2007 S-corporation reform
By Mark E. Battersby

Corporations offer liability protection. Partnerships give pass-through tax benefits. Imagine having the benefits of each of these rolled into one entity for your chiropractic practice.

You can have both. A unique type of business entity, the S-corporation, offers its principals or shareholders the limited liability of a corporation while allowing income and deductions to pass through to the tax returns of those principals or shareholders. Even better, lawmakers “reformed” the S-corporation tax rules to make these unique entities even more attractive.

According to the Internal Revenue Service, more than 1.7 million small businesses operate as S-corporations. The recently passed Small Business and Work Opportunity Tax Act of 2007 included a package of S-corporation reforms. The changes affect the treatment of passive investment income, partial sales of qualified subchapter S-subsidiaries (QSubs), and interest deductions by electing small business trusts (ESBT), as well as a reduction in earnings and profits (E&P).

STIMULATING S-CORPORATIONS

An S-corporation is a creature of federal tax laws. For all other purposes, it is treated as a regular corporation. This means in order to form an S-corporation, you first must incorporate under state law.

Then, you must file a special form electing to be taxed under a special provision of the tax law that preserves the corporation’s limited liability under state law, but avoids taxation at the corporate level. As a result, the annual income or losses of the S-corporation are passed through to shareholders in much the same way a partnership passes through such items to partners.

In addition, an S-corporation that is not required to maintain inventory (such as a chiropractic practice) can use the cash method of accounting, which is far simpler to use than the accrual method. Under this method, income is taxable when received and expenses are deductible when paid.

On the downside, S-corporations are subject to many of the same requirements as corporations and that means higher legal, tax, and accounting expenses. They must also file articles of incorporation, hold directors and shareholder meetings, keep complete records, and allow shareholders to vote on major corporate decisions.

Another difference between a standard C-corporation and an S-corporation is that S-corporations can only issue common stock. Experts claim this can hamper the chiropractic practice’s ability to raise capital.

Unfortunately, S-corporation status is automatically terminated if any event occurs that would have prohibited the incorporated chiropractic practice or business from making the S-corporation election in the first place. Termination of S-corporation status can be planned by the shareholder; it can be demanded by the IRS; or all of it can happen inadvertently.

Termination of the S-corporation election is effective on the date the disqualifying event occurs. It can also be retroactive to the date on which the disqualifying event occurred, regardless of when and by whom the terminating event was discovered.

PASSIVE INCOME

The passive investment income test has long been a trap for S-corporations that convert from operating as a regular C-corporation. Passive investment income generally means receipts of royalties, rent, dividends, interest, annuities, and sales or exchanges of stock or securities (at least to the extent of gains).

Until now, an S-corporation was subject to tax at the corporate level, at the highest corporate tax rate, on its excess net passive income, if it had accumulated earnings and profits at the close of the tax year, and more than 25 percent of its gross receipts were passive-investment income.

An S-corporation election is terminated whenever the S-corporation has accumulated earnings and profits at the close of each of three consecutive taxable years and its gross receipts for each of those years were more than 25 percent passive-investment income.

PARTIAL SALES OF QSUBS

Many chiropractors operating as S-corporations employ a QSub for joint ventures, special projects, and even expansion. A QSub is disregarded as a separate entity for federal tax purposes and its items of income, deduction, loss, and credits are normally treated as items of the S-corporation — that is, they are passed on to the shareholders’ tax returns.

Once the QSub is no longer wholly-owned by the S-corporation, however, it ceases to be a QSub and is treated as a new corporation that acquired all its assets from the parent S-corporation in exchange for stock.

Suppose, for example, an S-corporation sells 21 percent of the stock of a QSub to an unrelated party. The deemed transfer of all assets to the QSub is treated as a taxable sale because the S-corporation was not in control of the QSub immediately after the transfer because of the sale and, thus, the transfer did not qualify for nonrecognition treatment.

Thanks to the S-corporation reforms, when the sale of stock of a QSub results in the termination of the QSub election, the sale is treated as a sale of an undivided interest in the assets of the QSub (based on the percentages of the stock sold), followed by a deemed transfer to the QSub.

Based on our earlier example, the S-corporation will be treated as selling a 21 percent interest in all the assets of the QSub to the unrelated party, followed by a transfer of all tax assets to a new corporation in a transaction to which Section 351, Transfer to a Controlled Firm, rules apply. Thus, the S-corporation will recognize — and pay tax on any gain on — only 21 percent of the gain or loss in the assets of the QSub.

ESBTs

So-called Electing Small Business Trusts, or ESBTs, were created to permit interests in family-owned corporations to be transferred to a trust in which the trustee has the discretion to accumulate income, rather than distribute it as a Qualified Subchapter S Trust (QSST) is required to do.

The S-corporation stock held by an ESBT is treated as held in a separate trust while your practice retains its status as an S-corporation. The QSST’s income from the S-corporation stock is taxed at the highest individual tax rate (35 percent for 2007).

The new law allows an ESBT to deduct interest paid on money borrowed to acquire S-corporation stock. Consequently, leveraging S-corporation ownership in an ESBT just became less expensive, given its newly-allowed deductibility against income otherwise taxed at the 35 percent rate.

EARNINGS AND PROFITS

Any corporation that did not choose to be treated as an S-corporation before Dec. 31, 1996, is required to consider the accumulated earnings and profits (E&P) from those earlier years.

The new law allows an S-corpor-ation to reduce its accumulated E&P by its pre-1983 accumulated E&P from years when it was an S-corporation. This benefit involving pre-1983 E&P had previously been available only to a corporation that was an S-corporation for its first taxable year after 1996. The provision takes effect for tax years beginning after May 25, 2007.

AT RISK

Finally, the so-called “at-risk” rule in our tax law does not allow losses that exceed the amounts an investor has “at risk.” Generally at risk is the amount of investment an investor could lose.

The at-risk rules apply to all individuals, including S-corporation shareholders. The at-risk amount is usually determined at the close of the S-corporation’s tax year and normally applied at the shareholder level. Consequently, an S-corporation shareholder who realizes his or her at-risk amount is low and wishes to deduct an anticipated S-corporation net loss can make additional contributions to the practice entity.

FRINGE BENEFITS AND S-CORPORATIONS

Only fringe benefits received by employee-shareholders owning 2 percent or less of the S-corporation stock are deductible by your practice as a business expense. Today, an employee-shareholder who owns more than 2 percent of the stock, and is treated as a partner, is entitled to deduct an amount equal to 100 percent of the amount paid for medical insurance for himself, his spouse, and dependents.

This amount is taken as an individual deduction on the principal/shareholder’s personal income tax return — along with the income and losses of the chiropractic practice operating as an S-corporation.

Mark E. Battersby is a tax and financial advisor, freelance writer, lecturer, and author with offices in suburban Philadelphia. He can be contacted at 610-789-2480.

DISCLAIMER: The author is not engaged in rendering tax, legal, or accounting advice. Please consult your professional advisor about issues related to your practice.