Tax Law

Within the last month, President Clinton signed into law four separate acts that have significant tax implications for S corporations, businesses, individuals and charities:

1. The Small Business Job Protection Act of 1996;
2. The Health Insurance Portability and Accountability Act of 1996;
3. The Personal Responsibility and Work Opportunity Reconciliation Act of 1996; and
4. The Taxpayer Bill of Rights 2.

In addition, proposed "check the box" regulations recently issued by the IRS (summarized below) simplify entity classification for federal tax purposes, and clear the way for an increasing number of business enterprises to operate as limited liability companies.

The following is a brief summary of these recent legislative changes.

HOW THE TAX LEGISLATION AFFECTS S CORPORATIONS

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").

OTHER CHANGES AFFECTING BUSINESSES

Safe Harbors for Treatment of Workers as Independent Contractors Rather Than Employees. Section 530 of the Revenue Act of 1978 was enacted to provide employers with relief from significant employment tax liability that resulted from certain workers improperly being treated as independent contractors rather than employees. However, given the IRS's restrictive interpretation of this Section, businesses have had difficulty getting relief here. Effective in 1997, Section 530 is amended to clarify the standards applied in determining whether independent contractor status will be respected. The new standards should provide taxpayers with a more reasonable opportunity to prove independent contractor status in appropriate cases.

Employers are provided relief from employment taxes under Section 530 only upon satisfaction of a number of conditions. The condition that is most often subject to dispute is whether the employer had a reasonable basis for treating a worker as an independent contractor as opposed to an employee. The new legislation lessens the burden on the employer to establish independent contractor status.

Small Employers Eligible for Savings Incentive Match Plans for Employees (SIMPLE Plans). Small employers who do not currently maintain a qualified plan may now adopt a simplified retirement plan: Savings Incentive Match Plans for Employees (SIMPLE), which may be structured as either an IRA or a 401(k) plan. To qualify as a small employer, you must have 100 or fewer employees who received at least $5,000 in compensation in the year prior to adoption of the plan. SIMPLE plans permit an employee to contribute up to $6,000 annually. Employers must match contributions under one of two formulas. Under the matching formula, employers must match up to 3% of an employee's compensation. However, in an IRA type plan, an employer can elect to match less than 3% for a given year but the matching percentage cannot drop below 3% in more than two out of the five years preceding the election.

Under that alternative formula, the employer may make a non-elective 2% contribution for each eligible employee up to $3,00 per employee. Like other qualified plans, employers will receive a current deduction for contributions, while employee/participants will not be taxed until the money is withdrawn from the plan. A significant benefit of SIMPLE plans is that they are not subject to nondiscrimination rules and may be top-heavy.

Employer Provided Educational Assistance. Prior to January 1, 1995, employer-provided educational assistance payments of up to $5,250 per individual were excluded from the employee's taxable income. This program expired, however, on January 1, 1995. Under the new legislation, this program has been reinstated retroactively for tax years beginning after December 31, 1994. However, the new law does not exclude from income, assistance payments for graduate-level courses beginning after June 30, 1996. Unfortunately, this program is scheduled to lapse again for courses beginning after June 30, 1997.

Phased-in Increase in Expense Limitation. Under Section 179, eligible taxpayers may currently deduct, rather than depreciate, up to $17,500 of qualified business property placed in service during the year. Under the new legislation, this amount will increase to $25,000 by the year 2003 over a scheduled phase-in period.

HOW THE TAX LEGISLATION AFFECTS INDIVIDUALS

Spousal IRA Deduction

Under prior law, deductible IRA contributions on behalf of a non-working spouse were limited to $250. For tax years beginning after December 31, 1996, non-working spouses may generally contribute up to $2,000 per year to a deductible IRA. This amount is proportionately reduced if the working spouse is an active participant in an employer-sponsored retirement plan and earns over $40,000, and it is completely phased out if the working spouse has $50,000 of income. Other limitations on deductible IRA's continue to apply.

