The New and Improved S Corporation (1997)

In calendar year 1994, 2,036,700 S corporation returns were filed with the Internal Revenue Service. The IRS examined only 18,839, or fewer than 1%, of these returns. Source: Internal Revenue Service 1995 Data Book, Publication 55b. The Small Business Job Protection Act, passed by Congress in August 1996, was intended to provide tax breaks for small businesses as well as to impose tighter rules on expatriates, foreign trusts and entities doing business in Puerto Rico. Also included in the act were numerous changes to the rules governing the use of S corporations. Many of these changes--detailed . in this article-improved the flexibility of this form of ownership, making it easier for such businesses to operate and for owners to transfer their interests during their lifetimes and at death. WHO CAN BE SHAREHOLDERS? The act changed a number of rules about who can and cannot have an ownership interest in an S corporation. Number of permitted shareholders. The act increased the maximum number of eligible shareholders of an S corporation to 75 from 35 effective for tax years beginning after December 31, 1996. This significantly increases the number of entities that now may qualify as S corporations. Electing small business trusts as eligible shareholders. Under prior law, a trust generally was not permitted to own stock in an S corporation, although certain trusts such as qualified subchapter S trusts (QSSTs) were--and remain--eligible. The act created (effective for tax years beginning after December 31, 1996) an electing small business trust (ESBT) that may be an eligible S corporation shareholder. In general, the difference between the two trusts is that the ESBT itself is treated as an S corporation shareholder whereas the beneficiary of a QSST is considered the S corporation shareholder. To qualify as an ESBT, all trust beneficiaries must be individuals or estates (or, after 1997, certain charitable organizations) eligible to be S corporation shareholders (charitable organizations may hold contingent remainder interests). Also, no interests in the trust may be acquired by purchase (as defined in the act). Instead, the trust interests must be acquired by gift, bequest or similar means. Each potential current income beneficiary of the trust is counted as a shareholder for purposes of the 75-shareholder limitation. To be considered an ESBT, the trustee must include an election with the trust's tax return; such elections may be revoked only with Internal Revenue Service permission. This provision permits taxpayers more latitude in doing estate planning by allowing them to more easily fund trusts with S corporation stock. This means taxpayers can more easily transfer their S corporation stock to family members to minimize their estate tax liability. In notice 97-12, the IRS provided procedures for making the ESBT election: The trustee must file a statement with the service center where the corporation files its income tax return. The statement must * Contain the name, address and taxpayer identification number (TIN) of the trust, all potential beneficiaries and the corporation. * Identify the election as one under IRC section 1361 (e)(3) * Specify the date on which the election is to become effective and the date on which the corporation stock was transferred to the trust. * Provide all information and representations necessary to show that all potential beneficiaries meet the shareholder requirements of section 1361 (b)(1) and the trust qualifies as an ESBT under section 1361(e). The trustee must file the election within the period required for filing a QSST election under Treasury regulations section 1.1361-1(j)(6)(iii) (generally, within the two-month-16-day period after stock is transferred to the trust). In the case of newly electing S corporations, the trustee may attach the ESBT election to Form 2553, Election By A Small Business Corporation. …