New S Corp Rules May Help Small Businesses Weather Economy

Small businesses are being squeezed by troubled credit markets, high energy prices, and sharply rising costs. In many cases, their ability to weather the economic downturn will hinge on cost cutting and maximizing cash flow.

Next to labor, taxes are the biggest expense facing small businesses, and that's unlikely to change anytime soon. But a movement is afoot in Congress to provide relief by modifying rules that govern S corporations. The changes could not only reduce taxes, but also help S corporations tap new sources of capital. According to the U.S. Chamber of Commerce, more than 55 percent of all corporations file taxes as S corporations; of those, about 3.5 million are considered small.

The debate is important because it marks the first significant examination of S corporation rules since that the tax code provision was enacted 50 years ago. The House Small Business Committee's Subcommittee on Finance and Tax held a hearing on the issue this week, and several bills are pending in Congress that would make important changes. "As everybody knows, the times are changing. What was right and proper 50 years ago doesn't always add up to what is right and proper today," said the subcommittee's ranking member, Rep. Vern Buchanan, R-Fla.

Before Congress created S corporations, entrepreneurs had two basic choices. They could go into business by forming a regular C corporation, or they could form a partnership or sole proprietorship. A C corporation provided liability protection, but required paying taxes twice, at the corporate and individual level. Under a partnership or sole proprietorship, business owners paid taxes only once at the individual level, but they had to sacrifice the liability protection of a corporation.

In 1958, Congress, at the Eisenhower administration's urging, created subchapter S of the tax code. Small businesses that incorporated under the new provision could, for the first time, be taxed a single time, like a partnership, yet still enjoy liability protection like a corporation. In exchange, however, they gave up a number of corporate benefits. For example, they could only be incorporated domestically, shareholders were limited in number and had to be U.S. citizens. And S corps could only issue one class of stock.

Nonetheless, the change proved hugely popular. The number of S corporation tax returns has increased from less than 500,000 in 1978 to more than 4 million today. Partnerships have seen similar growth, increasing from 1.2 million in 1978 to about 3 million today, while the number of regular C corporations peaked in 1986 at 2.6 million and has declined steadily ever since, according to Rick Klahsen, a managing director of RSM McGladrey, a Minneapolis-based business and tax consulting company.

When S corporations were created in 1958, C corporations paid a quarter of all federal tax receipts. In the last five years, their contribution has ranged between 7 and 15 percent, said Klahsen, who also serves on the advisory board of the S Corporation Association, a trade group based in Washington, D.C., that represents S Corporation owners.

The group has been pushing for reforms since its inception in 1996. Now, with the economy creating a pressing need to help small businesses weather the downturn, this is the best chance in a decade for Congress to act on significant legislation. Here are some of the changes the group is seeking:

Built-In Gains Tax: Businesses converting to an S corporation must hold on to any appreciated assets for 10 years or pay tax on the gain from a sale at the highest corporate rate of 35 percent. The group wants to reduce the time period to seven years.

Excessive Passive Investment Income Rule: An S corporation loses its status and becomes a C corporation if it has excessive passive income for three consecutive years. The group is seeking to repeal this provision.

Nonresident Alien Shareholders: Overseas residents are prohibited from owning stock in S corporations because of the difficulty of collecting income taxes from them. The group wants to allow nonresidents to buy stock to better position companies for global investment. In return, S corporations would withhold and pay taxes on their income.

Preferred Stock: S corporations are currently prohibited from issuing qualified preferred stock. The group seeks to repeal the provision with limitations. This reform increases access to capital from investors who insist on having a preferential return and facilitates family succession.

Convertible Debt: The group wants to permit S corporations to issue debt that may be converted into stock, provided that the terms of the debt are substantially the same as the terms that could have been obtained from an unrelated party. This reform would also change the current law's safe-harbor debt provision to permit nonresident aliens as creditors.

Community banks also have a stake in the issue. Since they were allowed to elect Subchapter S status in tax year 1997, more than 2,500 banks, or about one-third of all banks, have become S Corporations, according to the Independent Community Bankers of America. The group is principally pushing to increase the number of allowable S Corp. shareholders to 150 from 100. The move would allow more small banks to convert, without being forced to disenfranchise shareholders to meet the current limit.

Many of these changes are incorporated in several bills that are pending before Congress. In these difficult economic times, when maintaining cash flow and raising new capital are vital to the survival of so many small businesses, these changes could bring significant relief without a major upheaval in the tax code. "I don't think we're talking about a matter that requires complete overhauling," said Buchanan. "It seems to me that we can achieve greater fairness, safety, and opportunity by simply bringing the existing system into the modern age." Indeed, it's about time.