Penalty-Free Distributions from Ariz for Payment of Certain Medical Expenses and Health Insurance Premiums. Commencing with distributions subsequent to 1996, the 10% penalty tax on early distributions from qualified retirement plans will no longer apply to distributions from an IRA used to pay medical expenses of a taxpayer and his or her spouse and dependents in excess of 7.5% of adjusted gross income. Further, the 10% penalty tax will not apply to distributions from certain terminated employees' IRAs used to pay health insurance premiums for the taxpayer and his or her spouse or dependents, subsequent to the taxpayers's separation from employment.

Long-Term Care Costs/Insurance. Unreimbursed Long-Term Care Costs. Unreimbursed long-term care expenses will be treated as medical expenses so long as the services are not provided by a relative.

Generally, long-term care insurance contracts issued subsequent to 1996 will be treated as accident and health insurance contracts for tax purposes. As a result of this change, taxpayers will have the following new tax benefits:

Exclusion of Employer Paid Premiums. The cost of employer provided long-term care insurance will be excluded from the insured's income. However, employer provided long-term care insurance premiums will not be excludable from the employee's income if provided through a cafeteria plan or other flexible spending arrangement.

Certain Expenses Deductible for Self-Employed Taxpayers. The deduction for health insurance premiums (see below) also will apply to long-term care insurance premiums. The annual amount of such premiums that may be deducted is limited based on the age of the insured.

Amounts Received Under Contracts Excluded. Amounts received under certain long-term care insurance contracts are excludable from income. However, the exclusion from income on per diem contracts is capped at $175.00 per day (this amount will be indexed for inflation subsequent to 1997).

The long-term care insurance provisions apply generally to contracts issued after December 31, 1996. However, certain contracts issued prior to January 1, 1997 that meet state long-term care insurance requirements when issued will be treated as long-term care insurance contracts.

Health Insurance Deduction for Self-Employed Individuals. Commencing in tax years beginning in 1997, the deduction for health insurance premiums of self-employed individuals and their spouses and dependents will be increased from 30% to 80%. The increase is phased in from 1997 through 2006 according to the following table:

Tax Year Beginning In: Percentage Deduction

1997 40%
1998 through 2002 45%
2003 50%
2004 60%
2005 70%
2006 and thereafter 80%

The increase in the health insurance deduction is available to self-employed individuals as well as individuals who are general partners (and limited partners receiving guaranteed payments), members of limited liability companies or shareholders owning more than 2% of the outstanding stock of S corporations.

Required Distribution Date Modified for Certain Participants in Qualified Plans. Participants in qualified plans (excluding IRAs), other than 5% owners, will no longer be required to commence distributions after attaining 70½ so long as they are still employed and the plan expressly provides for this deferral of distribution. Under the new law, qualified plans can provide that distributions must commence on or before April 1 of the calendar year following the later of (1) the year in which the employee attains age 70½; or (2) the calendar year in which the employee retires. The modified distribution rules are effective for years beginning subsequent to December 31, 1996. However, the Conference Report clarifies that a qualified plan may allow a participant who is currently receiving distributions to elect to stop such distributions until required to begin distributions under the new rule.

Suspension of Tax on Excess Distributions From Qualified Plans. The new law provides that the 15% excise tax on excess distributions (those distributions exceeding $155,000 per year or lump sum distributions exceeding $775,000) will be suspended during the years 1997 through 1999. However, the 15% estate excise tax on excess retirement accumulations will still apply. It is important to note that making distributions from qualified plans to take advantage of the suspension of the 15% excise tax on excess distributions may not always be advantageous. In order to make a determination as to whether a withdrawal would make sense, a taxpayer would have to evaluate the length of time the withdrawal could be postponed, the after-tax rate of return on withdrawn funds (keeping in mind early withdrawal penalties which continue to apply), and the rate of return on funds kept within the qualified plan.

Situations where a distribution to avoid the excise tax may be advantageous include the following:

1. Where the participant and spouse (if any) have short life expectancies and, therefore, will not benefit from tax-free build-up;

2. Where the participant desires to begin an aggressive gift-giving program funded by excess distributions; or

3. Where a participant wishes to fund an investment opportunity having an after-tax return that significantly exceeds the rate of return of assets in the plan and the impact of having a current tax on the distribution.

