Good news: two new tax laws offer small-business owners sweet rewards

Entrepreneur, Jan, 1997 by Joan Szabo

Good things do come to small-business owners who wait long enough. In the last session of Congress, lawmakers finally delivered several choice tax benefits to many small companies.

Provisions in two recently enacted tax laws are the source of the good news. One major change, contained in the Small Business Job Protection Act of 1996, will make life easier for about 2 million small companies structured as subchapter S corporations. (We touched on this change in November's "Tax Talk" column but now explain it here in more detail.)

The other reason to cheer is the Taxpayer Bill of Rights II. It expands the arsenal of remedies small-business owners and individual taxpayers can use to resolve tax disputes with the IRS. The statute provides a new passel of rights that will be especially useful in audit situations.

* S CORPORATION CHANGES

As you may remember, with sub-chapter S corporations, the earnings of a business "flow through" to the owners, where they are then taxed at the owner's personal tax rate. This is in contrast to a regular C corporation, where the business is taxed as an entity separate from its owners, and the owners' income is then taxed at personal rates. This means C corporation owners pay taxes twice.

Paying federal taxes only once is a major reason many small-business owners have been attracted to S corporations. Another plus: They provide owners with corporate limited liability.

If your company is already set up as an S corporation, the new law should make it easier to attract capital, grow your company and establish a viable estate plan, says Samuel P. Starr, a partner with the accounting firm Coopers & Lybrand LLP in Washington, DC.

To help attract capital and grow a company, the new law increases the number of allowable shareholders in an S corporation from 35 to 75, starting this month. "Expanding the number of shareholders makes it possible to have more investors and, hopefully, attract more capital," says Starr.

Robert Webb, director of tax services for the Denver-based accounting firm Gelfond Hochstadt Pangburn & Co., doesn't expect this change to have a major impact. "Since most S corporations are utilized primarily by family businesses or closely held businesses, the existing 35-shareholder limit has not proved to be a significant problem for them. Most S corporations will continue to have less than 35 shareholders," Webb maintains. While this may well be true, tax experts say it is still beneficial to have the flexibility of going above 35.

Another provision in the law is expected to have an even greater effect on raising capital. It will allow certain tax-exempt organizations, such as qualified pension plans, to be eligible shareholders in S corporations starting in January 1998. "This should provide even greater access to capital because there are pension plans willing to invest in closely held small-business stock," says Starr. As a result, S corporations will have an opportunity to seek funding from these kinds of institutional investors - something they couldn't do in the past.

Owners of S corporations also gained more flexibility in structuring their businesses. The new law allows S corporations to own 100 percent of affiliated companies. "Before the new bill was enacted, these companies operated in a restrained environment, where they could not own more than 79 percent of another corporation," Starr explains. Now S corporations can own the entire company.

This is especially beneficial for companies with multiple lines of business because they can treat these other entities as divisions of the parent company. In addition, these subsidiaries can now be structured as either C corporations or subchapter S corporations.

This change also offers S corporation owners greater protection. Businesses generally create subsidiary corporations "to isolate liability," says Webb. "You may have a construction operation and a retail business. Your aim is to make sure the two businesses are separate so if there is a construction liability, [no one can] have access to your retail assets."

Finally, the new law makes it easier for S corporation owners to do more effective estate planning. It's now possible for them to establish small-business trusts with up to 75 beneficiaries. "Now they can put S corporation stock into a trust that can have, for example, a host of children and grandchildren as beneficiaries. This enables business assets to be transferred to relatives," Webb notes. The trust can also accumulate income and is not required to distribute the funds to beneficiaries each year, which was the case in the past.

The downside? The trust must pay taxes at the maximum marginal tax rate each year, which could be as high as 39.6 percent.

Keep in mind that if you are starting a business, the new law doesn't make S corporations more attractive than limited liability companies (LLC). LLCs remain "fairest of them all," Starr says.

CPA Ralph J. Anderson Jr. agrees. A partner in charge of taxation and financial services for the New York City accounting firm M.R. Weiser & Co. LLP, Anderson says, "It is my belief that even with the changes in the new law, an LLC remains a better choice for most smaller companies just getting off the ground." (For more on the pros and cons of LLCs, see "Legal Aid," September 1996.)