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S CORPORATION PROVISIONS IN MINIMUM WAGE BILL?

January 15, 2007

Last week the top two Senate taxwriters introduced a tax bill that may be attached to the minimum wage increase that the new Congress is expected to pass. The bill extends a few existing tax breaks, including 15-year depreciation for leasehold improvements and restaurant buildings. It extends the increased Section 179 amount an additional year, through 2010, and it makes cash-basis accounting available to businesses with receipts up to $10 million, regardless of whether the business has inventories.

The bill also makes some changes in S corporation rules.

NON-RESIDENT ALIEN OWNERSHIP. The S corporation rules have never permitted non-resident aliens to own S corporation shares, presumably because of the difficulty of collecting tax on income allocated offshore. The bill would permit non-resident aliens to own S corporation stock through "electing small business trusts" (ESBTs). These trusts were created in 1996 to enable more trusts to own S corporation shares.

When an ESBT owns S corporation stock, a tax is imposed on the trust itself at the highest individual rate. This differs from the usual treatment of trusts, where S corporation income is taxed directly to trust beneficiaries. The ability to collect the tax at the trust level is presumably what makes Congress willing to allow non-resident aliens to use them to hold S corporation stock.

CAPITAL GAINS. The bill removes capital gains from the category of "passive investment income" for the arcane and obsolescent tax on such income that can apply to former C corporations. Why they don't repeal this tax altogether is beyond me.

BANK DIRECTOR SHARES. The bill allows the issuance of "qualifying director shares" required by banking law that may be ignored for S corporation purposes. Owners of such shares would not be allocated S corporation income and loss from an S corporation bank.

RESERVE-METHOD BANKS. When a bank makes an S corporation election, it must give up the "reserve" method of accounting. Under the reserve method, banks can take a deduction for estimated bad debts using a formula. S corporation banks can only write off debts as they actually go bad.

The reserve for bad debts normally is taken into income over four years following an S corporation election. This income is typically "built-in gain" to the S corporation, taxed at both the bank level and the shareholder level. The bill allows banks that make S corporation elections to take the reserve into income in their last C corporation year.

QSUB DISPOSAL. If an S corporation owns 100% of a subsidiary, it can elect to treat the subsidiary as a "Qualified subchapter-S subsidiary," or "QSUB." The QSUB is then taxed as a division of the parent S corporation.

If the S corporation were to dispose of 1% of the its QSUB stock, it would be deemed to contribute the QSUBs assets to a new corporation with a 1% minority owner; the transaction would be tax-free as a "Section 351 transaction." The subsidiary would then be taxed as a C corporation.

If, however, the corporation were to dispose of 21% of its stock, it would be taxable as if it sold all of the assets of the QSUB; Section 351 has an 80% "control" requirement to qualify for tax-free treatment.

The bill would recast such a transaction as a sale of 21% the QSUB assets to an unrelated party, followed by a contribution of the assets to the "new" corporation. As a result, only 21% of the asset gain would be taxed, instead of 100%.

Some version of this bill seems likely to pass with the expected minimum wage boost. We will keep you posted.

Link: Joint Committee Explanation of "Small Business and Work Opportunity Act of 2007."

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