TAX BREAK

Changes in S Corporation Laws

by Rebecca L. Maahs

 

The American Jobs Creation Act of 2004 (the “AJCA”) is a $136 billion tax package which closes certain loopholes, while creating new tax breaks for business such as S corporations. Below is a discussion of the changes which took effect as of December 31, 2004, unless otherwise noted.

 

Number of Shareholders  

The maximum number of eligible shareholders is increased from 75 to 100. In addition, all family members (common ancestors, lineal descendants of common ancestors and the spouses thereof up to six generations) may elect to be treated as one shareholder.

 

Transfer of Suspended Losses Incident to Divorce

Losses that are suspended because of basis and “at risk” limitations are transferred to the spouse who receives the stock as part of a divorce settlement.

 

Exclusion of Investment Securities Income from Passive Income Test for Bank

S Corporations 

The new law creates an exception to the passive investment limitations of Internal Revenue Code of 1986, as amended (the “Code”) §1362(d)(3) for banks, bank holding companies and financial holding companies to exclude interest income and dividends on assets required to be held by such entities (i.e., stock in the Federal Reserve Bank, Federal Home Loan Bank, Federal Agricultural Mortgage Bank or participation certificates issued by a Federal Intermediate Credit Bank) from the passive investment income of those entities. 

 

Relief from Inadvertently Invalid Qualified Subchapter S Subsidiary Elections

and Terminations

The bill extends the relief that is now available to inadvertently invalid subchapter S elections and terminations under §1362(f) of the Code to qualified subchapter S subsidiary (“QSub”) elections and terminations, so that inadvertently invalid QSub elections may be waived by the IRS.

 

Expansion of Bank S Corporation Eligible Shareholders to Include IRAs

An IRA (including a Roth IRA) may now be a shareholder of a bank that is an S corporation to the extent of the bank stock held by the IRA on October 22, 2004. Under the Code, the individual for whose benefit the IRA is held would be treated as the shareholder. The new law also provides an exemption from the tax under §4975 of the Code on prohibited transactions for the sale by an IRA to the IRA beneficiary of bank stock held by the IRA on October 22, 2004. The exemption would apply to such a sale if: (1) the sale is pursuant to an S corporation election by the bank, (2) the sale is for fair market value and is on terms at least as favorable to the IRA as the terms would be on a sale to an unrelated party, (3) the IRA incurs no commissions, costs or other expenses in connection with the sale, and (4) the stock is sold in a single transaction for cash not later than 120 days after the S corporation election is made.

 

Repayment of Loans for Qualifying Employer Securities 

Prior to the enactment of the AJCA, the IRS had taken the position that distributions by an S corporation on stock held by an employee stock option plan (“ESOP”) could not be used to pay-off a loan unless the stock was pledged to secure the loan, even though comparable dividend distributions from a C corporation could be used in such a manner. The new law makes it clear that all distributions of earnings by an S corporation on shares held by an ESOP can be used by pay down an ESOP loan, not just distributions of pledged shares. In effect, the new legislation ensures that an ESOP that holds stock of an S corporation will be entitled to apply earnings distributions in the same manner that an ESOP that holds stock of a C corporation can apply dividends. A retroactive effective date, back to December 31, 1997, is provided for the new law. Therefore, ESOP-owned S corporations that previously may have inadvertently applied distributions on unpledged shares toward the repayment of ESOP loans will be shielded from penalties.

 

 

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