August 1996

S Corporation Provisions

The Small Business Act provides long-sought reforms to corporations organized under subchapter S of the Internal Revenue Code ("S corporations"). Many of these reforms were included in tax bills vetoed in 1990 and 1995.

Generally, the Act liberalizes the ownership restrictions on S corporations, further reduces the technical barriers to qualifying as an S corporation, and rationalizes accounting rules governing the allocation of S corporation income among the shareholders. The more important provisions include increasing the maximum number of S corporation shareholders to 75; allowing S corporations to have C or S corporation subsidiaries; allowing for the tax-free liquidation of a C corporation into an S corporation; and permitting recently terminated S corporations to reelect S status.

Number of Eligible Shareholders Increased

The Act increases the maximum number of S corporation shareholders from 35 to 75. This change will particularly help S corporations that want to award stock to employees.

Effective date: The provision applies to taxable years beginning after 1996.

Treatment of Financial Institutions Not Using the Reserve Method

The Act allows a bank that is otherwise an eligible corporation to elect to be treated as an S corporation unless it uses a reserve method of accounting for bad debts.

Effective date: The provision applies to taxable years beginning after 1996.

Tax-Exempt Organizations Allowed To Be S Corporation Shareholders

The Act would allow tax-exempt qualified retirement trusts and charitable organizations to be shareholders in S corporations. Items of income or loss of an S corporation will flow through to qualified tax-exempt shareholders as unrelated business taxable income ("UBTI"), regardless of the source or nature of such income.

Effective date: The provision applies to taxable years beginning after 1997.

Certain Trusts Permitted to Hold S Corporation Stock

Certain specific trusts may hold stock in an S corporation. These include grantor trusts, voting trusts, certain testamentary trusts, and "qualified subchapter S trusts." Ownership of stock by any other trust would invalidate an S corporation election. The Act adds "electing small business trusts" to the list of trusts eligible to hold stock in an S corporation. "Electing small business trusts" are certain electing trusts in which all the beneficiaries are individuals or estates that are eligible to be S corporation shareholders. Under this rule, charitable organizations may hold contingent remainder interests. No interest in the trust may be acquired by purchase. Each current and contingent beneficiary of the trust is counted as a shareholder for purposes of the new 75 shareholder limitation.

Effective date: The provision applies to taxable years beginning after 1996.

Trust Eligibility After Death of Grantor or Testator Extended

The Act extends from 60 days to two years the period during which:

• A grantor trust may remain an S corporation shareholder after the death of the grantor (if the entire corpus of the trust is includible in the gross estate of the grantor).
• A trust receiving S corporation stock under a will may be an S corporation shareholder.
• Testamentary trusts may hold S corporation stock.

Effective date: The provision applies to taxable years beginning after 1996.

Financial Institutions Permitted to Hold Safe-Harbor Debt

An S corporation may not have more than one class of stock. The Act expands the definition of straight debt that is not treated as a second class of stock to include debt held by creditors that are actively and regularly engaged in the business of lending money.

Effective date: The provision applies to taxable years beginning after 1996.

Authority to Validate Certain Invalid Elections

The Act permits the IRS to accept an otherwise invalid S election, if the defects in the election are caused by an inadvertent failure to qualify as a small business corporation or to obtain the required shareholder consents (including elections regarding qualified subchapter S trusts), or both. The IRS may treat a late subchapter S election as timely if there was reasonable cause for the failure to make the election timely.

Effective date: The provision applies to taxable years beginning after Dec. 31, 1982 (the effective date of the present-law provision regarding inadvertent terminations).

Interim Closing of Books Allowed

The Act provides that the election to close the books of an S corporation upon the termination of a shareholder’s interest is made only by all the "affected shareholders" and the corporation itself and no longer needs to be agreed to by all the S shareholders. Affected shareholders are those whose interest is terminated and those to whom shares are transferred during the year.

Effective date: The provision applies to taxable years beginning after 1996.

Post-Termination Transition Period Expanded

The Act allows a former S corporation to make potentially non-taxable distributions (to the extent of the accumulated adjustment account) to shareholders during the 120-day period beginning on the date of any IRS audit adjustment of its S period income, loss, or deductions after termination of the S corporation election.

