S corporation reform on the move.Businesses operating as S corporations are hindered by tax rules that limit their growth and ability to obtain financing. The S corporation laws are complex and contain traps that reduce the benefits of S status. Concern has grown because an increasing number of companies have adopted the S corporation format; in 1993, the last year for which statistics are available, they filed slightly over 48% of corporate tax returns--nearly 1.9 million. Fortunately, help has arrived via the S Corporation Reform Act of 1995 (S 758), introduced in the Senate in May. As of early July, a House of Representatives companion bill had not yet been introduced. This article discusses the proposed legislation and the problems it would solve. BACKGROUND S corporation laws were enacted in 1958 and substantially revised by the Subchapter S Subchapter S IRS regulation that gives a corporation with 35 or fewer shareholders the option of being taxed as a partnership to escape corporate income taxes. Revision Act of 1982. However, S corporations did not become popular until 1986 when Congress inverted inverted reverse in position, direction or order. inverted L block a pattern of local filtration anesthesia commonly used in laparotomy in the ox. the tax rates so that individuals were subject to a lower tax rate (28%) than corporations (34%) for the first time since 1913. Many S corporations were formed at that time to take advantage of the pass-through of income and losses and to lower individual tax rates as well as to benefit from limited liability. Although the marginal tax rates Marginal Tax Rate The amount of tax paid on an additional dollar of income. As income rises, so does the tax rate. Notes: Many believe this discourages business investment because you are taking away the incentive to work harder. were re-inverted by the Omnibus omnibus: see bus. Reconciliation Act of 1993 (individuals pay a maximum 39.6% tax rate while small corporations pay a top rate of 34%), it still makes sense for most S corporations to retain their status to avoid the double tax on regular corporate earnings and appreciation of assets. Despite streamlining over the years, the Years, The the seven decades of Eleanor Pargiter’s life. [Br. Lit.: Benét, 1109] See : Time S corporation rules remain overly restrictive for many small businesses and their owners: * S corporations are limited to 35 shareholders, none of whom may be partnerships, other corporations or nonresident non·res·i·dent adj. 1. Not living in a particular place: nonresident students who commute to classes. 2. aliens. * Tax-exempt organizations and some trusts are not eligible to be shareholders. * They may not issue preferred stock Stock shares that have preferential rights to dividends or to amounts distributable on liquidation, or to both, ahead of common shareholders. Preferred stock is given preference over common stock. Holders of preferred stock receive dividends at a fixed annual rate. or own more than 80% of another corporation's stock. * Shareholder--employees do not receive certain tax-favored fringe benefits fringe benefits, n.pl the benefits, other than wages or salary, provided by an employer for employees (e.g., health insurance, vacation time, disability income). . If one of the eligibility rules eligibility rules, n.pl the conditions that define who may be entitled to dental benefits, when persons first become entitled to such benefits, and any provisions that determine how long an individual remains entitled to benefits. is violated, S corporation status is lost and earnings are subject to double taxation. WHY REFORM NOW? The existing subchapter S rules do not reflect the practical considerations of doing business in today's world. The small business community and the tax professionals who serve it have long believed that current rules put S corporations at a disadvantage compared to regular corporations, partnerships and limited liability companies. For example, small businesses today seek venture capital for financing needs. S corporations, however, are prohibited from issuing convertible preferred stock Convertible Preferred Stock Preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually anytime after a predetermined date. Also known as "convertible preferred shares". , which is necessary to attract such capital, probably because this type of financing was not common when the prohibition on multiple classes of stock was enacted. This situation would be corrected by the House version of the proposed legislation. The effort to bring the S corporation rules into line with the complexities of current small business operations Business operations are those activities involved in the running of a business for the purpose of producing value for the stakeholders. Compare business processes. The outcome of business operations is the harvesting of value from assets arose when the American Institute of CPAs and members of the American Bar Association S American Bar Association (ABA), voluntary organization of lawyers admitted to the bar of any state. Founded (1878) largely through the efforts of the Connecticut Bar Association, it is devoted to improving the administration of justice, seeking uniformity of law corporation committee joined with the U.S. Chamber of Commerce The U.S. Chamber of Commerce is the world's largest not-for-profit federation of businesses, representing more than 3 million businesses and organizations in the United States. As of 2003, the chamber was comprised of 3000 state and local chambers and 830 business associations. to draft a package of legislative changes. The group presented proposals to many on Capitol Hill. Senator David Pryor David Hampton Pryor (born August 29, 1934) was a Democratic member of the United States House of Representatives and United States Senator from the State of Arkansas. Pryor also served as Governor of Arkansas from 1975 to 1979 and was a member of the Arkansas House of (D-Ark.), an advocate for small business, agreed to co-sponsor the legislation with Senator Orrin Hatch Orrin Grant Hatch (born March 22, 1934) is a Republican United States Senator from Utah, serving since 1977. Hatch is a member of the U.S. Senate Committee on Finance, where he serves on the subcommittees on Energy, Natural Resources, and Infrastructure and Taxation and IRS (R-Utah). The House companion bill is co-sponsored by E. Clay Shaw
