Small Business Job Protection Act Creates New Opportunities For S Corporations
Subtitle C of the recently enacted Small Business Job Protection Act, (H.R. 3448) (the “Act”), has liberalized the qualifications for “S corporations.” The result is an expansion of the opportunities and ways in which S corporations can be used, especially in the area of estate planning.
One of the biggest drawbacks to incorporating is that corporations must pay taxes on any profits. Shareholders must then pay taxes upon the distribution of dividends. This “double taxation” can make the corporate form unattractive to business promoters. Subchapter S of the Internal Revenue Code eliminates the federal income tax levied against certain qualifying small business corporations. S corporations are essentially taxed under partnership rules. Income is allocated and taxed to shareholders under their individual income tax regardless of whether there is any actual distribution of profits. This is commonly known as “flow-through” taxation.
II. S Corporations
Historically, corporations could qualify as S corporations by meeting the following criteria: there could be no more than 35 shareholders; shareholders could only be natural persons, estates, and qualifying trusts; no shareholder could be a nonresident alien; and the corporation could have only one class of stock. [I.R.C. ‘ 1361(b)] In order to qualify, corporations must affirmatively elect to be treated as S corporations by filing Form 2553.
III. The Amendment
The amendment changes the maximum number of shareholders for an S corporation from 35 to 75. The new limit is effective for taxable years beginning after December 31, 1996.
There are other changes effected by the Act. Under prior law, S corporations could not own more than 80% of any other corporation. This prior law effectively prevented S corporations from acquiring or creating wholly owned subsidiaries. S corporations, after December 31, 1996, can hold 100% of the stock of a subsidiary.
The Act also relaxes certain restrictions on the ownership of S corporations by trusts. Under current law, qualified Subchapter S trusts could have only one income beneficiary. The Act amends the code allowing trusts to hold S corporation stock and to “spray” S-corporation income among those individuals who are beneficiaries of the trust. This amendment will create new opportunities for the use of the S corporation as an estate planning tool. The amendment is effective for tax years beginning after December 31, 1996.
The Act changes current law by allowing banks to be eligible small business corporations. This will allow qualifying banks to be treated as Subchapter S corporations and avoid double taxation.
Prior law also prohibited qualified retirement plan trusts and 501(c)(3) charitable organizations from becoming shareholders in S corporations. The Act will allow these types of organizations to be qualified tax-exempt shareholders of S corporations. Each such organization will count as one shareholder, effective for tax years beginning after December 31, 1997. These changes will, like some of the other changes, affect the utility of the S corporation as a tax and estate planning tool.
Amendments to Subchapter S will increase the availability of flow through taxation for many corporations, including banks. Business planners will also be able to consider using the S corporation as a vehicle for holding wholly owned subsidiaries. The new rules related to trust and charitable organization ownership of S corporations will allow for additional flexibility and creativity in both estate and non-profit organization planning.
Richard Byron Peddie is no longer with the law firm of Frascona, Joiner, Goodman and Greenstein, P.C. For Business Law needs please contact Gary S. Joiner or Jon H. Sargent.