Copyright 1996 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
The Act increases the number of shareholders allowed from 35 to 75. The provision applies to tax years beginning after December 31, 1996.
Comment-- This, and a number of other changes for S corporations, should make them more attractive. Caution. There are other shareholder rules. Make sure you're aware of them. Also, a husband and wife owning shares in their own names are treated as one shareholder for both the old and new shareholder limits.
Most trusts cannot be shareholders in an S corporation. Only a trust which meets all of several criteria can qualify. These rules are narrow and have imposed substantial limits on tax planning possibilities. The Act significantly liberalizes the rules by creating a 'small business trust'. All beneficiaries of a small business trust must be individuals or estates eligible to be S corporation shareholders. Charitable organizations may have a contingent remainder interest. Only trusts whose interest is obtained by gift, bequest or means other than purchase can qualify. Thus, the trust will not qualify if you purchase an interest in it.
Income in an electing trust from stock in an S corporation is taxed separately at the highest individual rate (39.6% for ordinary income and 28% for capital gains). Capital losses are allowed only to the extent of capital gains. When computing the taxable income of the trust, no deduction is allowed for amounts distributed to beneficiaries, and generally no deductions or credits are allowed. On the other hand, the income is not included in the distributable income of the trust nor in the income of any beneficiary.
Example--The Susan Sharp trust is an electing S trust that has a 20% interest in Madison Inc. Madison has ordinary income of $30,000 for the year, 20% ($6,000) of which is passed through to the trust. In addition, the trust has interest income of $10,000. All income is distributed to the beneficiaries. The interest income is passed through to the beneficiaries and taxed to them. The trust pays a tax of $2,376 on the S corporation income. The beneficiaries pay no tax on the S corporation income.
Tax Tip--This new trust rule allows for considerably more estate and tax planning. However, the price paid is the high tax rate on the income. Of course, if the beneficiaries are already in the 39.6% bracket, the disadvantage vanishes. This is not an approach to be taken lightly. There's no way of telling if the trust can be used to advantage until you work through the numbers.
On the termination of all or any portion of the trust, the loss carryovers or excess deductions are taken into account by the entire trust.
This provision is effective to tax years beginning after December 31, 1996.
An S corporation can only have a single class of stock (nonvoting common is permitted). Certain debt ('straight debt') is not treated as a second class of stock so long as it is an unconditional promise to pay on demand or a specified date. Principal repayment or interest can't be contingent on profits and the debt cannot be convertible into stock. Finally, the creditor can only be an individual, an estate, or certain qualified trusts that can be S corporation shareholders.
The new law changes the last rule. Debt will be considered straight debt a if it is held by creditors, other than individuals, that are actively and regularly engaged in the business of lending money.
Comment--Under the old law a bank loan made to an S corporation could invalidate the S election. This removes a major drawback associated with an S corporation. Caution. The other rules involving straight debt still apply.
The provision applies to tax years beginning after December 31, 1996.
One of the biggest drawbacks to electing S corporation status is that a mistake in making the election or an inadvertent action that results in termination of the election can have serious tax consequences. And many of the rules can be both obscure and strict.
The Act provides that the IRS can issue regulations to waive the effect of an inadvertent termination under more circumstances and waive the effect of an invalid election caused by an inadvertent failure to qualify as an S corporation or to obtain the required shareholder consents. In addition, the Act also allows the IRS to treat a late filed election as timely where it determines that there was reasonable cause for the failure to timely file.
Comment--We don't suggest you rely on the generosity of the IRS to waive a problem. However, the new law should make the election a little less dangerous.
Comment--The provision applies to taxable years beginning after December 31, 1982. That might make it possible to ask the IRS for a waiver for a prior year. Check with your tax advisor for your particular situation.
When a shareholder disposes of his interest in an S corporation, profits or losses are generally allocated based on the number of days in the year he held the stock. There's a second option. The S corporation can terminate its tax year and allocate the profit or loss on that basis. Under prior law, that election required the consent of all shareholders.
Under the new law, the election only requires the consent of affected shareholders, those that are selling shares and those that are buying those shares. However, if shares are transferred to the corporation, affected shareholders include all persons who were shareholders during the year.
Tax Tip--In some cases this change can provide significant tax planning opportunities if a substantial profit or loss is generated either early or late in the year.
Under old law an S corporation could not own 80% or more of the stock of another corporation, whether an S corporation or a regular (C) corporation.
The Act makes two important changes here. First, an S corporation can now own 80% or more of the stock in a C (regular) corporation. However, the S corporation is not allowed to file a consolidated return. Dividends received by the S corporation from the C corporation will not be treated as passive investment income to the extent the dividends are attributable to the earnings and profits of the C corporation derived from the active conduct of a trade or business.
