Highlights of 1996 Tax Legislation
| Publication year | 1996 |
| Pages | 3 |
| Citation | Vol. 25 No. 11 Pg. 3 |
1996, November, Pg. 3. Highlights of 1996 Tax Legislation
In August 1996, three bills were enacted that amend federal tax law. Signed by President Clinton on August 20, 1996, the Small Business Job Protection Act of 1996 ("SBJPA"),(fn1) is a $21 billion tax relief package designed to ease the tax burden borne by small businesses. The Taxpayer Bill of Rights 2 ("TBR-2"),(fn2) signed into law on July 30, 1996, was passed to institute privileges and procedural changes for the protection of taxpayer rights in dealings with the Internal Revenue Service ("IRS"). The Health Insurance Portability and Accountability Act(fn3) was adopted primarily to make possible the purchase of health insurance policies for an individual who loses group coverage and to limit the exclusions for pre-existing conditions. The Health Insurance Act also modified income, estate, and gift tax rules for expatriates---individuals who renounce U.S. citizenship.
This article focuses on five elements of this new tax legislation: S Corporation provisions, employee versus independent contractor, important business provisions, protections of TBR-2, and notable miscellany. It is not intended as a comprehensive review of all of the changes---specifically, it does not address the pension provisions of SBJPA (these will be examined in an article to be published in The Colorado Lawyer in 1997).
The changes in the S Corporation provisions provide for more flexibility and fewer "tax traps," although the new flexibility is accomplished, to some extent, at a high cost---e.g., the new "electing small business trust" brings with it taxation at the highest income tax rate. The new requirement that a person inheriting stock in an S Corporation must treat as income in respect of a decedent ("IRD") certain items of S Corporation income may have a particularly adverse effect where the stock passes to a surviving spouse.
Overall, for a new enterprise selecting its form of legal entity, the new provisions do not make the S Corporation significantly more attractive.(fn4) The modifying additions to § 530 of the Revenue Act of 1978(fn5) do provide more guidance for taxpayers in the determination as to whether a worker is an independent contractor or an employee for employment tax purposes, which constitutes a step forward. Of the business provisions, the increased expensing for business property and the possibility of a medical savings account should be a tax help to some small businesses.
The procedural changes of TBR-2 are improvements, though not dramatic ones. Of the miscellaneous changes, the most notable are those in the pension area, to be examined in another article. Although the changes reviewed in this article are not dramatic, practitioners need to be aware of these provisions.
Enacted in 1958, Subchapter S of the Internal Revenue Code of 1986 as amended ("Code") was originally designed to allow a business enterprise to choose its form of legal entity (e.g., corporation or partnership) without the "influence of the federal income tax" as a determining factor.(fn6) Prior to that time, the income from any business in corporate form was subjected to a "double income taxation" scheme. Profits, under a double taxation scheme, are taxed first when earned by the corporation and taxed again when the profits are distributed to the shareholders of the corporation in the form of a dividend. Subchapter S of Code §§ 1361 through 1379 allows an electing "small business corporation" to be taxed essentially as a partnership. That is, the shareholders are taxed directly at individual tax rates, and only once, on corporate level profits. In addition, if a "small business corporation" is incurring losses, its shareholders are generally allowed to deduct those losses against their personal income taxes under the flow-through regime of Subchapter S.
For the first time since the Subchapter S Revision Act of 1982, the Subchapter S provisions have been significantly modified. As was the case in 1982, the reformation of SBJPA simplifies the rules and requirements by which a business may elect to be taxed as a "small business corporation." With a few notable exceptions, these provisions relating to S Corporations become effective for taxable years beginning after December 31, 1996.
To elect S Corporation status, an enterprise must qualify as a "small business corporation."(fn7) Previously, to be eligible, a domestic corporation was limited to thirty-five shareholders; SBJPA expands the permissible number of shareholders to seventy-five. (As under prior law, a husband and wife continue to be treated as one shareholder under the new seventy-five shareholder limit.) This overall increase in the number of permitted shareholders will allow more entities the opportunity to elect S Corporation status.
