|DAVID S. GIBSON, CPA, is a tax manager with Imowitz, Koenig & Co. LLP in New York City. He is a member of the New York State Society of CPAs closely held and S corporations committee.|
The Small Business Job Protection Act, passed by Congress in August 1996, was intended to provide tax breaks for small businesses as well as to impose tighter rules on expatriates, foreign trusts and entities doing business in Puerto Rico. Also included in the act were numerous changes to the rules governing the use of S corporations. Many of these changes—detailed in this article—improved the flexibility of this form of ownership, making it easier for such businesses to operate and for owners to transfer their interests during their lifetimes and at death. rules governing the use of S corporations. Many of these changes—detailed in this article—improved the flexibility of this form of ownership, making it easier for such businesses to operate and for owners to transfer their interests during their lifetimes and at death.
Who Can Be Shareholders?
The act changed a number of rules about who can and cannot have an ownership interest in an S corporation.
Number of permitted shareholders . The act increased the maximum number of eligible shareholders of an S corporation to 75 from 35 effective for tax years beginning after December 31, 1996. This significantly increases the number of entities that now may qualify as S corporations.
Electing small business trusts as eligible shareholders . Under prior law, a trust generally was not permitted to own stock in an S corporation, although certain trusts such as qualified subchapter S trusts (QSSTs) were—and remain—eligible. The act created (effective for tax years beginning after December 31, 1996) an electing small business trust (ESBT) that may be an eligible S corporation shareholder. In general, the difference between the two trusts is that the ESBT itself is treated as an S corporation shareholder whereas the beneficiary of a QSST is considered the S corporation shareholder.
To qualify as an ESBT, all trust beneficiaries must be individuals or estates (or, after 1997, certain charitable organizations) eligible to be S corporation shareholders (charitable organizations may hold contingent remainder interests). Also, no interests in the trust may be acquired by purchase (as defined in the act). Instead, the trust interests must be acquired by gift, bequest or similar means. Each potential current income beneficiary of the trust is counted as a shareholder for purposes of the 75-shareholder limitation. To be considered an ESBT, the trustee must include an election with the trust's tax return; such elections may be revoked only with Internal Revenue Service permission.
This provision permits taxpayers more latitude in doing estate planning by allowing them to more easily fund trusts with S corporation stock. This means taxpayers can more easily transfer their S corporation stock to family members to minimize their estate tax liability.
In notice 97-12, the IRS provided procedures for making the ESBT election: The trustee must file a statement with the service center where the corporation files its income tax return. The statement must
- Contain the name, address and taxpayer identification number (TIN) of the trust, all potential beneficiaries and the corporation.
- Identify the election as one under IRC section 1361(e)(3).
- Specify the date on which the election is to become effective and the date on which the corporation stock was transferred to the trust.
- Provide all information and representations necessary to show that all potential beneficiaries meet the shareholder requirements of section 1361(b)(1) and the trust qualifies as an ESBT under section 1361(e).
The trustee must file the election within the period required for filing a QSST election under Treasury regulations section 1.1361-1(j)(6)(iii) (generally, within the two-month-16-day period after stock is transferred to the trust). In the case of newly electing S corporations, the trustee may attach the ESBT election to Form 2553, Election By A Small Business Corporation. For purposes of the ESBT's consent to the S corporation election under IRC section 1362(a), only the trustee need consent to the S corporation election.
Exempt taxpayers as eligible shareholders . Certain tax-exempt organizations now qualify as eligible S corporation shareholders effective for tax years beginning after December 31, 1997. The organizations that qualify are qualified pension, profit-sharing and stock bonus plans as described in IRC section 401(a) and any type of organization—such as a school or church—that qualifies for tax-exempt status under IRC section 501(c)(3). For purposes of determining the number of S corporation shareholders, a qualified tax-exempt shareholder counts as one shareholder. Any items of income or loss flow through to the tax-exempt shareholders as "unrelated business taxable income" regardless of the source or nature of the income.
Expansion of postdeath qualification for certain trusts . Under prior law, a trust that did not qualify as an S corporation shareholder and that acquired S corporation stock at the death of a shareholder was allowed to hold the stock for 60 days without causing the S election to terminate. In the case of a grantor trust, the 60-day period ran from the date of the shareholder's death. For a trust that became a shareholder by virtue of a transfer under the terms of a will, the 60 days began on the date the stock was transferred to the trust. The new law—effective for tax years beginning after December 31, 1996—increases the 60-day period to two years. This gives estate administrators substantially more time to either qualify the trust as an eligible shareholder (to make an ESBT election) or to transfer the stock to other eligible shareholders.
