This article by Stuart L. Adams, Jr. appeared in the 

The Advisor

Entrepreneurs Get New Tools

(Spring 1997)

Entrepreneurs who have followed the course of regularly promised legislation and the promised streamlining of administrative red tape for business have gotten used to hearing the promises but not seeing real results. Finally, the dawn of the new year has brought many significant positive changes for small and start-up businesses. 1997 marks a new era of flexibility and certainty in several areas.

There are quite a few changes which have improved things for entrepreneurs. This article will focus on the following recent changes:

L "S" Corporations Become More Attractive

L Limited Liability Companies Become Safer

L Simplified Independent Contractor Rules

S Corporation Changes

An "S" corporation is a corporation which is eligible to elect "S" status by filing an election form with the IRS. The one page form indicates all the shareholders desire the corporation to be treated as an S corporation. In general, an S corporation does not pay any income taxes. The income and expenses are passed on to the shareholders in the same proportion as their ownership of its stock. This is one way of avoiding what could otherwise be the double taxation of income in the "C" corporation.

The S corporation device was created to help smaller businesses. For tax years starting with 1997, the maximum number of shareholders who may own stock in an S corporation was increased from 35 to 75, with a husband and wife and their estates being counted as a single shareholder.

Not everyone qualifies as an S corporation shareholder. No shareholder may be a nonresident alien. All shareholders must be individuals, estates, certain qualifying trusts, and starting this year, may include certain tax-exempt organizations.

A major drawback to electing S status was the inadvertent termination problem. Previously, if a corporation’s S election was invalid when made or if some disqualifying event occurred, the termination was fatal to S status. Under new rules, the IRS has become more flexible on this issue and the IRS may waive the termination or a corporation may now be able to make a timely correction.

Previously, S corporations could not be part of an affiliated group. Now, an S corporation may own another corporation, whether C or S. The S and C corporations cannot file consolidated returns, but the change now allows a company to set up subsidiaries in other states or to separate the business into independent entities which might, for instance separately own real estate and a license for a business located on the real estate. This eliminates another major prior drawback of the S corporation.

There are several other changes in the treatment of S corporations which now make them substantially more useful to the entrepreneur, and these should be reviewed with your tax and business counselors.

Limited Liability Company Changes

The limited liability company is a relatively new type of business entity in this country. If it is properly structured and organized, following a combination of federal tax laws related to partnerships and state laws, which authorize creation and recognition of the new entity on a local basis, a very useful and flexible entity could be created. The limited liability company (LLC) was designed to include the favorable treatment of a partnership for Federal income taxation purposes but the limited liability of corporate shareholders.

Many entrepreneurs, attorneys and accountants have been reluctant to pursue new business ventures in the LLC form, despite its many advantages in some situations over other business entity forms. This was primarily related to both the uncertainty of how the IRS or local tax agencies might treat its owners, as well as the risk of improperly structuring the entity or inadvertent action which would later disqualify it. Like the S corporation situation, an improperly organized LLC, or later change in its membership or structure could wreak havoc on its owners. Business planners even feared a reversal of benefit with LLCs being taxed as corporations while suffering the individual liability of partnerships.

Much of the early uncertainty has dissipated as courts start to deal with the new business entity and state legislatures improve local enabling legislation. Now the IRS has finalized new LLC regulations, which went into effect January 1, 1997. Under the new regulations a small business which is not a corporation can simply put a check mark in the appropriate box on the IRS form to choose whether it elects to be treated as a corporation or partnership.

This change does away with somewhat complicated rules. Not only will this simplify the organization of new LLCs, but it will also allow LLCs organized under the old rules to eliminate some of the artificial technical provisions attorneys previously had to insert in the organizational documents to avoid the IRS determining the entity was actually a corporation, rather than an LLC.

Under the old rules there was a four factor test that had to be met to prove an LLC was not a corporation. Under the new rules, any unincorporated business can automatically be treated as a partnership. Even one person LLCs can now be treated as partnerships, if allowed by state law. Most states required there to be at least two "members" for an LLC to exist. This caused a number of fictions to be created to qualify the entity, based upon a presumption there must be two partners to have a partnership. Most states will probably now start to change their LLC laws to allow one person LLC, thus opening this business entity to a wide range of entrepreneurial endeavors.

This device still deserves research for the particular venture or entrepreneur. State laws differ and both tax and business counsel should still be involved in the decision to start, convert or merge into the LLC form. Because most of the drawbacks and restrictions of the S corporation are now gone from the LLC entity, its use is expected to increase for small and start-up businesses, despite the new liberalization of S corporation rules.

Independent Contractor Rules

For years the IRS has used a "20 point test" to determine if a worker should be classified as an employee or an independent contractor. The IRS was presumably inclined to classify workers as employees, since it could then require up front payment of taxes. Businesses, however, realized there was increased cost and paperwork for employees, involving FICA, FUTA, medical and pension issues.

Instead of the questionable usefulness of the 20 point test, the IRS is now looking to see if three conditions have been met. If a worker makes more than $600 during the year he must receive a 1099 form. The First factor is now whether all Federal tax returns required to be filed have been filed consistently treating the worker as an independent contractor. Second, the business must have consistently treated all workers doing the same job as an independent contractor. Businesses must be consistent in treatment of workers. Third, the business must have some reasonable basis for not treating the worker as an employee. This could be based upon factors such as judicial precedent, a prior IRS ruling, or industry standard.

Since misclassification of a worker can be costly, but never ending cost and paperwork related to employees will tend to encourage many businesses to cut close to the line, even these less than fool proof changes should assist entrepreneurs in judging more accurately where that line is.

Numerous Other Changes

There were numerous other positive changes in laws effecting business that took effect in 1997. Room permits only a few to be mentioned here, but we suggest you review these changes with your business and tax advisors.