1-15 A BRIEF HISTORY Small Business Protection Act of 1996 and Subsequent Legislation As part of legislation designed to use the tax code to

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15 1-15 A BRIEF HISTORY Small Business Protection Act of 1996 and Subsequent Legislation As part of legislation designed to use the tax code to provide incentives for small business, Congress substantially revised Subchapter S in the Small Business Protection Act of These amendments were designed to make Subchapter S available to a wider range of corporations and to eliminate traps for the unwary. In addition, a number of technical changes were made. The most significant change was to increase the number of eligible shareholders from thirty-five to seventy-five in order to facilitate corporate ownership by additional family members, employees and capital investors. 2 The Act also expanded the class of eligible shareholders. Congress created a new entity, an Electing Small Business Trust, that permitted income to be distributed to a class of individuals rather than to a single beneficiary. 3 The ability to have a spray trust hold stock in an S corporation facilitates estate planning where the stock is a major family asset. In addition, certain tax-exempt entities became eligible shareholders of an S corporation. 4 Ending a major limitation on corporate planning, Congress permitted S corporations to hold subsidiaries. An S corporation may have a C corporation subsidiary, which can elect to file a consolidated return with other C corporations, although not with the S corporation parent. 5 An S corporation also can have a wholly owned subsidiary, so long as it would be eligible to be an S corporation were it not for the fact that the stock was owned by a corporation. This Qualified Subchapter S Subsidiary is not treated as a separate corporation and all tax-relevant items are treated as belonging to the parent. The addition of this provision permits S corporations to put different businesses in different corporate entities. 6 Other ways in which the availability of Subchapter S was expanded include repeal of the rule that financial institutions cannot be S corporations and a new rule permitting financial institutions to hold certain debt of S corporations. A major problem for S corporations is the myriad of technical rules, particularly those concerning elections. Although the Service had the authority for many years to waive inadvertent terminations, it 1 Pub. L. No (1996). 2 Joint Committee on Taxation, 104th Cong., General Explanation of Tax Legislation Enacted in the 104th Congress 112 (1996). 3 See 3.03[3][f] infra. 4 See 3.03[6] infra. 5 See 3.06[1] infra. 6 See 3.06[2] infra. (Rel. 27)

16 1.09 S CORPORATIONS 1-16 did not have the authority to waive late elections or invalid elections. The 1996 Act gave it this authority so that an election can continue uninterrupted even though it was filed incorrectly or the applicable consents were not obtained. 7 The 1996 Act also made numerous other changes designed to make the calculation and pass through of corporate income and distributions simpler. The most significant of these alters the way in which distributions are taxed: corporate income adjusts basis and the taxability of distributions is determined before losses are permitted. The Taxpayer Relief Act of 1997, 8 while large and complex, made only minor changes to Subchapter S itself, tinkering with the 1996 changes to the eligible shareholder rules. Nevertheless, planning became even more challenging what with changes in capital gains rates, that were phased-in over a period of years. The Jobs and Growth Tax Relief Reconciliation Act of 2003 lowered the top capital gains rate to 15 percent and at the same time made the rate on dividends the same as that on capital gains. This substantially altered the tax planning landscape by changing the relationship between salary, distributions and exchanges. The American Jobs Creation Act of continued the trend of making S corporations easier to use. It increased the limit on the number of eligible shareholders to 100, permitted a transfer of suspended losses to a spouse, and allowed family members to elect to be taxed as one shareholder. The Working Families Tax Relief Act of 2004, 10 the Pension Protection Act of 2006, 11 the Work Opportunity Act of 2007, 12 and the Tax Technical Corrections Act of also included revisions to Subchapter S. 7 See 5.06 infra. 8 Pub. L. No , 111 Stat. 788 (1997). 9 Pub. L. No , 118 Stat (2004). As a result of various amendments to Subchapter S, many more corporations have become eligible to elect Subchapter S status. In fact, most small businesses use some kind of flow-through taxation either partnership, S corporation, or limited liability company and are not subject to tax at the entity level. In 2004, 64 percent of all corporations with assets less than $10 million had an S election in effect and 37 percent of those corporations with assets greater than $10 million did. Toder and Koch, Fewer Businesses Are Organized as Taxable Corporations, Tax Notes 491 (Aug. 6, 2007). 10 Pub. L. No , 118 Stat (2004). 11 Pub. L. No , 120 Stat. 780 (2006). 12 Pub. L. No , 121 Stat. 112 (2007). 13 Pub. L. No , 121 Stat (2007).