WHAT REFORM WOULD DO The proposed legislation would add flexibility in structuring businesses, remove some hidden tax traps, make it easier to obtain venture capital, change the treatment of certain fringe benefits and generally preserve the ability of family-owned businesses to use the S corporation format. By removing artificial barriers, the legislation would ensure S corporations have fewer constraints on how they conduct day-to-day business transactions. In addition, this increased efficiency could be a boost to the economy by generating additional jobs. The legislative proposals to reach each of these goals are summarized below. Increase flexibility in business structures. The prohibition against S corporations belonging to affiliated groups would be repealed. S corporations owning 100% of corporate subsidiaries could treat them as divisions of the parent for federal tax purposes. Lesser ownership of C corporation subsidiaries also would be permitted. Today, if an S corporation owner wants to start a new business but does not want to subject existing business assets to the new venture's liability exposure, the start-up must be structured as a sister S corporation rather than as a subsidiary. Not only does the proposed legislation allow S corporations to own regular corporate subsidiaries, it also permits wholly owned corporate subsidiaries to be treated as branches or divisions of the parent--as one pass-through entity filing one tax return. Allow more access to capital. Changes to restrictions on the number and types of eligible shareholders would enhance an S corporation's opportunities to attract capital. The legislation proposes to increase the number of allowed S corporation shareholders from 35 to 50 in the Senate bill and 75 in the House version. Qualified retirement plans and employee stock ownership plans would be allowed to invest in S corporation stock, potentially generating capital from institutional investors Institutional Investor A non-bank person or organization that trades securities in large enough share quantities or dollar amounts that they qualify for preferential treatment and lower commissions. as well as corporate employees. Nonresident aliens would be permitted to own S corporation stock, subject to withholding, making it easier to attract foreign investors as well as to expand operations outside the United States United States, officially United States of America, republic (2005 est. pop. 295,734,000), 3,539,227 sq mi (9,166,598 sq km), North America. The United States is the world's third largest country in population and the fourth largest country in area. . Under the proposed Senate legislation, S corporations would be permitted to issue nonconvertible preferred stock; dividends would be deductible interest for federal tax purposes. This measure would help raise capital and assist in estate planning Estate Planning The overall planning of a person's wealth, including the preparation of a will and the planning of taxes after the individual's death. Notes: Contrary to popular belief, estate planning involves much more than preparing a will, and it is not only for the . The House bill goes further and would allow S corporations to issue convertible preferred stock. S corporations would be able to offer venture capitalists Venture Capitalist An investor who provides capital to either start-up ventures or support small companies who wish to expand but do not have access to public funding. Notes: Venture capitalists usually expect higher returns for the additional risks taken. a stake in the corporation's appreciation to enhance the potential rate of return. An S corporation is not considered to have more than one class of stock if outstanding debt obligations to shareholders meet a "straight" debt safe harbor Safe Harbor 1. A legal provision to reduce or eliminate liability as long as good faith is demonstrated. 2. A form of shark repellent implemented by a target company acquiring a business that is so poorly regulated that the target itself is less attractive. that prevents conversion of straight debt into stock. Safe harbor straight debt would be expanded to allow it to be held by new types of shareholders--individuals in the business of lending money--permitting further access to new capital. The definition of safe harbor straight debt would be modified to permit convertibility. Today, if an S corporation issued certain convertible debentures Convertible Debenture Any type of debenture that can be converted into some other security. Notes: For example, a convertible bond can be converted into stock. to outside investors these instruments could be construed to be a prohibited second class of stock. Preserve family-owned businesses. Up to seven generations of one family would be treated as a single shareholder for purposes of complying with limitations on the number of shareholders (one family per S corporation). Several types of trusts would be permitted to be S corporation shareholders, provided all beneficiaries are individuals, estates or exempt organizations. These trusts could accumulate earnings and sprinkle distributions to multiple beneficiaries. Each beneficiary would be counted as one shareholder. Charitable organizations This article is about charitable organizations. For other uses of the word charity, see Charity. A charitable organization (also known as a charity) is an organization with charitable purposes only. and private foundations would be eligible shareholders. Frequently, S corporation owners want to make gifts of stock to charity for estate planning purposes, with the expectation of someday redeeming