The Subchapter S Revision Act of 1982
| Jurisdiction | United States,Federal |
| Citation | Vol. 12 No. 1 Pg. 1 |
| Pages | 1 |
| Publication year | 1983 |
1983, January, Pg. 1. The Subchapter S Revision Act of 1982
Signed by the President on October 19, 1982, and generally effective for taxable years beginning after 1982, the Subchapter S Revision Act of 1982 ("Act")(fn1) significantly improves the planning opportunities available to the owners of small businesses who choose to operate in corporate form, but who would prefer the attributes of partnership taxation. Widely supported by both the Treasury Department and all segments of the legal, accounting and business communities, the Act accomplishes two highly desirable objectives. It simplifies the rules relating to eligibility for Subchapter S status and eliminates many of the technical provisions of Subchapter S that have proven to be traps for those less knowledgeable about their intricacies or have conferred unintended benefits on taxpayers sophisticated enough to manipulate them. At the same time, by closely conforming the tax treatment of Subchapter S corporations to that accorded partnerships, the Act reduces many of the tax considerations that influence the selection of a form of doing business and increases the importance of other considerations, such as the desirability of limited liability or centralized management, that affect that decision.
The goal of this article is to summarize the principal provisions of the Act---those relating to eligibility for Subchapter S status, the tax treatment of Subchapter S corporations and their shareholders, and certain of the new rules relating to the administration of the new Subchapter S tax laws. This article also seeks to highlight certain of the remaining distinctions between partnership and new Subchapter S taxation, since tax advisors may now find Subchapter S corporations to be an appropriate alternative in situations where only partnerships were suitable in the past.
The Act discards the familiar term "Subchapter S corporation" and instead creates a distinction between what is now called an "S corporation" and a "C corporation," the latter being defined as any corporation that is not an S corporation. In turn, an S corporation is any "small business corporation" with respect to which there is in effect an election under new § 1362(a).(fn2) That election may be voluntarily revoked or involuntarily terminated under certain circumstances.
The Act retains the prior law definition of a "small business corporation" as any domestic corporation that has no shareholder other than an individual, an estate or certain qualifying trusts; has no nonresident alien as a shareholder; and does not have more than one class of stock.(fn3) However, the Act increases the number of permitted shareholders from twenty-five to thirty-five, to correspond with the maximum number of shareholders permitted under Rule 506 of Regulation D, a private placement exemption issued pursuant to § 4(2) of the Securities Act of 1933.(fn4)
Members of an affiliated group of corporations remain ineligible for Subchapter S status. The Act broadens this rule to deny Subchapter S treatment to any corporation that owns 80 percent or more of the stock in any subsidiary (other than a subsidiary that has not begun business and has no taxable income), even if the corporation and its subsidiary are not permitted to file consolidated returns. In addition, the Act now states that banks and other financial institutions, insurance companies, corporations eligible for the Puerto Rico or possessions tax credit, and DISCs or former DISCs do not qualify as small business corporations.(fn5)
The Act generally preserves the types of trusts that can qualify as a shareholder of an S corporation, including grantor trusts, both during the lifetime of the owner and for a period of sixty days following the owner's death (two years, if the entire corpus of the trust is included in the owner's gross estate), trusts to which stock has been transferred pursuant to the terms of a will, but only for a period of sixty days, and voting trusts. In keeping with the rule that an S corporation must be a domestic corporation and that it cannot
have a nonresident alien as a shareholder, the Act adds that no foreign trust can be a shareholder in an S corporation.(fn6)
A "qualified Subchapter S trust" remains a permissible shareholder in an S corporation. As under prior law, a qualified Subchapter S trust is a trust which has only one current income beneficiary, a beneficiary who must be a U.S. citizen or resident and who has made an election to have the trust treated as a qualified Subchapter S trust.(fn7) Previously, each successive income beneficiary had to make a separate election to have the trust treated as a qualified Subchapter S trust. Now, however, the Act provides that the election will be treated as having been made by each successive beneficiary unless any such beneficiary affirmatively refuses to consent to the election.(fn8)
The definition of a qualified Subchapter S trust was obviously designed to prevent the use of trusts to circumvent the maximum limitation on the number of shareholders of a Subchapter S corporation. In keeping with this objective, the statute previously required the trust document to provide that there be only one income beneficiary at any time. Relaxing this rule slightly, the Act now requires only that the trust agreement provide for one income beneficiary during the life of that beneficiary. Therefore, the trust may be created for the benefit of multiple beneficiaries following the current income beneficiary's death.(fn9) While the likelihood of multiple remaindermen will not disqualify the trust during the current income beneficiary's lifetime, the trust will lose its qualified status at the current income beneficiary's death if there is then more than one individual entitled to current income or principal distributions under the trust.(fn10)
Liberalization of the definition of a qualified Subchapter S trust is of particular benefit to a shareholder desiring to make either a lifetime or testamentary transfer of stock in trust to a spouse in a manner qualifying for a gift or estate tax marital deduction. Under the former statute, neither a traditional testamentary marital trust, with a life estate and general power of appointment granted to the surviving spouse, nor a "QTIP" trust(fn11) created during life or at death would have been eligible as a qualified Subchapter S trust if it provided for more than one beneficiary at the surviving spouse's death, as is typically the case. The Act will now permit such a trust to be funded with stock in an S corporation, and the corporation's status as an electing small business corporation will not terminate when the stock is transferred to it if the shareholder's spouse makes a timely election.
There is an apparent inconsistency regarding the consequences of the termination of a qualified Subchapter S trust's status. The Act's legislative history states that a qualified Subchapter S trust will continue to be an eligible shareholder for the sixty-day or two-year period following the death of the current income beneficiary, a result that is consistent with such a trust's classification as a grantor trust.(fn12) However, the Act itself states that, if the trust ceases to meet any of the requirements for classification as a qualified Subchapter S trust, then the provisions of the statute allowing the trust to be an eligible shareholder "shall not apply to such trust as of the date it ceases to meet such requirements."(fn13)
Resolution of this apparent inconsistency requires recognition of the fact that the one current income beneficiary requirement is a requirement applicable only to the terms of the trust document. Thus, immediate termination of the qualified Subchapter S trust's status as such upon the sole income beneficiary's death should not occur, so long as the trust agreement continued to provide for only one income beneficiary during that beneficiary's life.
One of the more advantageous changes made by the Act is to permit differences in voting rights among the shares of an S corporation's stock. The corporation will not be treated as having more than one class of stock solely because of differences in voting rights, so long as the rights of the shareholders to the profits and assets of the corporation are otherwise identical.(fn14) Thus, a small family corporation will be allowed to issue voting common stock to the members of the older generation to preserve management control at that level and nonvoting common stock to the younger generation. Also, the founders of a business seeking additional capital might retain voting common stock and issue nonvoting common stock to outside investors in order not to dilute their voting control.
A persistent problem under the prior law with respect to the one class of stock requirement related to the characterization of debt instruments as equity securities. Under traditional tax law principles, certain purported debt instruments may be reclassified as stock, because of their convertibility, subordination, proportionate ownership, and other factors. While the ordinary effect of such a reclassification is to transform interest and principal payments into dividends, such a reclassification is particularly disadvantageous to a Subchapter S corporation because of the risk that the reclassified debt could be regarded as a second class of stock, resulting in a termination of the corporation's Subchapter S status. The courts have occasionally held that certain debt...
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