Tax planning after the Small Business Job Protection Act.

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 corporation cannot have a corporate shareholder; that has not changed. Next, any qualified subsidiaries would also otherwise have to qualify as S corporations to make the election. But the mere fact that the subsidiaries have this corporate parent will not disqualify them from making the S election; thus, everything can be merged together, in effect, as long as the entities otherwise would have qualified for S status.

I'd like to add a very important tangential point. In December 1995, the Clinton Administration proposed legislation to tax the S election of certain large C corporations by treating the election as a deemed liquidation subject to immediate double tax. In effect, if this legislation is ever passed, it would destroy a large C corporations ability to elect S status. The cut-off point is for C corporations with $5 million or more in value. That proposal is in limbo right now; if enacted, its going to preclude the use of the S election in the future, because its going to create a tax when there is no realized gain - i.e., no actual sale of the assets. That's a terrible result. Therefore, it is critical to get clients to consider any potential S election as soon as possible, in case this legislation is enacted. Again, as Larry pointed out, before any S election is made because of the Act provisions, the state tax consequences have to be considered.

LARRY: Mike, the subsidiaries you were talking about were wholly owned subsidiaries?

MIKE: Yes.

LARRY: That doesn't mean that an S corporation couldn't own 85% of another corporation, just that those subsidiaries couldn't be QSSSs?

MIKE: That's correct. The Act offers a lot of possibilities. For example, a parent with many subsidiaries could elect to treat all or some of its wholly owned ones as QSSSs. If it has less than 100% ownership in some subsidiaries, it can hold them as C subsidiaries. The C subsidiaries will not be able to join with the S portion of the group, but they will be considered separate and can file their own C consolidated return with their other related companies if they otherwise qualify. Now, a variety of planning and structuring opportunities are available. The tax adviser should look at each company. What are its projections? Which ones, if wholly owned should be put into the S group? If not wholly owned, should they be made wholly owned? Is the client better off having some wholly owned subsidiaries out of the S group and some in the S group? What are the income and projections for each corporation? What is the BIG potential? These are tremendous planning opportunities to review the affairs of existing companies.

LARRY: I agree. It might be advantageous to plan to exclude some of the subsidiaries from the S group, to avoid some of the disadvantages (i.e., triggering events) that occur on leaving a consolidated group.

MIKE: Good point.

LARRY: Mike, can an S election be made with respect to some wholly owned subsidiaries, but not to all?

MIKE: Yes.

LARRY: That could be a very important planning point as well.

MIKE: There are also planning opportunities when S corporations create limited liability company (LCC) subsidiaries. Let's say a parent has a QSSS. The parent could have the QSSS drop some or all of its assets into an LLC, as long as the LLC has a second member. Why do that? To get partnership treatment at the operating level and not have any S restrictions (e.g., second class of stock). Also, an S corporation will be able to have a wholly owned LLC in those states that permit single-member LLCs. The LLCs will be disregarded for Federal income tax purposes once the check-the-box regulations become final.

LARRY: One final point on President Clinton's proposal - it may die with the end of the 104th Congress. Plus, it carries an effective date that predates the effective date of the Act, so that, even if Congress were to get to it, hopefully it would act to merge the impact of the two different effective dates.

MIKE: The original effective date (after a lot of outcry when it was introduced) was December 1995, which was later pushed back to Jan. 1, 1997. If this legislation is ever enacted, Congress will probably push the effective date back even further. But right now, the proposed legislation applies to S elections effective after Jan. 1, 1997.

DON: One of the highlights mentioned earlier, Mike, dealt with the increase in the number of shareholders that an S corporation can have. What do each of you think of this provision? What's it going to mean in terms of client development and tax planning?

MIKE: Don, quite a few S corporations were near the the limit under the 35-shareholder rule. So, it certainly would help them.

LARRY: If an S corporation is owned by more than one generation, by the time all the cousins, nephews, nieces and other relatives are added up, the 35-shareholder limit could be looming. Although most S corporations have fewer than 10 shareholders, the expansion of the limit could be important for many clients.

MIKE: I've seen situations in which C corporations have between 75 and 100 members, with several family groups and generations, and some employee ownership. Some of the minority shareholders could be redeemed to get down to 75, which is certainly easier than getting down to 35. The real potential of the provision is the ability of companies to give more employees stock without having to worry about the 35-shareholder limit. Going from 35 to 75 will give many companies more flexibility to give more employees ownership. Why is that an issue, when employees could be given stock appreciation rights, phantom stock or the like? Because in many situations, the incentive lies in giving people stock - they want equity ownership, a stock certificate. Often, they don't want some kind of concept that's like equity ownership, so this provision may expand employee ownership in S corporations.

