Perhaps it was a manifestation of President Clinton's remorse over having raised taxes "too much" in 1993. Perhaps it was a realization that subchapter S had not been substantially modified to reflect the changing business environment for some time. Whatever the reason, the new tax laws passed this summer took extensive, substantive steps toward making S corporations a more viable choice of business entity for the '90s and beyond.
The changes are primarily focused on increasing access to capital for S corporations, increasing estate planning opportunities for S corporations and easing the administrative burden on S corporations. The new provisions also provide a variety of new opportunities and challenges for S corporations that are not so easily classified under the three headings above. The new laws discussed herein provide valuable benefits for your S corporation clients and important planning opportunities for potential S corporations.
The following information has been compiled primarily from House, Senate and Conference Committee reports (House Report No. 104-586, Senate Report No. 104-281, and Conference Committee Report No. 104-737), as well as the Research Institute of America's Complete Analysis of the Small Business, Health Insurance and Welfare Reform Acts of 1996. Unless otherwise noted, all of the provisions are effective for tax years beginning after December 31, 1996. Given the extent of the changes, no one article can effectively cover in depth all the ramifications of the new law. It is hoped that this article will provide an effective overview that will lead practitioners to seek more information on changes that impact their clients.
Increased Access to Business Capital for S Corporations
A large piece of the S corp provisions in the new law are focused on increasing the availability of the election to more businesses. Increases in the number and type of shareholders allowed ensure that more businesses will be able to elect subchapter S status.
75 Shareholders - I.R.C. Section 1361(b)
The new law increases the number of individuals allowed to own stock in an S corporation to 75. Practitioners need to be careful, however, because some other changes in the law, particularly relative to electing small business trusts and tax-exempt organizations, will affect the manner in which shareholders are counted.
Financial Institutions Allowed to Hold "Straight Debt" - I.R.C. Section 1361(c)(5)(B)(iii)
Subchapter S corporations are still prohibited from issuing more than one class of stock under the new law. However, as under previous law, these entities are permitted to issue a specific type of debt known as "straight debt." An obligation to pay constitutes straight debt if it is an unconditional promise to pay a sum certain in money and the interest rate and payment dates are not contingent on profits, borrower's discretion or similar factors. In addition, the debt cannot be convertible into stock and it must be held by a specific type of entity. Under previous law, S corp debt could only be held by an individual (other than a non-resident alien), an estate or certain qualified trusts. The new law allows debt held by financial institutions to also qualify as straight debt.
Exempt Organization Shareholders - I.R.C. Section 1361(c)(7)
Under the new law, certain tax-exempt organizations are now eligible to hold S corporation stock. This change actually classifies under two of the outline headings in this article, because it provides S corporations with access to additional capital through employee stock ownership plans (ESOPs) as well as providing S corporation shareholders with an additional financial planning tool by allowing charities to own S corporation stock. Believing that these were options that S corporations and their owners needed, Congress included changes in the law that will make I.R.C. Section 501 (c)(3) charitable organizations and I.R.C. Section 401 (a) qualified stock bonus, pension or profit-sharing plans eligible shareholders of S corporations. For purposes of the 75-shareholder limit, each charity or retirement plan holding S corporation stock will count as one shareholder.
However, some drawbacks do exist for S corporations and their exempt shareholders under the new law. Exempt organizations holding S corporation stock will be treated as unrelated business taxable income (UBTI) on items of income which flow through from the stock. Gain or loss on the sale of S corporation stock will also be included in the calculation of UBTI for these entities. Capital gains and losses relative to S corporation stock held by...