Synopsis: This article summarizes the most important provisions of the Small Business Job Protection Act of 1996 relating to S corporations and suggests that the Act's provisions increase the attractiveness of using S corporations.

On August 21, 1996, President Clinton signed the Small Business Job Protection Act of 1996 (hereinafter referred to as the "Act") into law. The Act includes many provisions favorable to S corporations.1 The purpose of this article is to briefly summarize the most important provisions of the Act relating to S corporations.

A. Section 1301. Increase in Number Of Permitted Shareholders

Section 1301 of the Act increases the maximum number of eligible shareholders of an S corporation from 35 to 75. This expands the availability of subchapter S as a vehicle for large syndications, for family corporations where ownership extends among several generations, for employee stock ownership, and for attracting capital investors.

Under pre-Act law, only certain limited types of trusts were permitted to be S corporation shareholders.2 These included grantor trusts, certain testamentary trusts (but only for limited periods of time), voting trusts, and "qualified subchapter S trusts." A qualified subchapter S trust (hereinafter referred to as "QSST")3 is a trust which, under its terms, (1) is required to have only one current income beneficiary for life, (2) requires any corpus distributed during the life of the beneficiary to be distributed to the beneficiary, (3) requires the beneficiary's income interest to terminate at the earlier of the beneficiary's death or termination of the trust, and (4) if the trust terminates during the beneficiary's life, requires the trust assets to be distributed to the beneficiary. All of the income must be currently distributed to the beneficiary.

A drawback of using an S corporation as an estate planning vehicle under pre-Act law was the inability of typical "spray trusts" to hold S corporation stock for an unlimited period of time. QSSTs do not permit the accumulation of income or the ability to have multiple current beneficiaries and are, accordingly, unable to accommodate changing needs of beneficiaries over a period of time.

Section 1302 of the Act permits an "electing small business trust" (hereinafter referred to as "ESBT") to own stock of an S corporation. Any trust may be an ESBT, subject only to the following:

(1) All beneficiaries of the trust must be individuals or estates eligible to be S corporation shareholders, except that current charitable organizations may hold contingent remainder interests. For taxable years beginning after December 31, 1997, current charitable organizations may hold current interests in an ESBT.

(2) No interest in the trust may be acquired by purchase, i.e., the interest in the trust must be acquired by gift, bequest, or inheritance. However, the trust itself may acquire property by purchase, including stock of an S corporation by purchase.

(3) An election is required that is only revocable with the consent of the Internal Revenue Service (hereinafter referred to as the "IRS").

(4) Each potential current beneficiary of the trust is counted as a shareholder for purposes of the 75 shareholder limit. If there are none, the trust is counted as a single shareholder.

(5) The portion of the trust which consists of stock in one or more S corporations is treated as a separate trust for purposes of computing the income tax attributable to the S corporation stock held by the trust. This portion of the trust is taxed at the highest rates applicable to individuals on the S corporation income passing through to the trust and on gain or loss from the sale of the S corporation stock. With respect to this portion of the trust, no deduction is allowed for amounts distributed to the beneficiaries and the income is not included in the distributable net income of the trust or the beneficiary's income.

(6) A QSST or a tax exempt trust cannot be an ESBT.

The following should be noted with respect to ESBTs:

(A) The primary significance of the ESBT is that a trust which accumulates income and has multiple current beneficiaries may now qualify as a S corporation shareholder. The price for this benefit is complexity and taxation at the highest individual rates.

(B) The provision that each potential current beneficiary counts as a single shareholder is a potential trap for the unwary. For instance, if the death of a member of one generation that is a potential current beneficiary causes an additional number of potential current beneficiaries under the terms of the trust, there is an increase in the number of shareholders, which could possibly put the S corporation over the 75 shareholder limit. This provision will require counsel for the S corporation to not only be familiar with the trust instruments relative to all ESBTs, but also to continuously monitor the activity thereunder that relates to a change in the number of current potential beneficiaries. There is a 60-day grace period in which the trust has to dispose of the S stock if the 75 shareholder limit is exceeded.