Changes In Eligibility Rules
Under prior law, banks and thrift institutions to which IRC sections 585 or 593 applied were not eligible to be treated as S corporations. Such institutions are entitled to certain deductions and accounting methods—particularly the reserve method of accounting for bad debts—and Congress did not want individuals to have these benefits. Effective for taxable years beginning after December 31, 1996, banks (as defined in IRC section 581) may qualify as S corporations unless they use a reserve method of accounting for bad debts. Accordingly, any "large" banks (as defined in section 585(c)), which are not permitted to use a reserve method, may qualify for S status as long as all other requirements are met. By changing this law, Congress seems to have decided that a bank should be able to elect S status if it is not using the reserve method since shareholders would not gain an unfair advantage over shareholders of other types of S corporations.
The IRS has issued guidance, in notice 97-5 (IRB 1997-2), concerning the termination of an S corporation with "accumulated earnings and profits" and "passive investment income" that constitute more than 25% of its gross receipts for each of three consecutive years. The notice generally says the term passive investment income does not include gross receipts directly derived from the active and regular conduct of a lending or finance business, provided the corporation meets the requirements of IRC section 542(c)(6) (lending or finance company excluded from the definition of personal holding company).
Financial institutions permitted to hold safe-harbor debt . One of the requirements a corporation must meet to qualify as an S corporation is that it may have only one class of stock. This is not as straightforward as it seems. A corporation is deemed to have a second class of stock if any one of several circumstances exists. One such circumstance is that if certain debt (such as a promissory note) issued by an S corporation is treated as equity under general tax principles and has as a principal purpose the contravention of rights to distribution and liquidation proceeds, then this debt is considered a second class of stock unless it qualifies as straight debt (safe-harbor debt).
Safe-harbor debt is debt that is a written, unconditional obligation to pay a sum certain on demand, or by a specified date. The obligation (1) cannot provide for interest or principal payments that are contingent on profits or payable solely at the borrower's discretion, (2) cannot be convertible (directly or indirectly) into stock or another equity interest of the S corporation and (3) must be held by an individual, estate or trust eligible to own S stock (regulations section 1.1361-1(l)(5)(I)). The act amended the third part of the definition to include creditors, in addition to those listed here, that are actively engaged in the business of lending money (such as banks). For these purposes, a bank does not need to qualify as an eligible shareholder. This is a significant change since now an S corporation may borrow money from a bank and still meet the safe-harbor test without being concerned the debt could be considered a second class of stock.
Before Congress passed the 1996 act, S corporations generally were not allowed to be part of an affiliated group of corporations. This meant they could not own 80% or more of another corporation. Also, an S corporation was not allowed to have another corporation as a shareholder.
Effective for taxable years beginning after December 31, 1996, S corporations may now own 80% or more of a C corporation or 100% of a qualified subchapter S subsidiary (QSSS). However, an S corporation may not elect to file a consolidated tax return with a C corporation. A QSSS is any domestic S corporation wholly owned by an S corporation parent that elects to treat it as a QSSS. The QSSS, for tax purposes, is not treated as a separate corporation and all its assets, etc., are treated as assets, etc., of the parent S corporation.
This provision allows taxpayers to form tiers of corporations with an S corporation owning the stock of C corporations when the individual shareholder does not wish to directly own the C corporation stock. Also, when a shareholder for nontax reasons wishes to form several S corporations (the shareholder wants each business to be separate for liability reasons), he or she no longer must own all the stock directly and file separate income tax returns for each corporation. The taxpayer can cause one S corporation to own all the stock of the other S corporations and treat the subsidiary corporations as QSSSs. This would allow the parent S corporation to file just one income tax return—thereby reducing administrative costs and burdens. Before making a decision on such an organizational structure, however, the state tax implications should be examined.
Under IRS notice 97-4 (IRB 1997-2), when the parent corporation makes the election, the subsidiary is deemed to have liquidated under IRC sections 332 and 337 immediately before the election is effective. Such liquidations generally are nontaxable. When a corporation liquidates under section 332, that corporation must file Form 966, Corporate Dissolution or Liquidation , within 30 days of the adoption of the liquidating plan or resolution. In addition, the corporation must file a return for the short period ending on the date it goes out of existence.
