary stock.
A third significant change to the S corporation rules is with respect to qualifying shareholders. Under old law, corporations were eligible for S status only if their shareholders were all individuals, estates or certain forms of trusts. The new law expands this restricted shareholder list by adding tax-exempt entities. This change has advantages in two arenas.
First, owners of S corporations, unlike owners of other forms of businesses, have been unable to make charitable contributions of the S corporation stock. If they did so, the corporation’s S election would immediately be lost. Now, owners of S corporations will be able to make charitable contributions of S corporation stock, obtain a tax deduction for that contribution and maintain the corporation’s S election. Thus, this change will be a significant new incentive for certain forms of charitable contributions.
Secondly, the new law permits qualified retirement plans–which are tax-exempt trusts–to be shareholders in an S corporation. This will allow the employees of an S corporation to share in corporate growth through their qualified profit-sharing or pension plan.
One highly desirable change, however, was not made in these rules. Employee stock ownership plans, or ESOPs, are highly tax-favored employee-benefit plans designed to encourage employee ownership of corporate stock. The tax law provides the owners of closely held businesses with significant tax incentives to sell stock to an ESOP that will control 30 percent or more of the stock of the corporation.
But these special tax incentives for ESOPs have not been extended to S corporations. Thus, while an S corporation shareholder can sell his stock to an ESOP without disqualifying the S corporation, he will enjoy none of the special tax benefits that a C corporation shareholder would receive.
Estate planning for S corporation shareholders will be facilitated by a new eligible shareholder, the “electing small business trust.” While there will be much more flexibility available in using these trusts, there is a price to be paid. The S corporation income all will be taxed to the trust at the maximum income-tax rate. Another change that will facilitate estate planning is expanding the period–from 60 days to two years–during which a grantor trust or a testamentary trust can own S corporation stock following the death of the shareholder.
In general, all of the changes described above are effective at the beginning of 1997. While we can begin planning for their use now, we cannot actually implement such plans until 1997. Finally, the new act provides the Internal Revenue Service with some much-needed administrative flexibility.
The tax law always has contained specific provisions on how the S corporation election must be made. A form must be filed with the consent of all of the shareholders within a certain time period. Occasionally, corporations will make the S election but have some minor technical deficiency in the form.
Perhaps the wrong person signed on behalf of a minor shareholder. Perhaps the form was inadvertently filed a few days late. If the corporation nonetheless believed its election to be effective, it might operate for several years on the assumption that it was an S corporation, despite the defect in its election. If the IRS then disallowed its election on audit, very serious and wholly disproportionate tax penalties could apply to what was simply an innocent mistake.
Since the requirements for an S election are statutory, the IRS had previously felt that it was bound by law to disallow an election with even minor technical deficiencies. The new statute now gives the IRS the authority to waive inadvertent errors in S elections. The IRS can waive technical deficiencies in the election itself, as well as timing problems in the filing of the election.
Unlike the other provisions in the new act, this one is effective immediately and retroactive to 1982. Thus, even corporations with historic problems with the IRS now can request that the IRS waive the technical deficiencies and respect their S elections.
The new law contains many other provisions creating major and minor changes to the S corporation rules. In sum, however, they generally add significant flexibility to the S corporation form, and make it a more attractive form for doing business.
(Michael McEvoy is a partner in the law firm of Harter, Secrest & Emery, where he concentrates his practice on tax matters.)

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