(C) From purely a tax standpoint, it will usually be preferable to be a QSST rather than an ESBT, because under a QSST all or some of the income may be taxed at lower rates. Accordingly, the decision to be an ESBT over a QSST will not usually be tax driven. Moreover, the ESBT election is irrevocable (without the consent of the Secretary of the Treasury) so that a trust may not flip flop between ESBT treatment and QSST treatment. A QSST may not also be an ESBT.

An S corporation is not permitted to have more than one class of stock outstanding.4 Because purported debt may be characterized as equity under general income tax principles, whenever an S corporation borrows money there is a concern that the borrowing might be recast by the IRS as a second class of stock and, accordingly, cause termination of the S election. Current law provides a safe harbor where certain "straight debt" is not treated as a second class of stock.5 One of the requirements of straight debt under pre-Act law was that the creditor be an individual (other than a non-resident alien), an estate, or a certain qualified trust. Accordingly, loans by a bank or other financial institution did not meet the safe harbor definition of straight debt.

Section 1304 of the Act provides that the definition of "straight debt" is expanded to include debt held by creditors, other than individuals, that are actively and regularly engaged in the business of lending money. This provision should facilitate alternative sources of financing by S corporations without jeopardizing S status.

Under pre-Act law, the IRS did not have authority to validate a late or improper Subchapter S election or extend the due date for an S election; however, the IRS could waive the effect of an inadvertent termination under certain circumstances.6 Under § 1305 of the Act, the authority of the IRS to waive the effect of an inadvertent termination is extended to allow the IRS to waive the effect of an invalid election caused by an inadvertent failure to qualify as a small business corporation or to obtain the required shareholder consents, or to make the election timely, if there is reasonable cause.

To avail oneself of these provisions, it is still necessary to obtain a private letter ruling which entails expense and risk that it will not be granted. Arguably, this section should more closely parallel the "check the box" regulations7 to make choice of S status as easy as choice of partnership status under the new proposed "check the box" regulations.

Items of S corporation income, loss and deduction are generally allocated among the shareholders on a per share/per day basis.8 Accordingly, if the interest of a shareholder in an S corporation terminates during the S corporation's tax year, the shareholder is allocated a portion of the income or loss for the entire tax year (even the portion of the year after which the interest is terminated). This allocation is based upon the product of (a) the terminated shareholder's percentage interest, times (b) the fraction of the year during which he or she held the stock, times (c) net income or loss of the S corporation for the entire year.

It is often inequitable for a person to be allocated income or loss in respect to a portion of a tax year during which they held no stock in the S corporation. Accordingly, pre-Act law permited all persons who were shareholders of the S corporation during the tax year to elect to terminate the tax year as of the date of the termination of interest and, accordingly, to treat the tax year as two separate tax years, the first of which ends on the date of termination of interest.9 Accordingly, any shareholder, even if not affected directly by the election, could have prevented the election under pre-Act law.

Under the Act, the election to close the books of the S corporation upon termination of a shareholder's interest is only required to be made by all "affected shareholders" and the corporation rather than by all shareholders. For this purpose, "affected shareholders" means any shareholder whose interest is terminated and all shareholders to whom such shareholder has transferred shares during the tax year. If a shareholder transferred shares to the corporation, "affected shareholders" includes all persons who where shareholders during the year.

Under pre-Act law, an S corporation was not permitted to be a member of an affiliated group of corporations.10 Accordingly, an S corporation was unable to have owned 80% or more of the stock of another corporation (whether an S corporation or a C corporation). In addition, an S corporation could not have had as a shareholder another corporation (whether an S corporation or a C corporation).11 Under the Act, an S corporation may own any amount of the stock of a C corporation, including 80% or more of the stock of a C corporation.

In addition, § 1308 provides that an S corporation is allowed to own a "qualified subchapter S subsidiary" (hereinafter referred to as a "QSSS"). A QSSS means: (a) a domestic corporation; (b) that is not the type of corporation which is ineligible to be an S corporation;12 (c) 100% of the stock of which is held by an S corporation; and (d) the S parent of which elects to treat the subsidiary as a QSSS. If a QSSS ceases to be a QSSS, another election may not be made for five years without the consent of the IRS.

