Recent Changes in Subchapter S Laws Thinking about forming a Subchapter S corp? Find out how the changes made last year in the American Jobs Creation Act can affect your decision.

A reader sent in the following question to me recently in regards to Subchapter S corporations:

"For some time now, I have been thinking about forming a limited liability company (LLC) for my small service business. I attended a seminar recently and learned there's a new law, just recently passed, that has made subchapter S corporations a much more attractive option. What's this new law all about, and should I reconsider forming a Subchapter S corporation for my business?"

Late last year, Congress passed the American Jobs Creation Act of 2004, the fifth major tax cut in four years. This law garnered a lot of attention in the press earlier this year because of its most dramatic change: a provision that enables taxpayers to deduct either their state and local sales taxes or their state and local income taxes on their federal tax return, whichever is greater. If you live in a state (such as Alaska, Florida, Nevada, South Dakota, Texas, Washington or Wyoming) that has a state sales tax but no state income tax, that's a big deal.

But this same law made a number of significant (although, in the view of this writer, not terribly awe-inspiring) changes to the complex rules for Subchapter S corporations (essentially, a corporation that elects to be taxed as if it were a pass-through partnership). According to Diane Kennedy, a Phoenix-based CPA and author of Loopholes of the Rich: How the Rich Legally Make More Money and Pay Less Tax, the key changes are:

• The maximum number of shareholders Subchapter S corporations may legally have is now 100 persons (increased from 75).

• All members of a family who own shares in the corporation are treated as one shareholder for the purposes of counting the number of shareholders.

• Members of a family are "a common ancestor, lineal descendants of the common ancestor, and the spouses (or former spouses) of lineal descendants of common ancestors." (Got that?)

• If a shareholder of a Subchapter S corporation gets divorced and the judge awards his or her spouse shares of stock in the Subchapter S corporation, any "suspended" losses attached to the shares can be transferred to the ex-spouse along with the shares themselves.

According to Kennedy, the intent of the new law is to make it easier for larger, family-owned Subchapter S corporations to transfer assets to family members and engage in creative estate planning techniques without losing their Subchapter S status. However, for the vast majority of Subchapter S corporations--those having far fewer than 100 or even 75 shareholders--the new law will have little, or no, impact on their decision whether to form a Subchapter S corporation or an LLC for a new business.

So what should this reader do with his or her small service business? Let's review some basics. With an LLC, you get limited liability, pass-through tax treatment (the LLC is not a taxable entity, so everything passes through to the LLC owners and is taxed at their personal tax rates), and the LLC owners must pay both income and "self-employment taxes" (FICA, FUTA and Medicare) on everything the LLC earns.

The same is basically true of Subchapter S corporations, Kennedy says, but with one significant difference: "If you have a Subchapter S corporation and you put yourself on the payroll as a W-2 employee, withholding taxes from each paycheck as you take money out of the corporation, you can often save a significant amount of money in self-employment taxes."

True enough, but the question I would ask here is this: Is the tax saving worth the time and trouble of setting up a Subchapter S corporation? Like all corporations, Subchapter S corporations involve a lot of legal paperwork--you have to be fairly disciplined about keeping thorough records of business decisions you make (called "resolutions" or "minutes"). Forget to do the paperwork, and a judge or your state government may take your corporation away from you and expose your personal assets to the wolves.

Also, Subchapter S corporations are subject to a fair number of rules designed to make sure only small businesses can take advantage of them. For example, Subchapter S corporations can't issue preferred stock or have shareholders who aren't U.S. citizens or "green card" holders. Break any of these rules, and you lose the tax benefits of having a Subchapter S corporation.

One possible solution, according to Kennedy, is to set up an LLC, and then elect to have the LLC taxed as if it were a Subchapter S corporation. The IRS allows you to do this by filing IRS Forms 8832 (to elect to have your LLC taxed as a corporation) and 2553 (to elect Subchapter S status), and you'll probably also have to alert your state tax authorities so they don't get confused. But be careful: As the ancient mariners used to say on their maps when things got a little imprecise, "Here be demons." When deciding whether to form an LLC or Subchapter S corporation for any small business, talk to your accountant first, and keep your life as simple as possible.

Cliff Ennico is a syndicated columnist, author and host of the PBS television series MoneyHunt. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. Copyright 2005 Clifford R. Ennico. Distributed by Creators Syndicate Inc.