DON: Larry, you had mentioned earlier that the use of trusts as S shareholders has now become more important. Can you elaborate on that?

LARRY: There is now a new type of trust, Don, that can hold S stock. Prior to the Act, two kinds of trusts qualified as shareholders. One was a grantor trust for income tax purposes, which was very popular; the other was a QSST. The problem with the QSST is that it is hard for a trust to qualify, it is limited to one beneficiary, must distribute all of its income annually and has to meet certain other tests. The new legislation creates the ESBT, which can have multiple income beneficiaries and still be an S shareholder, if the election is made. A charitable organization can even have a contingent remainder interest in an ESBT However, for purposes of dealing with the number of shareholders, each potential ESBT income beneficiary is counted as a shareholder. Therefore, if a client created such a trust, and 12 people were the income beneficiaries, each would be counted as a shareholder for purposes of the 75-shareholder limit.

In addition, the taxation of ESBTs is very strange, something new in the trust area. In effect, an ESBT splits into two trusts: the first holds only S stock for tax purposes; everything else is in a separate trust. With respect to the S stock portion, under the statute, all income is subject to tax at the trust level, at the maximum rate applied to estates and trusts. The Committee Report states that maximum rate applicable to individuals must be used. Right now, those two rates are the same, but hopefully, this will be clarified by regulations. Therefore, all of an S corporation's passive items will be subject to tax at a 39.6% rate inside the ESBT. Included within the definition of S income are all capital gains generated either by the S corporation or by the sale of S stock; they are subject to a 28% maximum rate. The only deductions allowed against trust income are state income taxes and administrative expenses directly related to the stock. The S income does not form part of distributable net income and, therefore, is not subject to the accumulation or throwback rules when the trust terminates. There are also special rules that deal with carryovers and other losses. The ESBT is a unique type of trust not seen before. It could be advantageous for taxpayers who want to spread S income among a class of people, which, prior to the Act could not be accomplished with a trust as an S shareholder.

Take an example. A QSST can have only one income beneficiary; thus, to establish a trust for the benefit of a clients children using S stock, the client would have to establish a separate trust for each child. With an ESBT, one trust could be created and funded with the S stock, and the trustee could have the right to sprinkle or spray income among all of the children and any other beneficiary(ies). This should make trust administration a little bit easier, even with the requirement that the trust pay all the taxes.

DON: This area is going to be particularly fruitful for tax planning.

LARRY: It could very well be. There are going to be a lot of interesting variations in the way trust documents will be drafted to deal with the potential use of S stock. Very often, in trust instruments, there are pages of special provisions creating separate trusts, in the event that S stock could be transferred. Now, of course, a drafter could provide for an ESBT, which by statute is treated as two separate trusts, rather than having to provide for separate trusts in the estate planning documents.

DON: Larry, what about the rules relating to tax-exempt shareholders?

LARRY: There are some very interesting new rules in that area, Don. An organization described in Sec. 401(a) (generally, qualified retirement plans) or 501(c)(3) (generally, charitable organizations) would now qualify as an S shareholder. However, there are significant consequences to being qualified, particularly for employee stock option plans (ESOPs). Prior to the Act, ESOPs could not be qualified shareholders; after the Act, an ESOP can be an S shareholder, but the tax benefits of ESOPs that are available to C corporations are not available to S corporations. Thus, an S corporation's contribution to an ESOP isn't deductible, nor is a tax-free rollover in connection with an ESOP. With respect to an entity exempt under Sec. 501(c)(3) or 401(a) (charitable organizations and qualified retirement plans), the S income attributable to the exempt shareholder is unrelated business taxable income subject to unrelated business income tax, so that the entity will be paying tax on the income at the full corporate rate (currently, 34%). The entity itself counts as only one shareholder, even though an ESOP can have hundreds of participants.

One comment with respect to exempt organizations as S shareholders - the new provisions do not appear to allow a charitable remainder trust (CRT) to qualify as an S shareholder, because its not a Sec. 501.(c)(3) organization or exempt from tax under Sec. 501(c)(3). It's exempt from tax under Sec. 664; an ESBT cannot be turned into a CRT, either - the result would be a hodgepodge that qualified as neither.

