S corps finally get in shape to compete

Congress has enacted 17 changes in the law that will be generally beneficial to family business taxpayers.

By Tom Ochsenschlager

For many family businesses, the S corporation has always had an advantage over the regular corporation for tax purposes. The S corp form affords the same legal protection as a regular corporation while eliminating the double tax that occurs when income is taxed once at the corporate level and again after it is distributed to shareholders as dividends.

The drawback of S corporation rules was that not all companies could qualify. Furthermore, even companies that did qualify have not been competing on a level playing field with regular corporations in their ability to attract investment.

The Small Business Job Protection Act, passed by Congress in August and generally effective in 1997, may not have made the playing field perfectly level, but it did significantly reduce the incline for S corporations. The legislation added or changed 17 provisions that affect S corporations. Every one of the changes will be beneficial for family business taxpayers.

Double the number of shareholders. Many S corporations are second- and third-generation family owned companies. As families have expanded with each succeeding generation, some of these companies were edging close to the 35-shareholder maximum that an S corporation can have. Beginning in 1997, that figure will more than double, permitting S corporations to have as many as 75 shareholders.

Early on in the discussion of this legislation, there was some talk about keeping the maximum number at 35 but counting all family members as a single shareholder (as is the case now for husbands and wives). This would have been a better result for most family companies. But our second choice was to increase the number of permitted shareholders. We'll settle for that.

Another advantage of increasing the number of shareholders to 75, even for relatively small families, is that it gives S corporations the opportunity to attract more equity capital simply because they will be able to appeal to twice as many investors. Companies that are in an expansion mode and are willing to issue additional stock will find this to be a very favorable change in the law.

Retirement plans as shareholders. A recent article in the Wall Street Journal (September 13 ) reported that 42 percent of the money Americans have funneled into 401(k)s and similar retirement plans is invested in the employer's own stock. The Americans referred to in that article had to be working for regular corporations, because, under current law, it is not possible for a retirement plan to own stock in an S corporation. Under the new rules, that will change, enabling S corporations to offer their employees nearly the same opportunity. S corporations will even be able to set up employee stock ownership plans (ESOPs), which have been used by regular closely held corporations to provide incentives for employees while, at the same time, providing liquidity for the owners' stock.

A choice of trusts. Additionally, a new type of trust can be an S corporation shareholder. Generally under current law, only a trust with a single beneficiary which is required to distribute all their current income to the beneficiary is eligible to be an S corp shareholder. Under the new law, trusts that have multiple beneficiaries and accumulate income can be S corporation shareholders as well.

There are a couple of catches to these new trusts. First, the trust will be taxed on its share of the S corporation income at the highest marginal individual rate — currently 39.6 percent (28 percent for long-term capital gains). In contrast, the single-beneficiary trusts under the old rules were required to make distributions and were taxed at their marginal rate on the trusts' portion of S corp income. This meant that the beneficiaries paid less tax if they were in lower brackets.

These single-beneficiary trusts will continue to be qualified shareholders under the new rules. Although the multiplebeneficiary trusts permitted by the new law offer more flexibility, the beneficiaries may pay more tax on the S corp income if they are in higher brackets. The choice of which type of trust to use thus requires careful analysis.

Further, all the beneficiaries of the trust will have to be eligible shareholders of an S corporation. In other words, the trust would not be qualified as an S corp shareholder if, for example, the beneficiaries are nonresident aliens. And, finally, each beneficiary will count as a shareholder for purposes of the 75 shareholder limitation.

In spite of these limitations, this new type of trust is certain to prove very handy, particularly in cases of families who want the younger generation to have an equity interest in the company.

Charities can own S corp stock. Several years ago I was approached by a client who owned a very successful S corporation. The client had no immediate family and wanted to be able to gift some of his stock to various charities periodically. The stock was an ideal charitable contribution because it had greatly appreciated in value so that the deduction would be based on the appreciated value but the appreciation would go untaxed.

The trouble was that under the old law a charity could not be a shareholder of an S corporation. If the new legislation had been in effect at the time, my client could have accomplished what he wanted without revoking the S election. The new law permits tax exempt entities to hold stock in an S corporation. In such cases, each charity will be considered a single shareholder for purposes of the 75 shareholder limitation.

This new rule may even help with estate planning for family owned S corporations. Many families owning regular corporations have discovered impressive tax savings through the use of charitable remainder trusts. In general, these trusts enable the shareholder to receive a large charitable deduction currently, while preserving an income stream and reducing the value of the shareholder's estate. After 1996, S corporations should be able to use these trusts, too. (We'll need more IRS guidance, however, before we can be certain.)

S corporations can be parents. Many S corporations have een hampered in the past because they were not able to own more than 79 percent of a regular corporation's stock. The new law eliminates this restriction so that, beginning in 1997, an S corporation can own any amount of the stock of a regular corporation. It can also own another S corporation, but, in that case, it has to own 100 percent. This new rule will enable family owned S corporations that operate more than one business, or businesses in more than one location, to legally isolate the risk of each of the companies rather than having to conduct all the operations in a single entity or through the cumbersome arrangement of brother-sister companies.

Re-electing S status. There may be some business owners reading this who recently revoked their S election and, because the new law has since rectified the problem they had with S status, now wish they had not. If this describes you, the new law has one more pleasant surprise. Generally, if you revoke an S election, you cannot re-elect for another five years. The Small Business Act, however, provides a special transition rule that will permit a company that had revoked its S election at any time before the enactment date to re-elect S status without any waiting period.

Some missing pieces. We were hoping for two proposed changes that did not make it in the final version of the bill that passed Congress. The first would have permitted S corporations to have more than one class of stock. Permitting S corporations to issue equity such as preferred stock and convertible debentures would have gone a long way toward bringing S corporations up to par with C corporations for the financing of the '90s. Another proposal, somewhat less important, would have permitted foreign individuals to hold S corporation stock. Unfortunately, neither of these provisions made it in the act, and now that Congress has passed a major reform of the S corporation statutes, it is unlikely that the legislators will revisit S corporations any time soon.

More S corporations? Do these changes make the S corporation the entity of choice for new companies? Probably not. A relatively new type of entity, the limited liability company (LLC), incorporates the advantages of the S corporation but is not nearly as limited in the types of owners and types of equity that it can have. We expect that most new entities will be formed as LLCs. However, the new rules we have described here are very important to any company that is already a corporation, primarily because it is usually impractical for an existing corporation, whether it be a regular corporation or an S corporation, to convert to the LLC form of doing business.

 

Tom Ochsenschlager is a partner in the Washington, D.C., office of Grant Thornton LLP, the accounting and consulting firm.