• About DWP&M
  • Our Founders
  • Our Practice
     - Public Service
    - Litigation
    - Corporate
    - Municipal
    - Intellectual Property
    - Trusts & Estates
    - Real Estate
    - Environmental
    - Employment
  • Members of the Firm
  • Your Resources
     - Quarterly Newsletter
    - Appellate Tax Report
    - Litigation Newsletter
    - Firm News and Information
  • Request Info
  • Employment Opps.
  • Contact Us



    • Point of View
    Quarterly Newsletter

    CHOICE OF ENTITY: RENEWED VIABILITY OF THE S CORPORATION?

    As part of the Small Business Job Protection Act, Congress recently enacted several amendments to the provisions of the Internal Revenue Code applicable to S corporations.

    These changes, most of which took effect as of January 1, 1997, significantly reduce the restrictions placed upon business owners who wish to operate as an S corporation. These changes are important not only for those planning a new business but also for those currently operating S corporations who may be considering a change to a different type of entity.

    Most small business owners have two primary objectives with respect to their choice of business entity; namely, to incur only a single level of taxation and to limit the personal liability of the owners for the obligations and liabilities of the business.

    There areseveral different business forms which protect the owners of the entity from individual liability and which subject the entity and its owners to only a single level of federal taxation. These business forms include a limited partnership, a limited liability company and an S corporation. All of these entities are so-called "pass-through" entities since income and losses are passed directly through to individual owners without incurring a tax at the entity level. A limited partnership requires at least one general partner who will be liable for the debt and liabilities of the partnership. On the other hand, S corporations and limited liability companies (LLC's) do not require an owner to assume unlimited liability for the obligations of the business.

    Since Massachusetts legislation authorizing the use of limited liability companies became effective as of January 1, 1996, the limited liability company has been promoted as the entity of choice for many business owners. In addition to the formation of LLC's for new businesses, there has been an increasing number of conversions of existing business entities such as partnerships and S corporations into the LLC structure.

    Some of the traditional advantages of an LLC in contrast to the S corporation are:

    1. S corporations were typically limited to 35 shareholders while LLC's are not so limited;

    2. LLC's have few restrictions as to who may be a member while the Internal Revenue Code has not permitted corporations, partnerships, certain trusts and non-resident aliens to be shareholders of an S corporation;

    3. LLC's are generally allowed to have non pro-rata distributions and special allocations of profits and losses while income and losses of an S corporation must be allocated among the shareholders on a pro-rata basis based on stock ownership;

    4. LLC's are allowed to have more than one class of stock, while S corporations must have a single class of stock.

    5. Members of an LLC obtain a basis increase for their share of LLC debt but shareholders of an S corporation do not receive an increase in their stock basis for their share of corporate debt

    In essence, the LLC has been cited as a more flexible entity than the S corporation.

    Recent Tax Changes

    The new tax legislation contained in the Small Business Job Protection Act, however, reduces or eliminates many of the restrictions applicable to S corporations. For one thing, the new tax legislation increases the maximum number of S corporation shareholders from 35 to 75.

    Small Business Trusts

    The new tax legislation permits electing small business trusts to be shareholders of S corporations for tax years beginning January 1, 1997. To qualify, all beneficiaries of the small business trust typically must be either estates eligible to be S corporation shareholders or individuals. For a small business trust to be an eligible S corporation shareholder, the trust interest must have been acquired by reason of gift, bequest or other non-purchase acquisition.

    Each beneficiary of the existing trust is counted as a shareholder for purposes of the 75 shareholder limitation. This provision provides an opportunity for non-resident aliens to benefit from S corporation status. A non-resident alien as a beneficiary of an electing trust may have an interest in the S corporation without violating the prohibition against non-resident alien S corporation shareholders.

    next column

    Charitable Organizations

    Provisions prohibiting certain tax-exempt organizations from being S corporation shareholders are also eliminated. The new tax legislation allows charitable organizations which comply with IRC Section 501 (C) (3) and certain qualified plan trusts described in IRC Sections 401 (a) to be eligible S corporation shareholders. Each entity will count as one shareholder for purposes of the 75 shareholder limitation. This provision applies to tax years beginning January 1, 1998.

    Debt

    Generally under Subchapter S, debt is not treated as a second class of stock, provided however that:

    (1.) the debt is an unconditional promise to pay a sum certain on demand on a specified date;

    (2.) the interest rate on the debt is not contingent on profits and is not discretionary;

    (3.) the debt is not convertible into stock; and

    (4.) the debt is owed to a creditor that is a permissible shareholder in an S corporation.

    The new tax legislation expands the definition of debt which will not constitute a second class of stock to include debt held by non-individual creditors that are actively and regularly engaged in the business of lending money. This change is noteworthy in that it bolsters the S corporation's financing opportunities without the concern of losing corporation status.

    Corporate Shareholders

    Historically, S corporations were prohibited from having corporate shareholders. The new rule changes allow S corporations to have C corporation subsidiaries thereby allowing S corporations to be part of an affiliated group. Although the restriction on S corporations having corporate shareholders is technically still in existence, for tax years beginning January 1, 1997 a new type of Subchapter S corporation may be created. This special type of S corporation is referred to as a "qualified Subchapter S subsidiary". As long as the S corporation owns 100% of the Subchapter S subsidiary and makes the required election, the parent S corporation will not lose its S corporation status. This change allows increased flexibility to S corporation business owners in the structuring of their corporate holdings.

    Five-Year Waiting Period

    A traditional problem with either losing or terminating S corporation status was that the corporation would then have to wait five years to re-elect S corporation status. The new tax legislation eliminates this five-year waiting period thereby allowing S corporation owners to more easily rectify an inadvertent termination or loss of S corporation status.

    In sum, the new tax legislation has eliminated many of the restrictions and problems associated with operating as an S corporation. Many business owners will still find the LLC to be a less restrictive and more flexible form in which to operate. Yet, this new legislation will likely bolster the popularity of the time-tested S corporation and provide an additional incentive for existing S corporations to refrain from converting to limited liability companies.




    DOHERTY, WALLACE, PILLSBURY & MURPHY
    ONE MONARCH PLACE
    1414 MAIN STREET
    SPRINGFIELD, MA 01144-1002
    PHONE | 413-733-3111
    FAX | 413-734-3910

    Advertising