The Act also repeals audit procedures adopted in 1982 that require that the tax treatment of S corporation items be determined at the corporate, rather than the individual, level.

Effective date: The provision is effective for taxable years beginning after 1996.

S Corporations Permitted to Hold S or C Subsidiaries

The Act allows an S corporation to own 80 percent or more of the stock of a C corporation. The C corporation subsidiary could file a consolidated return with an affiliated C corporation, but not the S corporation. Dividends received by the S corporation from the C corporation will not be treated as passive investment income to the extent that the dividends are attributable to the earnings and profits of the C corporation derived from the active conduct of a trade or business.

The Act also allows an S corporation to own a qualified subchapter S subsidiary. A qualified subchapter S subsidiary is an otherwise eligible S corporation, 100 percent of the shares of which are held by its parent S corporation. The qualified subchapter S subsidiary is not treated as a separate corporation, and all the assets, liabilities, and items of income, deduction, loss, and credit of the subsidiary are treated as being those of the parent S corporation.

Effective date: The provision applies to taxable years beginning after 1996.

Treatment of Distributions During Loss Years

The Act modifies the order in which distributions and losses are taken into account in applying the loss limitation for the year and in determining the taxability of distributions. Similarly, for purposes of determining the accumulated undistributed post-1982 gross income less deductions, the Act provides that the excess of losses and deductions over income for that taxable year is disregarded. As a result of these changes, shareholders with substantial prior year earnings can receive a distribution early in the year without uncertainty about its tax treatment.

Effective date: The provision applies to taxable years beginning after 1996.

Allows Tax-Free Liquidation of C Corporation into S Corporation

The Act repeals the rule that treats an S corporation in its capacity as a shareholder of another corporation as an individual. Thus, the liquidation of a C corporation into an S corporation will be a tax-free event. The repeal of this rule does not change the general rule governing the computation of income of an S corporation.

Effective date: The provision applies to taxable years beginning after 1996.

Elimination of Certain Earnings and Profits

The Act provides that if a corporation is an S corporation for its first taxable year beginning after 1996, its accumulated earnings and profits as of the beginning of the fiscal year will be reduced by the earnings and profits (if any) accumulated before 1983 and while the corporation was an electing small business corporation.

Effective date: The provision applies to taxable years beginning after 1996.

Treatment of Certain Losses Carried Over According to At-Risk Rules

The Act permits losses that are not deductible in one taxable year because of the at-risk rules to be carried forward to the S corporation’s post-termination transition period (as expanded by the Act).

Effective date: The provision applies to taxable years beginning after 1996.

Adjustments to Basis of Inherited S Corporation Stock

The Act provides that a person acquiring stock in an S corporation from a decedent must treat as income in respect to a decedent (IRD) that person’s pro rata share of any item of income of the corporation that would have been IRD if acquired directly from the decedent. If an item is treated as IRD, a deduction for the estate tax attributable to the item generally is allowed. The stepped-up basis in the stock in an S corporation acquired from the decedent is reduced by the extent to which the value of the stock is attributable to items consisting of IRD.

Effective date: The provision applies with respect to decedents dying after the date of enactment.

Treatment of Certain Real Estate Held by an S Corporation

A parcel of land held by a taxpayer other than a corporation generally is not treated as ordinary income property solely by reason of the land being subdivided if:

• The land has not previously been held as ordinary income property and if, in the year of the sale, the taxpayer did not hold other real property.
• No substantial improvement has been made on the land by the taxpayer, a related party, a lessee, or a government; and
• The land has been held by the taxpayer for five years.

The Act extends these rules to land held by an S corporation.

Effective date: The provision is effective for sales in taxable years beginning after 1996.

Re-Election of S Status For Recent Terminations

Under current law, a small business corporation that terminates its subchapter S election may not make another election to be an S corporation for five taxable years unless the Treasury Secretary consents to such election. For purposes of this five-year rule, the Act provides that any termination of subchapter S status in effect immediately before the date of enactment of the provision is not to be taken into account. As a result, any small business corporation that has terminated its S corporation election within the five-year period before the date of enactment may re-elect subchapter S status upon enactment of the provision without the consent of the Treasury Secretary.

Effective date: The provision is effective for terminations occurring in a taxable year beginning before 1997.