DETROIT—Most political attention during the past 12 months has been focused on the recent presidential race. But small business has ample reason to be pleased with a flurry of federal and state governmental activity that, in many cases, helps business owners. Included in federal changes are less-stringent restrictions on ownership and activities of subchapter-S corporations; clarification of business responsibility in making contractor-vs.-employee designations, and increases in deductibility of some benefits like health insurance for the self-employed.
The following article summarizes major federal changes affecting small business. Tire dealers and retreaders will want to analyze rule changes in detail with their accountants or financial advisers.
Here are some selected tax and regulatory changes.
Federal law governing subchapter-S corporations changed in several ways:
1) Only 35 shareholders were allowed for subchapter-S corpora-tions in the past; now the limit is 75.
More shareholders means more flexibility in growing and funding an S corporation, and also allows for the freedom to add some types of trusts and exempt organizations as shareholders.
``I know, just from my own experience, that this will allow a lot more people to elect S corporation status,'' said Lawrence Slutsky, CPA, of Morof Sheplow Weinstein P.L.C. in Farmington Hills, Mich.
2) Exempt organizations and trusts may now be shareholders.
In the past, strict limits governed trusts, and no tax-exempt organizations were allowed. In some cases, the death of a shareholder whose assets were held in trust could invalidate S corporation status.
This new rule means a retirement plan, living trust, nonprofit organization or other sensible revenue-passing structure could become an S corporation shareholder. This gives more leeway in orderly transitions in closely held S corporations.
Each trust or organization counts as one shareholder; qualifying trusts may benefit only individuals or estates eligible to be S corporation shareholders. Interests in the trust can't be purchased.
``Historically, to have a trust that was an S corporation shareholder, you could not `spray' income,'' said Barry Lipson, an attorney with Lipson, Neilson, Jacobs & Cole, P.C., Troy. ``All the income had to be going to one beneficiary.
``Now it can be `sprayed,' so you could actually set up a trust that was passing income to four children, even though it was one shareholder,'' Mr. Lipson explained.
3) S corporations may now hold C and S corporation subsidiaries.
Past regulations isolated S and C corporation ownership. S corporations had a hard time holding subsidiaries, and their ability to hold certain amounts of stock in other companies was limited.
S corporations will now be allowed to own 100 percent of other S corporations as subsidiaries, and can hold 80 percent or more of a C corporation.
An S corporation may be able to string a grouping of S corporations together in cases where it might make tax sense.
``Now you have a better chance of multiple corporation ownership structures that could make a lot of sense for legal reasons, Mr. Slutsky said. ``They've made that much more flexible for you.''
4) The IRS can ``waive'' an invalid S chapter election.
S incorporation holds many desirable advantages, and to prevent it from being abused, the IRS previously came down hard on any indication that a company had invalidly elected subchapter-S status.
Now the IRS, by statute, may waive both invalid and accidental S elections. The IRS also is authorized to accept a late election of S status as though it were timely.
``Now they have the authority to do that, I'll be interested to see if that actually happens,'' Mr. Lipson said.
5) Re-electing S status:
Under old rules, if an S corporation lost its S status, it had to wait five years to elect S status again. Now S termination in a tax year beginning before Jan. 1, 1997, won't be taken into account.
As a result, it's a one-time chance to re-elect S corporation status if, for some reason, your company changed (or was forced to change) to a C corporation in the last five years.
However,``If you terminate after 1996, you'll still have to wait five years.'' Mr. Lipson advised.
Most businesses know the advantages of employing independent contractors.
Previously, if the IRS found that ``contractors'' should have been treated as ``employees,'' a business had little recourse but to pay heavy fines and reclassify a suddenly expensive work force.
Now IRS code section 530 has been codified and its ``safe harbor clause'' modified. Now, in some cases, business owners can treat a worker as an independent contractor for employment tax purposes regardless of the employee's status under the common-law independent contractor test. Income tax still must be paid.
In addition, a business is on safe ground if it employed independent contractors based on technical advice or judicial precedents, on prior audits during which the IRS failed to raise employment tax issues, or on a prior audit where employment tax was raised as an issue but the audit was resolved in the business owner's favor.
``Effective for audits after 1996, the IRS has to give a taxpayer written notice of the audit before it starts, and that there's going to be this classification issue,'' Mr. Slutsky said. ``It basically flip-flops the burden of proof over to the IRS.
``Section 530 is really important. You're going to see an easing up of treatment of small employers.''