the charity's interest. Under the proposed legislation, such stock gifts would not terminate S status. A charity would be subject to the unrelated business income tax Unrelated Business Income Tax (UBIT) in the U.S. Internal Revenue Code is the tax on unrelated business income, which comes from an activity engaged in by a tax-exempt 26 USCA 501 organization that is not related to the tax-exempt purpose of that organization. until the stock was redeemed. The proposed legislation also would allow private foundations to be shareholders. This is important to S corporation business owners who want to contribute to their communities through private foundations. Change S corporation fringe benefit fringe benefit Any nonwage payment or benefit granted to employees by employers. Examples include pension plans, profit-sharing programs, vacation pay, and company-paid life, health, and unemployment insurance. treatment. S corporation shareholders would be treated the same as regular corporation shareholders with respect to all benefits except health care, which would remain taxable to holders of more than 2% of S corporation stock. Note, however, that from 1995 onward, 30% of self-employed health insurance costs are deductible. Also, there would no longer be restrictions for S corporation shareholders on borrowing money from qualified retirement plans. Remove hidden tax traps. Currently, companies that err when electing S status or have a certain amount of income from passive sources can find their S status is invalid, subjecting them to the regular corporation tax. Under the proposal, the Internal Revenue Service could allow corporations to correct invalid S elections, including untimely elections, instead of revoking S status. The IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. also could provide automatic waivers of some inadvertent terminations of S elections, such as those due to administrative errors or inaction in·ac·tion n. Lack or absence of action. inaction Noun lack of action; inertia Noun 1. . Private letter rulings would no longer be necessary in these situations. S elections also would no longer be terminated if excess passive investment income is present. The excess passive income threshold would be increased from 25% to 50% of gross receipts the total of the receipts, before they are diminished by any deduction, as for expenses; - distinguished from net profits. - Bouvier. See under Gross, a. os> See also: Gross Receipt . A number of other technical changes are proposed to eliminate possible tax traps. STRONG SUPPORT While there is strong support for this legislation in the business community and on Capitol Hill, the prospects for enactment are unclear. The budget reconciliation process is the most logical vehicle to carry S corporation reform to enactment, but the process this year has been unusually contentious and predictions are difficult to make. One thing is certain, however: The more Congress hears about S corporation reform, the greater the legislation's potential for enactment. RELATED ARTICLE: EXECUTIVE SUMMARY * THE S CORPORATION REFORM ACT of 1995 would help eliminate disadvantages faced by the nearly 1.9 million S corporations in the United States. * S CORPORATIONS NOW ARE LIMITED to 35 shareholders, none of whom can be partnerships, other corporations or nonresident aliens. Ownership of 80% or more of another corporation's stock and issuance of preferred stock are prohibited. * IF COMPANIES VIOLATE ELIGIBILITY rules or err when electing S status, they do not qualify to be S corporations and are subject to the corporate double tax without remedy for invalid or untimely elections. * THE LEGISLATION IS INTENDED to change the S corporation laws to better reflect today's business Today's Business is a show on CNBC that aired in the early morning, 5 to 7AM ET timeslot, hosted by Liz Claman and Bob Sellers, and it was replaced by Wake Up Call on Feb 4, 2002. environment. It would increase flexibility by allowing S corporations to own 100% of S or regular corporation subsidiaries, encourage access to capital by increasing the shareholder limit to 50 (75 in the House bill) and permit more types of shareholders. S corporations also would be allowed to issue nonconvertible (or possibly convertible) preferred stock. * OTHER PROPOSED CHANGES WOULD promote preservation of family-owned businesses, change fringe benefit treatment, allow waivers of invalid or untimely elections and eliminate administrative traps that could jeopardize jeop·ard·ize tr.v. jeop·ard·ized, jeop·ard·iz·ing, jeop·ard·izes To expose to loss or injury; imperil. See Synonyms at endanger. S status. RELATED ARTICLE: Exhibit: S Corporation Reform
Provision Tax planning benefit
Wholly owned S and C Fosters less complicated
corporation subsidiaries structuring with separate oper-
permitted. ations placed in subsidiaries.
Number of shareholders Allows more shareholders for
increased and from 35 to 50 additional capital and for
(75 in House bill). estate-planning purposes.
Eligible shareholders include Expands sources of capital;
qualified retirement plans and helps retain employees; provides
employee stock ownership owner exit strategy.
plans.
Nonresident aliens may Attracts additional capital;
be shareholders. helps expand operations
abroad.
Nonconvertible preferred stock Attracts additional capital;
permitted (Senate). adds flexibility to estate
planning.
Convertible preferred stock Attracts venture capital;
permitted (House). promotes flexible estate
planning.
Up to seven generations of a Allows more shareholders;
family treated as single keeps company in the family.
shareholder.
Trusts are eligible Flexible estate planning with
shareholders.
accumulating sprinkling trusts.
Charitable organizations and Encourages charitable
private foundations may hold contributions of stock; provides
shares. flexible estate planning.
Invalid and untimely Removes traps on formation of
S elections are correctable. S corporations.
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