The Entrepreneurial Mind

I wrote about my bias for S-corps over LLCs in a post last month. It seems that I am not the only one who sees its benefits.

There is a move in Congress, called H.R. 4421, the "S Corporation Reform Act of 2005," to clean up a few of flaws in the laws that govern S-Corps that will make S-Corps even more attractive.

One of the traps that is a part of current S-Corp law involves this thing called passive income. I remember in our S-Corps that we spent a lot of money paying our CPAs to made certain that we avoided the so-called "sting tax" that goes along with passive income. Generally, passive income is a pretty good gig. It refers to income that you receive for activities in which you do not "materially participate." That's right, it is and investment in something that makes you money while you are sitting on the beach.

But when these passive investments are part of an S-Corp, the wrath of the IRS will come down on you. Thomas Sullivan from the Office of Advocacy of the SBA summarizes the current implications of passive income in an S-Corp in his testimony before Congress yesterday:

Specifically, if an S-corporation that previously was a C-corporation has undistributed dividends, and earns 25 percent of its gross receipts as passive investment income, then two things will happen. First, the S-corporation is taxed on its income at the highest corporate rate. Second, if the S-corporation earns too much passive investment income for three consecutive years, then the S election is terminated all together. The result is that the S-corporation becomes subject to double taxation. Double taxation is the penalty for earning too much of the wrong type of income (i.e. passive investment income) and/or earning that income too often, thus eliminating the purpose for electing S status.

This passive income rule does not apply to other pass-through entities like partnerships and LLCs. The rationale for why passive income has been treated this way is no longer relevant and the sting tax should be eliminated.

Another change that is part of the S Corporation Reform Act of 2005 would allow for more than one class of stock. S-Corps can only have one class under current law. This can create challenges for family business succession. Again from Sullivan's testimony:

It is common to plan for the next generation of leadership of a family business, by issuing preferred shares to the generation that is leaving the business as a means to provide for their retirement and their orderly withdrawal from the enterprise. However, because S-corporations may not have more than one class of stock, this practice is prohibited. Thus, family owned businesses must incur additional expense to ensure that the retiring generation is provided for.... H.R. 4421 would allow S-corporations to issue qualified preferred stock which will enhance succession planning for many small family-owned businesses.

A third change would allow for non-resident aliens to be owners in a S-Corp, which is currently not allowed under the law. In our emerging global economy, this provision also seems to need changing.

Finally, anyone who has formed an S-Corp knows that there is a limited window of opportunity to make the S-election. The proposed changes under H.R. 4421 would loosen this up a bit to allow for mistakes in filing or invalid elections to get corrected.

Changing the S-Corp law is not the stuff that inspires voters in campaign speeches. But, it is extremely important to help the entrepreneurs who are creating the vast majority of new jobs and generating about half of our national GDP.