Grab your opportunity: a new tax law may let family businesses keep more money in the bank

Entrepreneur, June, 2005 by Joan Szabo

Family-business owners are among the winners of tax benefits under the American Jobs Creation Act of 2004. The law makes as many as 10 different changes to S-corporation rules, but the changes affecting family-business owners are considered to be among the most significant. (Experts note that the majority of family businesses are organized as S corporations.)

The major benefit of S-corp. status is that owners generally pay less in federal taxes. With an S corp., income is typically taxed only once, at the owner level. Under a regular C corporation, it's taxed twice--once at the corporate level and again at the shareholder level when it's distributed.

Starting this year, the law boosts the allowable number of shareholders in an S corp. from 75 to 100. In addition, it allows up to six generations of one family to elect to be treated as one shareholder. As a result, it will be easier for larger family-owned corporations to qualify for and retain S-corp. tax status.

"As families grow and multiply over the years, some have started to bump up against the 75-shareholder limit," says Greg W. Smith, senior tax manager with PricewaterhouseCoopers in Washington, DC. The change in the law means these companies can still qualify for S-corp. status with as many as 100 shareholders.

S-corp. owners who may be thinking about an exit strategy enjoy another benefit as a result of their status--namely, owners are allowed to increase their tax basis in the corporation's stock for "flow through" earnings (less distributions); C corporations are not. The result? The S-corp. owner will generally recognize a smaller gain when selling the company's stock and enjoy higher after-tax proceeds.

As a result of the new tax law, there may be a number of privately held C corporations that would now benefit from electing S-corp. status. But if you own a C corporation, before making the switch, consult with your tax advisor to determine whether you are eligible to make an S-corp. election. If you are, it's also important to determine if the tax benefits of switching will outweigh any tax or non-tax disadvantages.

Great Falls, Virginia, writer JOAN SZABO has reported on tax issues for 18 years.