The new federal rules create the Savings Incentive Match Plan for Employees (SIMPLE), which features less paperwork and administrative burden than the Salary Reduction Simplified Employer Plan (SARSEP), which was eliminated Dec. 31.
Businesses without a pension plan, and with fewer than 100 employees, are eligible to start a SIMPLE pension plan as either a 401(k) or an independent retirement account.
The administrative ease brings a cost, however: Employers generally are required to match employee elective contributions up to 3 percent of the employee's salary.
A special rule lets the employer elect a lower matching contribution, not less than 1 percent, for any two out of five years.
Employer contributions are deductible, and employees can exclude their contributions from taxable income. Everybody's contribu-tions must be vested immediately.
``(A SIMPLE plan) is basically the same as a SARSEP, except the employer is required to make a contribution,'' Mr. Slutsky said. ``I think that is not as good for small business.''
Deductions for health insurance were limited to 30 percent of the amount paid. New rules will gradually raise the deduction over 10 years, topping out at 80 percent.
For self-employed business people, the increased deductibility of health-insurance premiums will begin making a bigger impact as the year 2006 approaches.
``It will have an effect on the small companies, especially those just starting out,'' said Dennis LaPorte, a partner in Follmer, Rudzewicz & Co. P.C., a CPA firm in Sterling Heights, Mich.
``For S corporations, partnerships and sole practitioners, it will have a bearing because they will be able to deduct a greater percentage of their health-insurance cost on the front page of their 1040,'' Mr. LaPorte said.
The current limit of $17,500 for expensing equipment purchases in the first year, instead of depreciating over the life of the equipment, is set to rise to $18,000 in 1997, to $18,500 in 1998, and, by irregular steps, to $25,000 in 2003.
This is good news for very small businesses, as long as cash flow allows them to offset taxable earnings with expensed equipment. Because equipment like computers becomes obsolete rapidly, this may allow smaller businesses to stay on the technology curve.
``The biggest thing it will be benefiting are the small businesses—those companies that are trying to do some last-minute tax planning, that can go out and buy a new computer or some small equipment. They'll be able to write off a little bit more,'' Mr. LaPorte said.
``Larger companies that buy more than $200,000 in equipment won't get the full benefit of that. Once they get over $200,000, that write-off is reduced, dollar for dollar.''
Job flexibility was limited for some people who worried that changing jobs could expose them to having their health coverage denied due to real or suspected long-term illness.
New laws create ``portability'' of health insurance by limiting the ability of health plans to deny coverage. In response, some states are contemplating law changes that could give insurers more opportunity to exclude bad risks.
Small businesses will face fewer barriers to hiring because potential employees won't face health insurance loss; health insurance may become more expensive as the risk pool can't eliminate the most costly users. Business owners will want to be aware of state legislation.
As Barry Cargill, the Small Business Association of Michigan's vice president for government relations, pointed out: ``We still have authority as a state to establish our own level for pre-existing conditions.''
Under federal law, a test group of self-employed individuals and those covered by only the most basic catastrophic insurance are allowed to open Medical Savings Accounts (MSA).
Like a cafeteria benefit plan, contributions are made pretax; unlike a cafeteria plan, unused contributions can accumulate year-to-year.
The test group is limited to 750,000 individuals each year; after the year 2000, only those with already-established accounts can continue contributing. Because the test group is small, it will take some energy and planning for small businesses to open MSAs.
Analysts suggest that most companies with that kind of energy and planning ability already have some form of health insurance coverage, so the broad applicability of MSAs is questionable.
On the other hand, the wisdom of IRA accounts was underappreciated when that vehicle was first suggested. Businesses should remain aware of MSA evolution.
``When I first saw it, I thought it was kind of bizarre the way they did it.'' Mr. Lipson said. ``From what I see right here, it's limited to individuals that are benefiting.''
Historically, if you had a retirement plan with benefits above $775,000, a lump-sum distribution would have been subject to both income taxes and a 15-percent excise tax. New federal laws allow any distribution received from 1997-1999 to avoid the excise, but not the income, tax.
A number of small businesses may be able to benefit key employees by reviewing the distribution from retirement plans and taking advantage of this window of opportunity.
``Where key employees have account balances in excess of the limits, this gives them a chance to broom this out.'' Mr. Lipson said.
A landlord who made extensive improvements to a property for a lessee used to have to recover the investment over the term of the lease.
The new law allows the lessor to recover the adjusted basis of an improvement at the end of a lease term, and should make it easier for lessors to invest in improvements to attract or retain tenants, with less worry about recovering their investment.