S CORPORATIONS RULES LIBERALIZED Congress made S corporations easier to set up and operate under the Small Business Job Protection Act it passed in August 1996.

More corporations will be able to qualify as S corporations, governing rules are simplified, and S corporations will be easier to pass on to the next generation. An S corporation is a business form that retains many of the benefits of a C corporation, but whose income is taxed at the shareholder level much like a partnership (thus avoiding the double taxation of C corporations). Under the new provisions, most of which took effect the start of 1997: An S corporation may now have up to 75 shareholders instead of the previous limit of 35. (Nonresident aliens still can't be S corporation shareholders.) A new type of trust can hold S corporation stock along with grantor trusts, voting trusts, certain testamentary trusts, and qualified subchapter S trusts. This trust is called an "electing small business trust." The important feature of this trust is that it can have more than one beneficiary, which is not allowed in the other types of trusts. Estate planning experts say this means that "sprinkle" or "spray" trusts may hold S corporation stock, and that it will be easier to pass on S corporation stock to beneficiaries such as family members. Only individuals or estates are eligible to be beneficiaries, with the exception of charities that hold a contingent remainder interest. Beneficiaries can receive the stock only through gift or bequest, not through purchase. Each beneficiary is treated as a single shareholder. The big drawback to this new rule is that S corporation income flowing into this new type of trust is subject to the highest income-tax rates imposed on estates and trusts (39.6 percent for ordinary income and 28 percent on capital gains).
Tax-exempt organizations such as qualified pension plans, profit-sharing plans, and foundations may now hold S corporation stock, but the income (or loss) will be treated as unrelated business taxable income, which can be taxed. S corporations may now hold more than 80 percent of the stock in another S or C corporation (but a C corporation can still not hold stock in an S corporation), which should allow more flexibility for companies with subsidiaries. The Internal Revenue Service is now permitted, at its discretion, to allow an S election that otherwise might be invalid because of a technicality. It couldn't do so before. Moreover, this rule change is retroactive to tax years starting in January 1, 1983. Corporations turned down for S status back then can reapply for an IRS waiver. Corporations that terminated their S status could not, without IRS approval, reapply for S status for five years. However, the act allows any corporation that terminated its S status before 1997 to reapply for S status regardless of the five-year rule. S corporations that terminate in 1997 or later will have to wait five years. It will be easier now to terminate a shareholder's interests in an S corporation. Terminating such an interest before meant having to close the books for all the shareholders, with their consent. Now the books may be closed with just the consent of the affected shareholders. Grantor trusts may now hold S corporation stock for up to two years after the grantor's death instead of only 60 days.

This column is produced by the Institute of Certified Financial Planners.