Recent Reform and Simplifications for S Corporations

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Subchapter S of the IRC became a tax fact in the lives of small business owners and tax professionals when Congress enacted the Technical Amendments Act of 1958. Years ago, Subchapter S corporations were the entity of choice if the owner of a small business wished to obtain the benefits of operating through the corporate form (limited liability) without suffering the detriment of double taxation on the business' earnings. Former 1RS commissioner Donald Alexander, appearing before the House Ways and Means Committee, explained the following:

[A]fter the Treasury's blessing of the limited liability company, plus the Treasury's adoption of check-the-box rules, partnership tax treatment (correctly called "tax nirvana") has been conferred upon entities that were not formerly treated as partnerships ... It is no wonder the recent wave of aggressive tax shelters typically used a partnership as the vehicle to transfer tax benefits. But some entities, like banks, must conduct their businesses in corporate form and others are required to do so by state laws or other rules. They must use Subchapter S. Many Subchapter S corporations are locked into elections made years ago; while they would prefer to adopt the tax-favored partnership form, they cannot without a heavy tax toll charge. Subchapter S corporations are found on Main Street, not Wall Street. They are not asking for the famous "level playing field," i.e., the favored tax treatment granted to partnerships. Instead, they are simply asking that some of the fetters imposed in another era be removed.

Congress apparently also believed that the initial legislation was not good enough for S corporations, and sought better laws. So far it has taken 45 years to modify, correct, and reform the law, and more remains to be done. Initially, the maximum number of shareholders was set at 10, and Congress accepted this until 1976, when the number of shareholders was increased to 25 persons. Only domestic corporations could be S corporations, none of the shareholders could be nonresident aliens, and all shareholders had to consent to treat their entity as an S corporation. Only one class of stock was allowed, although having voting and nonvoting stocks did not violate the singleclass requirement.

In 1982, Congress decided to adopt many aspects of partnership taxation, leaving out the complexities that applied to partners and partnerships. Legislatures and lobbyists wanted more flexibility and realized that converting S corporations to partnerships exposed both corporations and shareholders to taxation. Congress decided to change the tax regime of S corporations and to treat them as pass-through entities, although under rules different from partnership taxation rules.

More significant changes were made in 1996, including the following: 1) the number of S corporation shareholders was increased from 35 to 75; 2) S corporations were allowed to own subsidiaries; 3) certain types of tax-exempt organizations and trusts were allowed to own S corporation stock; 4) certain banks were permitted to elect S corporation status; 5) S corporations were allowed to create an employee stock ownership plan; 6) the 1RS was empowered to provide relief for late or invalid S corporation elections; and 7) S corporations were made exempt from the unified audit and litigation procedures.

The congressional records of the American Jobs Creation Act of 2004 articulate the substance of the new law and the congressional intent. Speakers at the congressional sessions believed that it was imperative to offer more incentives to S corporations, because the relative effectiveness of S corporations was likely diminished somewhat as a result of the Jobs and Growth Tax Relief Reconciliation Act of 2003. By reducing the tax rate on qualified dividends to 15% percent, the 2003 Act lessened (but did not eliminate) the double tax on corporate income, thereby reducing (but again not eliminating) the tax advantage offered by S corporations. …