Tax planning after the Small Business Job Protection Act.

• Author: Herskovitz, Donald L.
• Position: Panel Discussion

DON: Mike and Larry, let's start by discussing your general impressions of the new S corporation provisions and their importance to taxpayers.

MIKE: Don, this is a huge bill as far as S corporations are concerned. There are 18 distinct provisions that liberalize the S rules and make S elections much more widely available to many corporations. Its really a terrific bill with a lot of practice development opportunities for tax advisers.

LARRY: Well, Don, I certainly agree with Mike. There are four distinct provisions that affect trusts, estates and individuals. In addition, some overall state tax issues need to be considered.

DON: Let's turn to some of the specific provisions. Mike, what do you see as the highlights of the Act?

MIKE: By far, the most important highlight is the ability of an S corporation to be a member of an affiliated group. This is almost a revolutionary concept and will lead to a lot of practice development opportunities. Another highlight is that the maximum number of S shareholders has been increased from 35 to 75. Also, banks and other financial institutions can now, elect to be S corporations as long as the don't use the reserve method of accounting for bad debts. This is a big boon for many banks. Next, the IRS now has authority to waive inadvertently late or defective S elections, which will help some companies out quite a bit. Finally, a particularly important provision is a technical change on how to treat distributions during S loss years.

DON: Larry, what do you see as the highlights of the Act?

LARRY: There are many highlights, Don. The first allows a new kind of trust to be an S shareholder; the electing small business trust (ESBT) is an alternative to the existing qualified subchapter S trust (QSST). The second major change is to permit certain tax-exempt organizations to be S shareholders, even though there are some rather significant penalties if they are. The third major change is a clarification of existing law to extend the application of the income in respect of a decedent (IRD) rules to S corporations in a way similar to partnerships. The fourth change extends from 60 days to two years the period of time after death for a trust to continue to be a QSST.

DON: Mike, you said that the affiliated group issue is probably the most important provision. Why?

Mike: A lot of C corporations never had the ability to elect S status, because under pre-Act law, an S corporation could not be a member of an affiliated group. In other words, an S corporation could not own 80% or more of another corporation. This precluded many entities from electing S status when business reasons prevented them from liquidating their subsidiaries up into the parent to make the election. Very often, corporations have to be kept alive for nontax business reasons. Now, such entities should reexamine the possibility of electing S status.

By the way these provisions are effective for tax years beginning after 1996.

Under the Act, an S corporation that owns 100% of another corporation can elect to treat that corporation as a qualified subchapter S subsidiary (QSSS). If an election is made to treat a wholly owned subsidiary as an S corporation, the subsidiary will be deemed to have liquidated under Secs. 332 and 337 up into its parent. This means that any built-in gains (BIG) tax under Sec. 1374 will not be triggered (because its a tax-free liquidation), but the BIG taint will carry over to the parent. Once the election is made, its as if the subsidiary no longer exists for tax purposes; it becomes part of the parents assets and liabilities. If the S election is made, the existence of a LIFO reserve win trigger the recapture tax under Sec. 1363(d).

A careful reading of the statute makes it apparent that the S election can be made for tiered subsidiaries. In other words, if a corporation owns 100% of another corporation that owns 100% of a lower-tier subsidiary, and so on, the statute appears to allow the election to be made for all wholly owned tiered subsidiaries. Thus, there is a single corporation for income tax purposes. However, before the election is made, the consolidated return aspects have to be considered. For example, if an existing consolidated group has a deferred intercompany gain, the way the statute is written, that gain would appear to be triggered, because under the election, the QSSS would no longer be a member of an affiliated group under Sec. 1504. The election appears to trigger the deferred gain. Whether that was Congress's intent remains to be seen, but caution is warranted.

DON: Are there state tax issues you'd like to address, Larry?

LARRY: Yes. One of my concerns is what's going to happen in the various states with respect to this Federal legislation. A lot of states base their tax system on the Code as of a given date. While we have all these amendments for Federal purposes, they have yet to be adopted by those states into their own versions of the Code. So, before rushing to do any of the things that are permitted under the new rules, tax advisers should ensure that the S election will not be disqualified in the states in which the company does business. Also, at least one state, Pennsylvania, has an entirely different set of rules for S corporations. The likelihood that Pennsylvania will enact legislation any time soon is probably not too great. The practitioner must be sure to look at all the state tax issues before doing anything with an S corporation doing business in multiple states.

MIKE: Getting back to the QSSS, once the election is made, the subsidiary will no longer be deemed to exist for Federal income tax purposes, and all of the subsidiary's items will be considered the parent's items such as earnings and profits (E&P), any BIG tax exposure, any passive investment income (PII), etc. The law still does not permit the S election unless the parent itself qualifies as an S corporation. For example, the parent S...