New Developments for S Corporations

This past summer Congress passed and President Clinton signed the Small Business Job Protection Act. The Act contains a number of changes to the rules relating to Subchapter S corporations. Many of the changes permit increased utilization of S corporations and broaden the flexibility in the operation of them. Most of the important changes are effective for tax years beginning after December 31, 1996.

Increase in Permitted Shareholders to 75. Probably the most significant change is that the number of persons who are permitted to be shareholders in an S corporation is increased from 35 to 75. In general there is no attribution for purposes of determining the number of eligible shareholders. Except for husbands and wives and their estates, each individual owning stock is counted separately. Husbands and wives are treated as one shareholder for this purpose, and each potential current beneficiary of a trust is counted as a shareholder. The Act also expands the list of eligible shareholders to include electing small business trusts and certain charitable organizations. Included in the expanded definition, the Act permits qualified retirement plans, such as a pension or profit sharing plan, or a charitable organization such as a church or college, to be counted as one shareholder in determining the number of shareholders in an S corporation.

Ownership of Another Corporation. In the past, an S corporation was not permitted to own more than 80% of the stock of an active corporation. This meant that an S corporation could not own and operate a wholly-owned subsidiary. The Act now permits S corporations to own a Qualified Subchapter S Subsidiary (“QSSS”). A QSSS includes any domestic corporation that would have qualified as an S corporation and that is 100% owned by the S corporation parent. For this purpose, a QSSS is not treated as a separate corporation and all of its assets, liabilities and income are treated as the assets, liabilities and income of the parent S corporation. It is important to remember that a QSSS cannot be a foreign corporation.

An S corporation is also permitted to own stock in a C corporation. Formerly, this type of ownership may have caused a termination of the Subchapter S election. Caution: An S corporation cannot elect to file a consolidated income tax return with an affiliated C corporation. The result is that the C corporation pays corporate taxes on its income, and the S corporation income is taxed to the shareholders as if the corporations were separately owned.

While an S corporation now may own all of the stock of a C corporation, neither a partnership nor a C corporation is permitted to own stock in an S corporation.

Election by a Terminated S Corporation. In the past if a corporation had terminated its Subchapter S election, the corporation was not permitted to reelect Subchapter S status in the succeeding five fiscal years. Beginning January 1, 1997, the five-year rule is repealed. This means that any corporation which terminated its Subchapter S status prior to January 1, 1997 may reelect in a timely fashion, even if the prior termination was within the preceding five years.

Relaxed Rules for Trusts. Another important change relaxes the rules relating to the ownership of S corporation stock by certain trusts. An electing small business trust may now be a shareholder in an S corporation. This permits broader estate planning opportunities for S corporation shareholders by allowing trusts to be funded with S corporation stock. To qualify, all beneficiaries of a small business trust must be individuals or estates eligible to be S corporation shareholders.

Since most of the changes are effective in 1997, time is of the essence. The Act provides a number of new planning opportunities from an income tax as well as an estate and gift tax standpoint. If your business is incorporated and you have not elected S corporation status, now is the time to review the corporation’s and the shareholders’ income and estate tax interests, goals and objectives. If you are presently operating an S corporation, the changes made by the Act expand the opportunities for saving income and death taxes.

The recent changes present exciting new tax planning opportunities. We would be happy to answer your specific inquiries on the new S corporation rules – feel free to give us a call.
– Mike Beausang

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