One final note with respect to the provisions dealing with tax-exempt organizations - they are effective for tax years beginning after 1997. Unlike the general effective date, which is tax years beginning after 1996, these provisions have been delayed for a full year.

DON: One of the provisions in the Act, Mike, relates to an expanded definition of debt that allows financial institutions to provide financing without the debt being treated as a second class of stock. Care to comment?

MIKE: This is a very favorable provision, Don. Until now, a safe harbor debt provision permitted an otherwise qualified S shareholder (e.g., an individual or qualifying trust) to hold nonconvertible debt not contingent on the S corporation's earnings; such debt was not a second class of stock. However, this precluded financial institutions from issuing such debt, because they are not otherwise qualified S shareholders. Under the Act, there is a separate carve-out for financial institutions; they can hold safe harbor debt without the S corporation running the risk of a second class of stock. But the debt still must be nonconvertible; if the debt is convertible, the safe harbor no longer applies. It might still be debt and not equity, but the safe harbor rules no longer apply.

DON: One of the other Act provisions is that its now possible for the IRS to waive late or defective S elections. Can you explain that provision and what it means for taxpayers?

MIKE: For years, the Service had no authority to accept a late or invalid S election - for example, the corporation was a member of an affiliated group or had a disqualified shareholder, thus, the corporation was never an S corporation. Sec. 1362(f) only allowed the Service to fix inadvertent terminations (i.e., when the taxpayer was already an S corporation). There's been no provision to fix a late or defective S election. Over the last few years, more and more late or faulty elections have been made, and the IRS has been powerless to fix the situation. I've been advising clients for years to prepare for this statute; the proposal has been around since H.R. 11 in the Bush Administration; it was just a question of time before it would be enacted. Everybody was in favor of it, particularly the IRS. I always advised clients that if the S election had inadvertently been made late, to file the election late just to establish the intent to be an S corporation. If the client did nothing, and considered itself a C corporation, it would be harder to prove that the intent a;l along was to be an S corporation. It's important to prove intent, for example, if a company has BIG value, perhaps not as important for a start-up company. But suppose a client transfers assets from a sole proprietorship or a partnership into a new corporation, then makes a late S election. Even though it has the right, for example, to cut off its first year to accelerate the late election, its going to be considered a C corporation for its first short year, and if it has BIG value, its going to be subject to potential BIG tax later on. This could be a disaster. A much better strategy, if feasible, is for the company to take advantage of the new provision and treat itself as an S from day one, as long as it can show that the late or defective election was inadvertent.

There are a lot of unanswered questions in this new provision. One of them is, what happens if the company knew all along that its election was defective yet continued to treat itself as an S corporation? Could it then take advantage of the new provision?

LARRY: Those are very valid points, Mike. I only want to add that were not sure what the states are going to do about granting the same type of relief. While the Federal problems may state issues may still have to be dealt with.

MIKE: Absolutely.

DON: Another area of interest in the Act relates to the interrelationship of subchapter S to subchapter C. Mike, can you tell us how the Act affects the two subchapters?

MIKE: Don, the Act eliminates the Sec. 1371 rule that S corporations are treated as individuals in their capacity as shareholders of other corporations. This is a wonderful provision because it clarifies, once and for all, that an S corporation may liquidate a subsidiary tax free under Sec. 332 which, of course, is imperative under the new law to make a QSSS election. The Act also makes clear that an S corporation can treat a stock acquisition as an asset acquisition under Sec. 338. Next, in a somewhat related vein, practitioners no longer have to worry about the so-called "momentary ownership rule" when an S corporation acquires 100% of the stock of another corporation. Now, the S corporation doesn't have to spin off the target immediately, because S corporations can now be members of affiliated groups without losing S status.

Let's return for a moment to a point made earlier, a situation in which an S corporation has an 80%-or-more-owned C subsidiary, but owns less than 100%, so that the subsidiary cannot be a QSSS. Dividends received from the C held by the S corporation will not automatically be treated as PII. The Code looks to the actual operations of the subsidiary held by the S, if the subsidiary is in the active conduct of a trade or business, these receipts will be active, just as when an S corporation holds a partnership interest. The partnerships underlying operations are examined to determine if the receipts are active or passive. This approach can be very important for an S corporation whose only asset is an 80%-or-more-owned subsidiary; as long as the subsidiary is in an active trade or business, the S can hold the subsidiary, and the dividends paid by the active subsidiary to its parent will not terminate the parents S election after three years even if the parent has C E&P. This is a very nice provision.

