S Corporation Reform in the 2007 Small Business Act

Elimination of earnings and profits attributable to pre-1983 years.
Prior to 1983, income earned by an S corporation gave rise to earnings and profits. Concluding that it was inconsistent with the modern view of S corporations to continue to view pre-1983 S corporation income as giving rise to earnings and profits, in 1996 Congress eliminated pre-1983 earnings and profits for any corporation that was an S corporation prior to 1983, but only if the corporation was an S corporation in its first taxable year beginning after December 31, 1996. However, there seemed to be no policy reason why relief from pre-1983 S corporation earnings and profits should be dependent on whether the corporation continued to be an S corporation after 1996. Accordingly, the new law eliminates pre-1983 earnings and profits arising during an S corporation year, regardless of whether the corporation was an S corporation in its first taxable year beginning after December 31, 1996. This provision applies to tax years beginning after May 25, 2007.

Treatment of disposition of an interest in qualified Subchapter S subsidiary (“QSub”).
Under pre-Act law, an S corporation could be required to recognize 100 percent of the gain inherent in a QSub's assets if it sold more than 20 percent of the stock of the QSub. This result was counter to sound tax policy because the S corporation, in effect, was required to recognize gain on assets without making any disposition of those assets. The new law rectifies this situation by providing that the S corporation is only required to recognize gain proportionate to the percentage of stock sold. The new law applies to taxable years beginning after December 31, 2006.

Deductibility of interest expense of an electing small business trust (“ESBT”) on indebtedness incurred to acquire S corporation stock.

The new law eliminates a distinction between an individual purchaser of S corporation stock and a trust purchaser, and makes the ESBT more attractive. Under prior law, the only permissible deductions against an ESBT's income were its administrative expenses, such as costs incurred in the management and preservation of the trust's assets. Interest incurred to acquire S corporation stock was not deductible. The new law permits an electing ESBT to claim an income tax deduction for any interest incurred to purchase S stock. The new rule applies to taxable years beginning after December 31, 2006.

Capital gain not treated as passive investment income.
Federal tax law penalizes S corporations if they earn too much passive investment income. Specifically, if an S corporation that previously was a C corporation has undistributed dividends, and earns 25 percent of its gross receipts as passive investment income, then two things will happen. First, the S corporation is taxed on its income at the highest corporate rate. Second, if the S corporation earns too much passive investment income for three consecutive years, then the S election is terminated altogether. Passive investment income generally means gross receipts from royalties, rents, dividends, interest, annuities, and sale or exchanges of stock or securities (to the extent of gains).

However, the corporate-level passive investment income tax is imposed so that C corporations cannot convert to S corporations and thereby avoid the personal holding company (PHC) tax that applies to C corporations. But since PHCs are no longer prohibited from generating passive investment income from gain on the sale of stock or securities, it no longer made sense to impose that restriction on S corporations. Accordingly, the new law eliminates gains from sales or exchanges of stock or securities as an item of passive investment income. The new rule applies to tax years beginning after May 25, 2007.

Treatment of bank director shares.
Bank directors often own stock in a bank to comply with national or state banking law. Frequently, a bank director will enter into an agreement under which the bank will reacquire the stock upon the director's ceasing to hold the office of director, at the price paid by the director for the stock (“restricted bank director stock.”). However, federal tax law provides that an S corporation may have no more than 100 shareholders and may have only one outstanding class of stock. To clarify the treatment of bank director shares under the S corporation rules, the new law provides that restricted bank director stock will not be taken into account as outstanding stock in applying the S corporation rules. This means that:

• the stock will not be treated as a second class of stock;

• a director will not be treated as a shareholder of the S corporation by reason of the stock;

• the stock will be disregarded in allocating items of income, loss, etc. among the shareholders; and

• the stock will not be treated as outstanding for purposes of determining whether an S corporation holds 100 percent of the stock of a qualified subchapter S subsidiary.
  
  

The new provision generally applies to taxable years beginning after Dec 31, 2006, but the provision providing that restricted bank director stock is not treated as a second class of stock is effective for taxable years beginning after December 31, 1996.

Treatment of banks changing from reserve method of accounting.

Under current law, banks that use the reserve method of accounting are ineligible to make the S corporation election. If a bank makes an S corporation election, the bank is automatically switched to the specific charge-off method of accounting for bad debts. This change in accounting method results in recapture of the bad debt reserve over four years. The recapture of the reserve by the bank S corporation is treated as built-in gain subject to a special corporate-level tax. Under the built-in gain provisions, tax on the built-in gain must be paid both at the corporate and shareholder level in the year of recognition. In contrast, a C corporation would pay tax on the recapture amount at the corporate level but the shareholders would not have to pay tax on that amount until the C corporation paid dividends. The new law allows banks to take the recapture of the bad debt reserves into account in the last C corporation year, rather than the first S corporation year, thereby eliminating the imposition of a second layer of tax. The new rule applies to taxable years beginning after December 31, 2006.