The new tax legislation eliminates a number of the restrictions that apply to S corporations under current law. Except as specifically noted, all of the following provisions take effect for tax years after 1996.
Number of Shareholders. The number of permissible shareholders of an S corporation has been increased from 35 to 75.
Types of Shareholders.
Electing Small Business Trusts. Under current law only certain trusts are permitted to be S corporation shareholders. These trusts include grantor trusts, voting trusts, certain testamentary trusts and qualified subchapter S trusts ("QSSTs"). Unlike the QSST, the electing small business trust may have several current beneficiaries (provided that each is eligible to be a shareholder of an S corporation or is a charity with a contingent remainder interest). Additionally, an electing small business trust (unlike the QSST) need not require the distribution of all trust income to its beneficiaries. An electing small business trust may only acquire S corporation stock by way of gift, bequest or other "non-purchase" acquisition.
The electing small business trust provides us with greater flexibility to carry out the desires of our clients who are making lifetime gifts or planning for testamentary dispositions of S corporation stock. Many clients are reluctant to gift S stock knowing that the donee must receive income distributions that are made by the company. Also, our business clients often wish to leave their S stock in trust for a number of different beneficiaries to be used for any one or more of those beneficiaries as the trustees see fit. We can now accomplish these common goals by using electing small business trusts.
The price of using the electing small business trust is that all trust income from the S corporation will be taxed at the highest rate imposed on estates and trusts (currently 39.6% on ordinary income and 28% on net capital gain) regardless of whether the trust income remains in the trust or is distributed to its beneficiaries. If the income beneficiaries would otherwise be in the highest bracket this might be of no consequence.
Testamentary Trusts. To facilitate the administration of estates, a testamentary trust may now hold S corporation stock for two years from the date the trust is funded with S stock. Prior law provided only a 60-day window.
Financial Institutions. Under the new law, certain financial institutions that under current law are specifically prohibited from electing S status, (i.e., banks) will be allowed to elect S corporation status so long as they do not use a reserve method of accounting for bad debts.
Charitable Organizations. The new law also permits charitable organizations to qualify as S corporation shareholders (as discussed below).
Subsidiaries. S corporations may now hold subsidiaries. This represents a major breakthrough in S corporation reform.
Specifically, an S corporation will be permitted to own 80% or more of the stock of a C corporation. The dividends received from a C corporation subsidiary will not be treated as passive investment income to the extent the dividends are attributable to earnings and profits derived from the active conduct of a trade or business. The C corporation subsidiary may elect to join in the filing of a consolidated return with its affiliated C corporations, but the S corporation parent may not join in this election.
An S corporation may also own a qualified subchapter S subsidiary ("QSSS"). A QSSS includes any domestic corporation that would qualify as an S corporation if all of its stock were held by the shareholders of the parent S corporation and is 100% owned by an S corporation parent which elects to treat it as a QSSS. A QSSS is not treated as a separate corporation for tax purposes, and all of its assets, liabilities and items of income, deduction and credit are treated as the assets, liabilities, and items of income, deduction and credit of the parent S corporation.
S corporations may also take advantage of the subsidiary liquidation provisions of Section 332 and 337 of the Internal Revenue Code and may now make a Section 338 election upon a qualifying stock purchase (assuming all other requirements are met).
Single Class of Stock Requirement is Liberalized. An S corporation may not have more than one class of stock. Under current law, certain types of corporate debt may be reclassified as a second class of stock. These rules have been liberalized to provide that bona fide debt held by creditors actively and regularly engaged in the business of lending money will be treated as "safe-harbor straight debt" within the meaning of the Internal Revenue Code, and will not be treated as a second class of stock.
S Elections.
Defective S Elections. The IRS currently has the authority to validate an S election that has been inadvertently terminated after it has become effective. This authority has now been expanded to allow the IRS to validate an election that is inadvertently defective at the outset. Therefore, the IRS can now 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. The Act also allows the IRS to treat a late S corporation election as timely filed if the IRS determines that there was reasonable cause for the late election. These changes are effective for tax years after 1982.
Re-electing S corporation Status. A special grace period is made available to corporations whose S elections terminated at or will terminate prior to January 1, 1997. These corporations would normally be prohibited from re-electing S corporation status for a period of five years following the termination without IRS consent. Presumably to allow corporations that terminated S status within the last five years to take advantage of the benefits of the newly enacted S corporation changes, these corporations may once again elect S status without IRS consent even though it is within the five year period following S termination.
Accounting Issues.
Treatment of Distributions and Losses in Loss Years. The ordering rules for distributions and losses have changed. Under present law, income and expenses increase and decrease the basis of S corporation stock before accounting for any distributions during the year. As a consequence, if an S corporation has a loss during a year, the amount that may be distributed tax-free to the shareholders during the year may be reduced, causing a prior distribution to be taxable.
The S corporation rule is being changed to correspond to that applicable to partnerships. Accordingly, basis will be first increased by net gain and income, then reduced by distributions and finally reduced by net losses. The same rule will apply in determining the amount in the accumulated adjustments account for purposes of measuring the tax treatment of distributions during a given year.
Election to "Close the Books". An election to close the books of an S corporation upon the termination of a shareholder's interest will now require the consent of the corporation and all "affected" shareholders. This marks a change from the current rule which requires the consent of the corporation and all shareholders. As a consequence, consents need to be obtained only from shareholders whose tax results will be affected as a consequence of the election. A shareholder whose proportionate interest in the corporation remains the same all year will not be required to consent.
Basis Adjustments to Reflect Income in Respect of a Decedent. The rules governing basis adjustments to S corporation stock upon death of a shareholder are changed to correspond to the partnership rules. A stepped up basis in S corporation stock will be reduced to the extent the value of stock is attributable to items of income in respect of a decedent ("IRD").
