The Strategist

3rd Quarter 1996 - Volume 3 Issue 3

The week of August 19th, President Clinton signed three new bills into law. These bills, known as the Small Business Bill, the Health Insurance Bill, and the Welfare Reform Act of 1996, make some substantial changes to tax laws that could affect our readers.

In this issue, we will review some of the major changes. These bills are collectively referred to in this issue as the new law.

After many years of talk about reforming sub S tax law, the new law finally includes numerous provisions that take effect January 1, 1997 and January 1, 1998. Most people consider the preferred form of a new business entity to be an LLC (limited liability company). An LLC has income taxation like that of a partnership but provides limited liability protection much like a corporation.

However, corporations that were started before LLCs were an approved operating entity generally had to choose between a C corporation or an S corporation. The down side of a C corporation is that retained earnings are trapped inside the corporation and can only be paid out as salary subject to reasonable compensation rules or as dividends which creates double taxation (corporate level and personal level).

The other corporate form, subchapter S (S corporation) taxed corporate profits only at the personal level, like a partnership, allowing a pass through or only a single level of taxation. Many people desired to convert to subchapter S to take advantage of this single level of taxation. Unfortunately, they were unable to convert to S status for various reasons including the maximum number of shareholders (35) that owned stock or the fact that the corporation had subsidiaries. S corporations were not allowed to have 80% or more subsidiaries. The only way to qualify for S status would be to liquidate the subsidiary which would cause an additional tax.

The new law allows S corporations to now hold 80% or more C corporation subsidiaries and they can also own 100% of qualified subchapter S subsidiaries also known as QSSS. Additionally, the number of allowable shareholders for an S corporation has increased from 35 shareholders to 75 shareholders.

Another improvement that has occurred under the new sub S rules is a change in the type of entity that can own subchapter S stock. We are very excited about this change as we think this a great opportunity for planning.

First, let's review the previous subchapter S law. Only estates, individuals, and certain types of trusts called Qualified Subchapter S Trusts could own stock in a sub S corporation. A Qualified Sub S Trust or QSST could only have one beneficiary and required all of the income (dividends received from the S) to be paid out to that single beneficiary of the trust each and every year.

In other words, it was impossible to have two income beneficiaries of a single trust and it was impossible to accumulate dollars in the trust. If a trust either attempted to accumulate dollars or had more than one income beneficiary, the trust was not a qualified shareholder and would void the sub S election. If this election was voided, a five year wait was required before the corporation could reapply for sub S status. Fortunately, all of these items have changed with the new legislation.

The new law allows a new type of shareholder called an Electing Small Business Trust (ESBT). An Electing Small Business Trust can have multiple potential income beneficiaries and is not required to pay out the actual subchapter S dividends to these beneficiaries. Each potential income beneficiary is considered a shareholder and counts against the 75 shareholder limit. Should an individual establish an ESBT with their children as the potential multiple income beneficiaries, the trustee of the trust now has the ability to "spray" the income as needed or to accumulate the income.

Previously, many parents that owned subchapter S stock would not gift the subchapter S stock to a trust or to a child due to the requirements that the child receive the income. Many times parents were worried that children would not be responsible with the funds or the parents desired to have dollars accumulate in a trust for estate planning purposes. The new provisions for an ESBT take effect January 1, 1997.

One negative to this is that the ESBT cannot acquire subchapter S stock other than by gift or bequest. In other words, an ESBT is not allowed to purchase shares of subchapter S stock. Another minor negative is the income taxation of the ESBT. There is some bracket creep under normal trust income tax rules. The highest federal income tax bracket (39.6%) takes effect above $7,900 of gross income under most trusts.

However, with an ESBT there is no bracket creep and the first dollar of income is taxed at the maximum 39.6% federal rate. This applies only to the income on the portion of the trust that comes from the S corporation holdings. We do not think this is especially bad since, in most circumstances, the "Kiddie Tax" would have caused the child to have been taxed at the parents' rate which is generally 39.6%. We believe that the opportunities to accumulate assets in the trust allow for many estate planning opportunities.

The good news is not over for S corporations. The new tax law also allows certain charitable organizations and retirement plans to own subchapter S stock. Prior to the enactment of this law, if an S corporation's stock was owned by a charitable organization or a retirement plan, the S election was automatically voided and the corporation would then be taxed as a C corporation.

Now, any income derived by the charitable organization or retirement plan from sub S holdings is subject to unrelated business income. The taxation, as unrelated business income, also applies on the sale of the stock. Normally, neither a charitable organization nor a retirement plan would pay income taxes on earnings but now would do so on the S income.

The unified audit rules no longer apply to S corporations. Under old law, items of income, loss, deductions, and credits, (tax treatments that were determined at the corporate level) were audited at the corporate level similar to the rules that apply to partnerships. Now the audits of S corporations will only be on a shareholder by shareholder basis.

Another potential planning advantage under the new law is that an S corporation can now acquire stock in another corporation and make what is known as a Code Section 338 Election to treat the acquired corporation as making a deemed taxable sale of its assets resulting in a step-up in basis in the assets for the S corporation. It is important to point out that this is done at the cost of recognizing gain on the deemed sale. Previously, this option was not available.

Corporations that either intentionally or inadvertently terminated their S status before January 1, 1997 are not subject to the 5 year waiting rule before re-electing S status. Therefore, a corporation that may have terminated their S election within the last 5 years may re-elect S status without IRS consent. The 5 year waiting rule waiver appears to continue to apply when an S corporation is terminated in a tax year after January 1, 1997.

One other major change is that there is now an increase percentage of health insurance costs that can be deducted by self-employed individuals. Under previous law, self-employed individuals were entitled to deduct only 30% of the amount paid for health insurance for themselves and family members. Under the new law, the deduction is increased, beginning in 1997, to 40% and increases until the year 2006 at which point an 80% deduction is allowed. The increased deduction percentages are available for partners and more than 2% shareholders of S corporations.

This issue's QUICK TIP also comes from the newly enacted legislation. Prior to 1995, an individual could gift qualified appreciated stock (publicly-traded stock) to a private foundation and deduct the full fair market value of the stock. Beginning on January 1, 1995, the law changed to allow an income tax deduction equal to only the donor's basis in the stock.

In other words, if I made a gift to my private foundation of publicly-traded stock with a cost basis of $10,000 but a fair market value of $100,000, on January 1, 1995, I could deduct from my income taxes only $10,000 (my cost basis). Had I made the gift one day earlier, on December 31, 1994, I could have deducted the full $100,000 value. The new law allows me to again deduct the full $100,000 fair market value of the stock.

It is important to note that there are some minor technical requirements but, in general, the income tax deduction for a contribution to a private non-operating foundation is restored to the pre-1995 law. This is only available for a short period of time. The provision allows full fair market value deduction from July 1, 1996 until May 31, 1997. Act quickly to take advantage of this if you wish to contribute appreciated stock to your private foundation.

As always with any tax law change, you should consult with your attorney or accountant to see how the changes affect you.

The Wealth Transfer Group, Inc. is not engaged in the practice of law or accounting nor are any of its employees, representatives, or agents. Tax and legal advice should be obtained from qualified personnel.
(c) 1996 The Wealth Transfer Group, Inc.
283 Cranes Roost Boulevard, Suite 145, Altamonte Springs, Florida, 32701 (407) 339-5787

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