To S or not to S? New law allows more businesses to pick S-corporation status.

• Author: Bates, Robert

The Small Business Job Protection Act of 1996, passed in August, creates many exciting planning opportunities for S-corporations.

The act provides greater flexibility in forming and operating S-corporations and allows more businesses to operate in the S-corporation structure. Because of the many tax advantages of operating as an S-corporation, this is an important planning arena for businesses, both at year-end and well into 1997.

WHAT ARE THE TAX BENEFITS OF AN S-CORP?

An S-corporation gets its name from the fact that its tax rules are described in Subchapter S of the Internal Revenue Code. It is a corporation that has elected to have its income, deductions, capital gains and losses, charitable contributions and credits pass through to its shareholders.

S-corporations and their shareholders are treated with rules similar to those that apply to partnerships and their partners. Thus, the S-corporation generally does not pay federal or Indiana income tax (some states do have corporate-level income taxes on S-corporations). Rather, the business income or loss is passed through directly to its shareholders, avoiding the dual level of tax that applies to C-corporations. Over the life of a business with $500,000 in net earnings, you could save as much as $75,000 in taxes by avoiding the second level of tax.

S status is beneficial for owners incorporating a new business that anticipates losses in the early years. The election will permit the losses to flow through to shareholders so that the losses may be deducted on their individual returns.

An S-corporation can be particularly effective for lifetime and estate-tax planning within a family. The transfer of shares to children can utilize the lower tax brackets of minor children over the age of 13.

The build-up of shareholder tax basis in profitable S-corporations can have a...