Deduction for Contribution of Appreciated Stock to Private Foundations. A deduction equal to the fair market value of publicly traded stock (that is capital gain property) contributed during the period from July 1, 1996, through May 31, 1997 to private foundations is now available. The deduction only applies to the extent that total contributions of the stock of a particular corporation do not exceed 10% of the outstanding stock of such corporation.

Resident Aliens Subject to New "Expatriation" Provisions. The Health Insurance Act includes changes which expand the present reach of U.S. income, estate and gift tax laws to former U.S. citizens who renounce their U.S. citizenship. Although the debate concerning these new rules was well-publicized, the most significant aspect of these changes may relate to their treatment of U.S. residents (e.g., so called "green card" holders) who are citizens of other countries, and who ultimately return to their country of citizenship. The new law expands the expatriation provisions to include long-term (residing in the U.S. for eight of the preceding 15 years) residents who terminate U.S. residency. Like expatriating citizens, for ten years after the "terminating event", they will be (i) taxable on their U.S. source income (determined under a newly expanded definition), (ii) subject to an expanded definition of U.S. gross estate (including stock in the foreign corporation in which the decedent had more than 50% of the vote or equity), and (iii) subject to U.S. gift tax on gifts of intangibles (which otherwise enjoy a blanket exclusion from gift tax if given by a nonresident). While some relief is available under the new law to certain former citizens who can demonstrate that renunciation of citizenship was not tax motivated, no similar provision is expressly made available to former non-citizen residents. The legislative history states that these new provisions are not to be defeated by any treaty provision.

HOW THE TAX LEGISLATION

AFFECTS CHARITABLE ORGANIZATIONS

Charitable Organizations Can Now Be Shareholders in S Corporations. Beginning in 1998, qualified charitable organizations may qualify as shareholders in an S corporation. This will provide new opportunities for donors to contribute interests in their S corporations to a charity. Unfortunately, the tax treatment of the income from the S corporation may create some problems for charities. The charity's share of taxable income and loss items flowing from the S corporation must be treated as unrelated business taxable income, regardless of whether this income is distributed to the charity by the S corporation. This could potentially cause a cash flow problem if the S corporation generates significant income but does not distribute the income to the shareholders. Additionally, any profit on the sale of the S-corporation stock by the charity will be treated as unrelated business taxable income.

Deduction for Contributions of Appreciated Stock to Private Foundations. As discussed above, contributions of certain appreciated stock to a private foundation made between July 1, 1996, and May 31, 1997, will result in a tax deduction in the amount of the full fair market value of the stock.

The Taxpayer Bill of Rights 2 gives taxpayers additional procedural rights in an attempt to remedy prior perceived abuses by the IRS. Some of the most important provisions in the bill are the following: (1) the creation of a new Taxpayer Advocate to help expeditiously resolve problems with the IRS; (2) the requirement that the IRS disclose collection information to divorced spouses regarding joint liabilities; and (3) liberalization of review procedures for offers to compromise tax liabilities where the liability does not exceed $50,000. The Taxpayer Bill of Rights 2 also contains one other provision that will affect all taxpayers: a taxpayer can now establish that a return was timely filed if it was transmitted on the last day of filing using a private delivery service (e.g. Federal Express). Prior to the bill, timely mailing could only be established through the U.S. Postal Service.

On May 9, 1996, the IRS issued proposed regulations under Section 7701 of the Internal Revenue Code to simplify entity classification for federal tax purposes. The "check the box" regulations will replace the four factor test currently contained in the regulations and should significantly reduce tax planning problems that arise in connection with the organization of business entities. Under the existing rules, an entity is classified as either a corporation or a partnership based upon an examination of four factors (i.e. limited liability, free transferability of interest, continuity of life, and centralized management). An entity that lacks two or more of these characteristics is treated as a partnership for tax purposes. An entity that possesses three or more of these characteristics is treated as a corporation for tax purposes.