DON: One of the provisions in the Act, Larry, relates to the extension to S corporations of the IRD rules that apply to partnerships. Could you elaborate?

LARRY: Don, the concept of IRD may not be terribly familiar to practitioners who mainly deal with S corporations and corporate taxes, as opposed to individual or estate taxes. IRD can come into play, for example, with a cash-basis entity that has unrealized receivables, the unrealized receivables constitute IRD. In the partnership context, that amount would flow out as ordinary income. For years, it had been unclear what the rule was with respect to S corporations; basically, the Act says that to the extent there is IRD inside of an S corporation, any basis step-up in the S stock must be reduced by the IRD.

One final note - the Act's IRD provision is effective for decedents dying after the date of enactment of the Act (Aug. 20, 1996).

DON: Larry, one of the points that you mentioned earlier was the extension of the 60-day period for certain trusts to two years. How do those rules work?

LARRY: This is really a great relief provision. Prior to the Act, certain grantor trusts, and certain other trusts that became S shareholders by reason of a death, had only 60 days within which to take action to prevent the termination of the S election. That 60-day period has now been expanded to two years, which gives estates, executors, spouses, and importantly, tax advisers, more time to plan for the orderly transition of the stock without having to disrupt the business.

DON: Mike, there's been a technical change in the treatment of distributions by an S corporation during loss years. Could you explain it?

MIKE: A typical problem in the S area is the lack of a lookback rule. Here's a common scenario - an S corporation that used to be a C corporation, with C E&P from prior C years. In 1995, it had a lot of income and a $250,000 accumulated adjustments account (AAA). In early 1996, it distributed the $250,000 in the belief that it was a tax-free distribution out of AAA. In 1996, the company lost $750,000; thus, under existing rules, at the end of 1996, it had negative AAA and positive C E&P. The distribution in the early part of 1996, which the shareholders thought really applied to the 1995 positive AAA, is going to be a taxable dividend out of C E&P because there is no AAA left. Under the new rules, the loss for the year will not reduce AAA in determining the taxability of the distribution, so that the $250,000 of AAA at the end of the 1995 will not be reduced, and the distributions will still be tax free to the extent of the ending AAA. This is a very favorable change that offers a lookback rule that didn't exist before.

The Acts S corporation provisions are very favorable overall, except for one provision requiring that distributions reduce stock basis before calculating the amount of loss that can be passed through. As we all know, the amount of loss that can be passed through and taken on a shareholders return is limited by basis, among other things. In the past, distributions were taken into account after the amount of loss was determined. Under the Act, any distributions made during the year reduce outside basis in determining the amount of loss allowed at the end of the year. Thus, the rules are more favorable for distributions, but a shareholder can end up in more of a suspended loss position.

DON: The Act provides that a C corporation that was an S corporation and terminated its election in the last five years can now re-elect S status. Can you explain those rules, their implications and the tax planning possibilities?

MIKE: Under pre-Act law, if S status was terminated voluntarily, it could be reelected in the following five years only with IRS consent. The IRS hardly ever granted permission unless there was more than a 50% change in ownership since the termination. Now, S status can be re-elected without IRS permission, even if the termination was voluntary. This is definitely an issue to be discussed with clients. Between this and the Clinton proposal discussed earlier, action may have to be taken rather quickly.

DON: We've had a detailed discussion of the new provisions, but there are still several other Act provisions that have to be studied. Nevertheless, given our discussion, do either of you have any concluding thoughts on die new S provisions?

MIKE: First, tax practitioners should consult with their C corporation and affiliated group clients that can possibly benefit now from an S election. They should be doing studies for them as quickly as possible as to the advisability of electing S status, and which subsidiaries should and should not be part of the S election, as was discussed earlier. Second, they should be contacting all of their existing S clients as soon as possible to make them aware of these changes and to meet with them to see, for example, if they should be restructuring their trusts and other entities.

DON: Larry, what are your concluding thoughts on the new provisions?

LARRY: I certainly agree with Mike about the need to do this planning before year-end, keeping in mind the state tax consequences of the planning techniques being considered. These changes have a significant impact on two areas other than income tax planning; succession planning and estate planning. Regrouping and restructuring closely held companies can have a dramatic impact on the succession plan, as well as on the owners' estate plans.