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Img5.gif 2007 S Corporation Tax Law Changes


   New Tax Law Changes 
   That Benefit S Corporations  

The Small Business and Work Opportunity Tax Act, which was signed by President Bush on May 25, 2007, contains a number of provisions that are beneficial to businesses operating as S corporations. Here is the list:

  Favorable New Interest Deduction Rule for an Electing Small Business Trust (ESBT). Under tax law, an ESBT is allowed to be an S corporation shareholder (although most other trusts are not). ESBT taxable income that is attributable to its S corporation stock ownership is subject to a trust-level tax at the maximum individual federal income tax rate, which is currently 35 percent. (It doesn't matter whether the ESBT distributes the income or not; the trust-level tax applies regardless.) The Small Business and Work Opportunity Tax Act includes a new rule that allows an ESBT to deduct interest expense from debts used to acquire its S corporation shares against its S corp taxable income. This favorable change reduces the amount of income subject to the 35 percent trust-level tax.

Effective Date: Tax years beginning after 12/31/06.

 Gains from Securities Sales Are No Longer Treated as Passive Investment Income. Some S corporations have earnings and profits (E&P) that accumulated during years when they were C corporations.

An S corporation in this category is exposed to a corporate-level tax on excess net passive income. The tax is imposed when more than 25 percent of the corporation's gross receipts for the year are from passive investment income.

Even worse, a corporation's S election can be revoked when more than 25 percent of its gross receipts are from passive investment income for three consecutive years. For purposes of these two unfavorable rules, the new law includes a provision that excludes gains from sales of securities from the definition of passive investment income. In addition, for purposes of these two rules, an S corporation's gross receipts only include the amount of gains from securities sales (rather than the larger amount of proceeds from such transactions). These changes make it less likely that S corporations will run into trouble under the passive investment income rules.

Effective Date: Tax years beginning after 5/25/07.

 Favorable New Rule on Treatment of QSUB Stock Sales. A qualified Subchapter S subsidiary (QSUB) is a state-law corporation that is 100 percent owned by its parent S corporation. For federal tax purposes, the parent is allowed to treat the QSUB as a "disregarded entity." In other words, the subsidiary is treated for tax purposes as an unincorporated branch or division of the parent S corporation, rather than a separate corporation.

Beneficial QSUB status vanishes as soon as the parent S corporation no longer owns 100 percent of the subsidiary's stock. That's always been clear, but there has been confusion and controversy about the tax implications when a parent S corporation sells some of its shares.

The Small Business and Work Opportunity Tax Act includes a new provision clarifying that such a stock sale transaction will be treated as:

1. The sale of an undivided interest in the subsidiary's (former QSUB's) assets (based on the percentage of shares sold) and

2. A subsequent acquisition of all the subsidiary's assets and an assumption of all of its liabilities by a "new" corporation in a "Section 351" transaction.

Typically, Section 351 transactions are tax-free deals. Therefore, following this new provision will usually result in no additional taxable gain for the parent S corporation (or its shareholders) upon the deemed formation and capitalization of the "new" corporation.

Effective Date: Tax years beginning after 12/31/06.

 Bank Adjustments after Changing to S Corp Status. When a bank corporation changes from C to S status, it must abandon the use of the reserve method of accounting for bad debts in its first tax year for which S status applies. The Small Business and Work Opportunity Tax Act includes a new provision that allows the corporation to elect to include all of the taxable income triggered by the accounting method change (the "Section 481 adjustment") in its final C corporation tax year. If the election is made, it avoids any built-in gains tax on the income from the Section 481 adjustment, and it avoid having to pass any of that income through to the S corporation's shareholders.

Effective Date: Tax years beginning after 12/31/06.

 New Rules for Restricted Bank Director Shares. For legal reasons, S corporation banks sometimes must issue restricted stock to directors. This can cause problems because an S corporation cannot have:

1. More than 100 shareholders or
2. More than one class of outstanding stock.
The Small Business and Work Opportunity Tax Act includes a new rule stating that restricted bank director shares are not counted as outstanding stock for purposes of these two restrictions.

With regard to the 100-shareholder restriction, the new rule is effective for tax years beginning after 12/31/06. With regard to the one-class-of-stock restriction, the new rule is retroactively effective for tax years beginning after 12/31/96.

Another new law provision says that an S corporation distribution paid to the owner of restricted bank director shares (other than a distribution to wholly or partially redeem shares) is treated as:

1. Taxable income for the recipient director and 
2. A deductible expense for the S corporation.

This last rule is also effective for tax years beginning after 12/31/06.

 Special Rule Allows Elimination of Pre-1983 Earnings and Profits. Let's say a corporation is currently an S corporation and was one for any tax year that began before 1/1/83. But it was not an S corporation for its first tax year that began after 12/31/96. In this somewhat unusual scenario, a new provision allows the S corporation to subtract any earnings and profits (E&P) that were accumulated during its pre-1983 S corporation years from its current E&P balance. This favorable change can reduce the amount of S corporation distributions that are treated as taxable dividends.

Effective Date: An affected S corporation's E&P balance is reduced at the start of the first tax year that begins after 5/25/07. Ronald J. Cappuccio, J.D., LL.M.(Tax) 1800 Chapel Avenue West Suite 128 Cherry Hill, NJ 08002 Phone:(856) 665-2121      Fax: (856) 665-9005 Email:

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