A QSSS is not treated as a separate corporation and all of the assets, liabilities and items of income, deduction and credit of the QSSS are treated as those of the parent S corporation. Transactions between the S corporation and a QSSS are not taken into account and items of the QSSS (such as earnings and profits, passive investment income, and built-in gains) are considered to be those of the parent. When a QSSS ceases to be one, it will be treated as a new corporation acquiring all of its assets and assuming all of its liabilities immediately before cessation from the parent S corporation in exchange for its stock.

If an election is made to treat an existing corporation as a QSSS, it will be deemed to have liquidated under Code §§ 332 and 337 (generally permitting tax-free treatment) immediately before the election is effective. Built-in gains tax13 and LIFO recapture14 may apply where the subsidiary was previously a C corporation.

The following issues are noteworthy in connection with these provisions:

(1) Section 1308 does not expressly provide for tiers of QSSSs, i.e., a QSSS owned by another QSSS. Presumably, future regulations will provide for this, since it does not appear to create any abuse and is within the spirit of the provision.

(2) In general, if a corporation forms a subsidiary under Code §§ 351 and 357, and transfers assets with liabilities in excess of basis, gain will be recognized under Code § 357(c). It appears, however, that if an S corporation forms a QSSS, and contributes assets with liabilities in excess of basis to the QSSS, no gain will be recognized under these provisions because the QSSS is not treated as a separate corporation and all of the assets and liabilities of the QSSS are treated as those of the parent S corporation.

(3) On the other hand, if the parent S corporation transfers one percent of the stock of a QSSS, causing it to cease to be a QSSS, it will be treated as if the QSSS was formed as a new corporation which acquired all of its assets and assumed all of its liabilities from the parent, immediately before the cessation, in exchange for stock. Accordingly, it would appear that at the time of the cessation there would be a transfer under Code §§ 351 and 357, causing gain in the event that the subsidiary has liabilities in excess of basis. Moreover, if the parent transfers sufficient QSSS stock so that the parent owns less than 80% of the QSSS immediately after the sale, query whether Code § 351 fails to apply at all and there is a tax imposed upon the parent corporation measured by the excess of the fair market value of the subsidiary stock deemed to be received over the parent's basis in the net assets transferred.15

By repealing the rule that an S corporation in its capacity as a shareholder of another corporation is treated as an individual, § 1310 of the Act clarifies that a C corporation subsidiary may be liquidated into an S corporation parent, tax-free, under Code §§ 332 and 337 and that an S corporation will be eligible to make a 338 election.16 This provision of the Act does not change other provisions of pre-Act law such as denying the dividends received deduction under Code § 243 to S corporations or permitting S corporations to engage in tax-free mergers.

Under pre-Act law, banks were prohibited from being S corporations.17 Under § 1315 of the Act, a bank is allowed to be an S corporation unless the bank uses a reserve method of accounting for bad debts described in Code § 585.

Under pre-Act law, tax exempt organizations described in Code § 401(a) (relating to qualified retirement plan trusts, including ESOPs) and Code § 501(c)(3) (relating to charitable organizations) could not be shareholders of an S corporation.18 Section 1316 of the Act permits pension trusts, ESOPs and charitable organizations to be shareholders of an S corporation. For purposes of the numerical limitation on S corporation shareholders, each qualified tax exempt shareholder counts as a single shareholder.

Under § 1316, items of income or loss of an S corporation flow through to qualified tax exempt shareholders as unrelated business taxable income (hereinafter referred to as "UBTI"),19 regardless of the source or nature of such income. In addition, gain or loss on the sale or other disposition of stock of an S corporation by a qualified tax exempt shareholder will be treated as UBTI. It should be noted that certain special tax benefits relating to ESOPs will not apply with respect to S corporation stock held by the ESOP.

This provision is not effective until tax years beginning after December 31, 1997.