Under the new regulations, the classification of an entity will depend upon the type of legal entity involved, the number of owners and whether or not an election is made. This should significantly enhance the ability of taxpayers to create tax "pass-through" business entities and should simplify the drafting of partnership and limited liability company (LLC) operating agreements.

The most significant aspects of the "check the box" regulations are:

Entities formed as corporations under state law will automatically be classified as corporations for federal tax purposes.

Unincorporated domestic business entities (such as limited liability companies and limited partnerships) having two or more members will be classified as partnerships for federal tax purposes unless the entity affirmatively elects to be taxed as a corporation.

Unincorporated domestic business entities that have one member will be disregarded for federal tax purposes (i.e. they will be taxed as sole proprietorships) unless the entity affirmatively elects to be taxed as a corporation.

Automatic "Corporation" Classification. Any business entity that is organized under a federal or state statute that describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic, will be a corporation for federal tax purposes. Thus, corporations formed under state corporation statutes, such as the New Jersey Business Corporations Act, will be automatically classified as corporations for federal tax purposes.

Elective Classification for Unincorporated Entities. Domestic entities that are not automatically classified as corporations, such as a limited liability company and a limited partnership, may elect to be treated as either (i) a corporation or a partnership (if the entity has two or more members) or (ii) a non-entity i.e. sole proprietorship (if the entity has only one member). Because partnership/non-entity classification will apply under the default rules, with respect to the formation of new entities, an election generally will be necessary only if corporate status is desired.

Classification of Foreign Entities.

A number of foreign limited liability business entities listed in the proposed regulations are automatically classified as corporations for federal tax purposes. If a foreign entity is not automatically classified as a corporation for federal tax purposes, the following default classifications will apply unless the entity affirmatively elects otherwise: (i) partnership classification if the entity has at least two members and any member has unlimited liability; (ii) the entity will be disregarded if it has a single owner with unlimited liability and (iii) corporation classification if no member has unlimited liability.

Default Rules.

If an entity fails to check any box, the proposed regulations provide certain default rules. The default rules differentiate between new and existing entities. "New" entities would be those formed after the regulations become final. "Existing" entities are those formed at any time before the regulations are final. Any "new" domestic unincorporated entity with two or more members would be classified as a partnership if it fails to make any election. Any "existing" entity that is eligible to make an election but fails to do so generally would have the same classification that it claimed under the four factor test in effect immediately before the "check the box" regulations become final. Note: It will be important to review existing limited partnership agreements and limited liability company operating agreements to evaluate whether modifications should be made now that it is no longer necessary to satisfy the mechanical four pronged test of present tax regulations. For example, many of these agreements (for the sole purpose of complying under the four-part test) impose more severe restrictions on transferability of interests than the partners/members would otherwise have imposed; once the tax regulations are finalized, these provisions can and should be modified.

Mechanics of the Election. The IRS is expected to issue a form for making the election. The election will generally be effective on the date it is filed. However, the regulations permit an entity to specify an effective date 75 or fewer days prior to filing. Once an election is filed, an entity must generally wait 60 months prior to making another election. Although the first version of the proposed regulations provided that all members of an entity must consent to the election, the latest version provides that an election can be made unanimously or by any officer, manager, or member of the electing entity who is authorized to make the election and who represents to having such authorization under penalties of perjury.

Effective Date. At the present time, the "check the box" provisions are only in proposed form. They will become effective when finalized and published in the Federal Register; we anticipate that may occur by year end.

Transition Rules. The proposed regulations indicate that the IRS will not challenge the classification of any unincorporated business entity formed prior to the time the regulations are finalized if (i) the entity had a reasonable basis for its claimed classification (ii) the entity claimed the same classification in all prior years; and (iii) neither the entity nor any member was notified in writing on or before May 8, 1996, that the classification of the entity was under examinations. This will protect partnership tax status of many existing limited liability companies and limited partnerships.

The "check the box" regulations reflect a very positive approach by the IRS to the long-standing problem of the tax classification of entities. We think it will have a significant affect on the organization of businesses in the U.S., and we would encourage our business clients to discuss the potentially favorable application of these anticipated new rules to their particular businesses.