The IRS and Treasury Department intend to issue regulations describing the manner in which a QSSS election must be made and the effective date of the election. Until regulations are issued, however, taxpayers should follow the procedures listed in notice 97-4 to satisfy the election requirements.
Inadvertent Terminations And Invalid Elections
The Small Business Job Protection Act extended the IRS's authority to waive the effect of an inadvertent termination (see IRC section 1362(f)) to allow it to waive the effect of an invalid election caused by an inadvertent failure to qualify as a small business corporation or to obtain the required shareholder consents (including elections regarding qualified subchapter S trusts and electing small business trusts) or both. Also, the IRS may now treat a late S corporation election as timely when it determines there was reasonable cause for the failure.
Under prior law, IRS authority to waive inadvertent terminations was limited to situations in which the S corporation had inadvertently terminated after making a valid S election. Accordingly, if a corporation inadvertently had failed to qualify as an S corporation or the required consents had not been obtained, the corporation's only recourse was to take steps to rectify the situation and become an S corporation for a subsequent year in which the corporation did qualify and obtain the necessary consents. Likewise, a corporation filing an S election late would become an S corporation for the next year in which all requirements were met. Obviously, the new law can be very helpful when unfamiliarity with the law results in improper organization of an S corporation. While this change is effective for taxable years beginning after December 31, 1982, it is unclear what the impact will be on inadvertent terminations that occurred during closed tax years.
The IRS has issued guidance in announcement 97-4 on how to obtain the relief discussed above. If a taxpayer believes reasonable cause exists for failure to file an election on a timely basis or for not filing an election, it must request relief in the form of a private letter ruling, the procedures for which are described in revenue procedure 97-1 (1997-1 IRB 11).
If a corporation wishes to obtain relief for inadvertent invalid elections, it must request a private letter ruling. In addition, the same rules that apply to corporations requesting relief for inadvertent terminations (regulations section 1.1362-4) apply to entities requesting inadvertent invalid election relief.
When corporations fail to obtain all the necessary shareholder consents on form 2553, regulations section 1.1362-6(b)(3)(iii) provides rules for obtaining section 1362(f) relief from the district director of the service center with which the corporation files its income tax return.
Reelections. Previously, any corporation terminating its S election had to wait five years to reelect S status unless the IRS consented to allow reelection sooner. The act eliminates the five-year waiting period for S elections that were terminated in a tax year beginning before January 1, 1997. Accordingly, any corporation that terminated its S election in 1996 or earlier may reelect without obtaining IRS consent.
Distributions During Loss Years
Under prior law, the adjusted basis of a shareholder's stock in an S corporation and the accumulated adjustments account (AAA) were adjusted by income and losses before determining the effect of distributions to the shareholders. Effective for taxable years beginning after December 31, 1996, shareholders must take distributions into account before applying the loss limitation for the year. Accordingly, distributions during a year reduce the adjusted basis of a shareholder's stock for purposes of determining the allowable loss for the year, but the loss for a year does not reduce the adjusted basis (or AAA) for purposes of determining the tax status of the distributions made during that year. The treatment of distributions by S corporations during loss years is now the same as that for partnerships. Exhibit 1 illustrates this provision.
As the exhibit shows, the major difference is that under prior law the shareholder was getting a full benefit of the operating loss in 1998, which, if she were in the top marginal tax bracket of 39.6%, would save her an additional $119 ($300 X 39.6%) of tax while at the same time she would pay tax on an additional $300 of capital gain, which is taxed at a lower rate (28%). Therefore, the shareholder would defer $35 under prior law ([300 - 39.6%] X [300 - 28%] = $35).
Take a Closer look
Because of the wide variety of changes the Small Business Job Protection Act made in S corporation rules, CPAs—both those who work for S corporations and those who advise them—should study the provisions carefully. When applying the new rules, companies must continue to consider both the tax and overall business implications. For example, a business with 50 investors—which now qualifies to be an S corporation under the new law—should consider other nontax factors before deciding to elect to be treated as an S corporation.
If investors wish to specially allocate income, losses and distributions, for example, an S corporation would not be the appropriate choice since S corporations are not permitted to specially allocate those items to shareholders. Instead, they must be allocated pro rata based on the number of shares owned. These are the kinds of issue CPAs must consider when studying the applicability of the new rules to their clients or employers. To facilitate this, exhibit 2 , summarizes all the S corporation provisions, including some not discussed in this article.