Although most of the existing restrictions on the type of S Corporation shareholders remain (i.e., non-resident aliens, many trusts, partnerships, C Corporations), SBJPA adds a new category of trust that is permitted as an S Corporation shareholder. Previously only so-called "qualified Subchapter S trusts," including limited voting trusts, testamentary trusts created under the terms of a will and limited in duration, and grantor trusts (including grantor trusts continuing for sixty days or two years after the death of the grantor) were permitted as shareholders.(fn8) No other trusts were allowed to own shares in an S Corporation.
SBJPA provides more flexibility. A qualifying shareholder now may include a grantor trust continuing after the death of the grantor, as well as a testamentary trust continuing for a two-year period (instead of sixty days).(fn9) In addition, SBJPA adds a new category of qualified Subchapter S trust: the "electing small business trust" ("ESB Trust").(fn10)
An ESB Trust must meet three main requirements. First, "all beneficiaries of the trust must be individuals or estates eligible to be S Corporation shareholders, except that charitable organizations may hold contingent remainder interests."(fn11) Second, no interest in an ESB Trust may be acquired by purchase.(fn12) Purchase is defined for this purpose as "any acquisition of the property where the basis is determined under § 1012" (i.e., "cost basis").(fn13) Therefore, "interests in the trust must be acquired by reason of gift, bequests," or other testamentary transfer. Finally, the ESB Trust must elect to be a small business trust.(fn14)
An estate plan is often designed to take advantage of the $600,000 unified credit(fn15) by a set aside of a "credit shelter trust," often with several non-spousal beneficiaries. Further, trusts for children and other family members are often structured in a mode that permits discretionary distributions of income. These types of trusts can now be structured to own S Corporation stock. This may be a substantial planning benefit, but there is an associated cost---the high rate of income taxation, as noted below.
Code § 641, which imposes the income tax on trusts, is amended by SBJPA with the addition of a new subsection (d).(fn16) Generally, new Code § 641(d) carves out "the portion of any electing small business trust which consists of stock in one or more S Corporations," and treats this portion of the trust as a separate trust. This portion of the ESB Trust is taxed at the highest rate under Code § 1(e) for trusts and estates (currently 39.6 percent), except for capital gains, which are taxed currently at a rate of 28 percent.(fn17)
This portion of the ESB Trust that is treated as a separate trust is not allowed an exemption under Code § 55 (d) for the alternative minimum tax. Further, in computing the taxable income of the separate ESB Trust, only the following items are taken into account: (1) items required to be taken into account under the pass-through rules of Subchapter S; (2) gain or loss from the disposition of the S Corporation stock; and (3) state or local income taxes or administrative expenses to the extent they are allocable to the income, loss, or deduction passed through from the S Corporation or gain or loss from the disposition of the S Corporation stock. No other deduction or credit is allowed in computing the taxable income of the ESB Trust and none of these items of income, loss, or deduction may be passed through to the beneficiary of the ESB Trust. In addition, "otherwise allowable capital losses are allowed only to the extent of capital gains."(fn18)
Although the separately treated S Corporation portion is taxed at the highest rate, an ESB Trust will incur only $845 more federal income tax annually than the tax imposed on most trusts and estates. That is because under Code § 1(e), currently, the highest rate is imposed on estates and trusts with taxable income of only $7,500.(fn19) The more significant potential tax increase imposed on ESB Trusts, however, arises from the inability of an ESB Trust to deduct amounts distributed to beneficiaries and thus spread the S Corporation income among beneficiaries in broader tax brackets below the highest rate.
For the remainder of the ESB Trust, which excludes the S Corporation portion, taxation is determined under the rules of Subchapter J of the Code, which generally covers taxation of trusts and estates. In other words, in determining the Trust's distributable net income, items from the separately treated S Corporation portion are excluded. Thus, the trustee has the ability to pass the taxation on income items such as dividends and interest (other than S Corporation...
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