S corporations after the 1996 tax legislation.

• Author: Richter, Michael H.

The recently enacted Small Business Job Protection Act of 1996 includes 18 separate provisions intended to provide taxpayers with greater flexibility in forming and operating S corporations. Eight of these provisions, taken together, provide a tremendous opportunity for planning with small business owners and wealthy family groups. The new rules are all effective for tax years beginning after 1996, unless otherwise noted.

Shareholder Ownership

There are four new or revised provisions on shareholder ownership. 1. The maximum number of shareholders has been increased from 35 to 75 shareholders. In counting the number of shareholders, a husband, wife and their estates are all treated as one shareholder (unchanged from prior law). 2. A new type of trust, an electing small business but (SBT), has been added as an eligible shareholder. To qualify, there may be no beneficiaries other than individuals, estates or charitable organizations; no interests in the trust may have been acquired by purchase; the trust must make an election to be treated as an SBT and cannot have made a qualified subchapter S trust election or be a tax-exempt trust.

The trust is taxed as if it were two separate trust. The portion of the trust holding the S stock is taxed on its flowthrough income, losses and associated experises at the trust level, using the highest tax rate applicable to trusts and estates. The remaining portion of the trust is taxed under the usual trust tax rules. 3. The post-death period that a testamentary trust may own S stock has been extended from 60 days to two years from the date of transfer to the trust. 4. Certain tax-exempt entities (i.e., qualified retirement plan trusts and charitable organizations) can be S shareholders after 1997. Each organization will be counted as one shareholder and will be required to consider flowthrough items, as well as gain or loss on the sale of the stock as unrelated trade or business income, regardless of the business conducted by the S corporation.

S Corporation Holdings

Rules have been added to allow S corporations to hold 80% or more C corporation subsidiaries or wholly owned qualified subchapter S subsidiaries (QSSSs). If there is more than one C corporation included in the affiliated group, the C corporations may elect to file a consolidated return, but the S corporation(s) cannot be included.

Although the S corporation rules have been revised to allow for wholly owned S...