Second, an S corporation is allowed to own a qualified S corporation subsidiary. A qualified subsidiary is one that would be eligible to be an S corporation if the stock of the corporation were held directly by the shareholders of its parent S corporation. In addition, the parent must own 100% of the stock in the subsidiary and the parent must make an election. The subsidiary is generally not treated as a separate corporation for tax purposes.
Comment--Both provisions (and the one below) add significantly to the tax planning opportunities for S corporations. The ability to set up separate corporations can be helpful when doing business in different states or to keep the businesses separate for legal or other purposes. For example, local law might require that the same entity can't hold both a license to sell liquor at a package store and a bar. Using two separate corporations may allow you to avoid the restrictions. Separate corporations can also be invaluable if the business has to be split at a later date.
The provision applies to taxable years beginning after December 31, 1996.
Under the Act, an S corporation, in its capacity as a shareholder of another corporation, is no longer treated as an individual. Thus, the provision makes it clear that the liquidation of a C corporation into an S corporation will be governed by the rules for regular corporations, including the provisions of sections 332 and 337 allowing the tax-free liquidation of a corporation into its parent. (Following a tax- free liquidation, the built-in gains of the liquidating corporation may later be subject to tax upon a subsequent disposition.) An S corporation also will be eligible to make a section 338 election.
Comment--Without this change, if an S corporation acquired all the stock in a regular corporation and liquidated the corporation, the transaction might be subject to the same double tax faced by a regular corporation that liquidates and distributes its assets to individual shareholders. This change allows for greater flexibility in making acquisitions.
Example--Madison Inc. (an S corporation) acquires all the stock of Chatham Inc. (a regular corporation). Under the new law Chatham could continue to operate as a regular corporation, or it could be liquidated into Madison tax-free. Madison could even make a special Code Sec. 338 election and obtain a step-up in the basis of the assets (but then tax would be due on the transaction).
This provision is effective for tax years beginning after December 31, 1996.
The Act provides that a person acquiring stock in an S corporation through a bequest or inheritance must treat as income in respect of a decedent (IRD) his or her pro rata share of any item of income of the corporation that would have been IRD if that item had been acquired directly from the decedent. Where an item is treated as IRD, a deduction for the estate tax attributable to the item generally will be allowed (under section 691(c)). The stepped-up basis in the stock in an S corporation acquired from a decendent is reduced by the extent to which the value of the stock is attributable to items consisting of IRD. This rule applies to decedents dying after the date of enactment.
Generally, only individuals, estates, and certain trusts can be S corporation shareholders. The Act expands the eligible shareholders.
Banks. A bank (defined in section 581) can be a shareholder unless the institution uses a reserve method of accounting for bad debts. This provision is effective for taxable years beginning after December 31, 1996.
Charitable organizations. A 501(c)(3) charitable organization can now be a S corporation shareholder. Pass- through items of income or loss are deemed to be unrelated business taxable income (UBTI) regardless of the source of the income. Gain or loss on the disposition of the stock will also be treated as UBTI.
Tax-exempt trusts. Trusts described in section 401(a) (pension, profit-sharing, etc. plans) are also allowed to be S corporation shareholders. In addition, certain special tax rules relating to employee stock ownership plans (ESOPs) will not apply with respect to S corporation stock held by an ESOP. These last two provisions are effective for taxable years beginning after December 31, 1997.
Comment--Again, these provisions increase the flexibility of S corporations. Allowing a charitable organization to be a shareholder could allow shareholders to gift of S corporation stock to charities.
The new law provides relief for those S corporations that might have terminated that status before enactment of the new law. Usually there is a 5-year waiting period during which the corporation cannot reelect S corporation status. The Act provides that any termination in effect immediately before enactment is not taken into account.
The Act provides that the adjustments for distributions made by an S corporation during a taxable year are taken into account before applying the loss limitation for that year. Thus, distributions during a year reduce the adjusted basis for purposes of determining the allowable loss for the year, but the loss for a year does not reduce the adjusted basis for purposes of determining the tax status of distributions made during the year.
The law also provides that in determining the amount in the accumulated adjustment account for purposes of determining the tax treatment of distributions made during a year by an S corporation having accumulated earnings and profits, net negative adjustments (i.e., the excess of losses and deductions over income) for that taxable year are disregarded.
Example--Fred Flood is the sole shareholder in Madison Inc. Fred's basis in Madison is $10,000. At the end of the year Madison has a loss of $20,000 and Fred takes a distribution of $6,000. Because the nature of the distribution is determined before the loss is taken into account, the $6,000 distribution is tax free to Fred. Fred's basis after the distribution is $4,000 ($10,000 less $6,000). Fred can take only $4,000 of the $20,000 loss on his personal tax return. Under the old rules the distribution to Fred could have been taxable.
Comment--While the new rules sound arcane, they can be very important if the corporation makes a distribution to shareholders in the same year as it has a loss. There's now a better chance that any distribution will be tax free. However, while the new law is decidedly beneficial, it doesn't eliminate all the complexities of this issue.