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 subchapter 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.)
If LLCs are so attractive, why aren't S corporation owners switching to this form of incorporation? Mainly because the move would trigger a substantial tax bill. "A lot of S corporation owners have been in business a long time and have accumulated a tremendous amount of appreciable assets in their corporation," Anderson explains. To switch, these owners would have to pay taxes on the assets.
In fact, S corporations are more appealing than they were in the past for companies already organized in this form. "Finally," says Anderson, "Congress loosened the regulations on subchapter S corporations and made them more viable for owners."
Know Your Rights
Individual taxpayers and business owners gained significant new benefits under the recently enacted law known as the Taxpayer Bill of Rights II. The law is expected to be especially helpful in audit or collection proceedings.
It expands provisions contained in the original taxpayer rights law passed in 1988. Under that law, it was possible to sue the IRS to recover legal expenses when you won a tax case against the service. But the burden was on the taxpayer to prove that the IRS position in the case was "substantially unjustified."
Now the IRS has to show that its position in a losing case had real merit, or the taxpayer can recover legal expenses. This is exceptionally good news for small-business owners and individual taxpayers, says Anderson, "because the IRS has to substantiate why they are after collections and why the money is due. It can't just say you owe and not say why."
In addition, the damage awards to taxpayers have been raised considerably. The maximum penalty the IRS faces in court if one of its employees recklessly or intentionally disregards the law or IRS regulations when dealing with a taxpayer is a whopping $1 million, a significant increase from the prior $100,000 limit.
The law also establishes a new Office of Taxpayer Advocate. Previously, this office with similar duties was subservient to IRS management. Now, the taxpayer advocate will be appointed by, and report directly to, the IRS commissioner, bypassing the middle management layers.
Tax collections also become more rational and less burdensome. If you've worked out an agreement with the IRS to pay the taxes you owe in installments, the new law gives you a little more leeway. If for some reason you miss a payment, the service must send you a 30-day notice of its intent to terminate the agreement before it calls off the pay-back plan. This gives you additional time to send in what you owe.
The new law also authorizes the IRS to return seized property, such as a business or other income-producing property, to a taxpayer when this would make it easier to collect the taxes that person owes. The amount exempt from IRS seizure also has been raised from $1,650 to $2,500 in personal property, and from $1,100 to $1,250 for books and tools of a trade. These amounts will be indexed for inflation starting this year.
On the independent contractor front, the new law codifies a recent IRS administrative practice of providing amnesty for businesses that may have erroneously classified workers as independent contractors. Says Anderson: "You can come forward and say `Starting now we will treat workers that we previously classified as independent contractors as full-time employees,' " and the IRS won't penalize you for the way these workers were classified in the past.
Most important, both tax laws represent a step forward for small-business owners, who can now enjoy a more level playing field.
Joan Szabo is a writer in McLean, Virginia, who has reported on tax issues for more than 11 years.
Gelfond Hochstadt Pangburn & Co., 1600 Broadway, #2500, Denver, CO 80202, (303) 831-5000;
M.R. Weiser & Co. LLP, 135 W. 50th St., 12th Fl., New York, NY 10020, (212) 641-6715.