Section 1317 provides that, except as otherwise provided in the individual sections (e.g., § 1316), the amendments made by these sections apply to taxable years beginning after December 31, 1996.

Section 1317 also includes a provision regarding re-electing subchapter S status. Under present law, if an S corporation terminates its election, it may not make another election to be an S corporation for five taxable years unless the Secretary of the Treasury consents.20 Under the Act, any termination of subchapter S status in effect prior to the enactment date of the Act is not taken into account. Accordingly, any small business corporation that had terminated its S corporation election within the five-year period before the date of enactment of the Act may re- elect subchapter S upon enactment, without the consent of the Secretary of the Treasury.

The Provisions Relating to S Corporations of the Act have their roots in various bills that were proposed over the last several years. Some S corporation changes that were proposed, but not enacted, are as follows:

(1) Treatment of the conversion of large corporations (over five million dollars in assets) to S corporations as taxable liquidations.

(2) Permitting S corporations to issue certain preferred stock.

(3) Availability of C corporation fringe benefit treatment to shareholder-employees of S corporations. Note, however, that § 311(a) of the Health Insurance Act, amending Code § 162(l)(1), provides that the deduction for health insurance expenses of self-employed individuals, partners in a partnership and shareholders owning more than two percent of the outstanding stock of an S corporation, is increased from 30% to 80% over a 10-year phase-in period.

There are still significant differences between partnership taxation and taxation of S corporations. Nevertheless, the Act has gone a long way toward eliminating certain disparities between partnership taxation and S corporation taxation, adding flexibility to S corporations, and ultimately enhancing the usefulness of the S corporation as a choice of entity.

1 See Small Business Job Protection Act of 1996, Pub.L. No. 104-188, 110 Stat. 1755 Subtitle C §§ 1301-1317.

2 See, generally §§ 1361(b) and (c) of the Internal Revenue Code, as amended.

3 See I.R.C. § 1361(d).

4 I.R.C. § 1361(b)(1)(D).

5 I.R.C. § 1361(c)(5).

6 I.R.C. § 1362(f).

7 Treasury Regulations, §§ 301.7701-1 through 301.7701-3, released December 17, 1996.

8 I.R.C. § 1377(a)(1).

9 I.R.C. § 1377(a)(2).

10 I.R.C. § 1361(b)(2)(A).

11 I.R.C. § 1361(b)(1)(B).

12 See I.R.C. § 1361(b)(2) for the definition of ineligible corporation.

13 See I.R.C. § 1374. This provision requires certain S corporations that were formerly C corporations to pay a tax on the sale or distribution of assets, the value of which appreciated prior to S conversion, if sold or distributed by the S corporation within 10 years of the conversion.

14 See I.R.C. § 1363(d).

15 See I.R.C. §§ 351(a) and 368(c).

16 I.R.C. § 338 permits certain purchasers of stock to elect to treat the stock sale as an asset sale for purpose of stepping up the basis of the assets of the target.

17 I.R.C. § 1361(b)(2)(B).

18 I.R.C. § 1361(b)(1)(B).

19 See, generally I.R.C. §§ 511 through 515. These provisions generally serve to impose an income tax, equal in rate to the tax on corporations, on the business income of certain tax exempt organizations if the business is not related to the exempt function of such organization.

20 I.R.C. § 1362(g).

Mr. Nathanson and Mr. Klug are principals in the St. Louis law firm of Rosenblum, Goldenhersh, Silverstein & Zafft, P.C. Mr. Nathanson received his J.D. degree, cum laude, from the University of Miami, and his B.A. degree, with high distinction, from the University of Michigan. Mr. Nathanson is past president of the Tax Section of the Bar Association of Metropolitan St. Louis and is an adjunct professor at the Washington University School of Law in the Masters of Taxation Program. Mr. Klug received his J.D. degree from St. Louis University School of Law and his B.A. degree, magna cum laude, from Rockhurst College.

©1997, Paul G. Klug and Jay Nathanson

JOURNAL OF THE MISSOURI BAR
Volume 53 - No.4 - July-August 1997