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Little wonder that the S corporation remains the most popular form of operating a small business under our tax rules -- despite the recent closing of an S corporation "loophole" by the recently enacted Job Creation and Worker Assistance Act of 2002. That law contained a provision reversing an earlier decision by the U.S. Supreme Court dealing with the discharge of indebtedness of an S corporation.

STIMULATING S CORPORATIONS
The S corporation is often far more attractive to the owner of a sign business then a standard (or 'C') corporation. That's because an S corporation offers a number of appealing tax benefits while still providing the owner or owners with the liability protection of a corporation. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. As a result, there's just one level of federal tax to pay.

An S corporation is a creature of the federal tax laws. For all other purposes, it is treated as a regular corporation. This means that 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 that a partnership passes through such items to partners.

While, in the past, S corporations were limited to 35 shareholders, today the limit is 75 shareholders. Expanding the shareholder number makes it possible to have more investors and attract more capital, at least according to some experts.

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 major difference between a standard or 'C' corporation and an S corporation is that S corporations only issue common stock. Experts claim that this can hamper the sign business's ability to raise capital.

In addition, unlike a standard corporation, an S corporation's stock can only be owned by individuals, estates and certain types of trusts. Tax-exempt organizations such as qualified pension plans were added to the list of those permitted to own S corporation stock in 1996. This change has helped provide S corporations with greater access to capital because a number of pension plans are willing to invest in closely-held small business stock.

AT RISK
Under our tax regulations for S corporations, the so-called "at risk" rule does not allow losses that exceed the amounts that an investor has "at risk." Generally, at risk is the amount of investment that an investor could lose.

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

JOB CREATION BILL
As a result of the Job Creation Act, S corporations have been placed on a par with partnerships. In a partnership, a partner's basis is increased by the partner's share of discharge of indebtedness income; then simultaneously, the partner's basis is decreased by the same amount.

Suppose, for example, that the sole shareholder of a sign business operating as an S corporation has a zero basis in the stock of that sign business. The S corporation borrows $100 from a third party and loses the entire $100. Because the shareholder has no basis in his or her stock, the $100 is "suspended" at the corporate level.

If that $100 debt is forgiven when the corporation is in bankruptcy or is insolvent, the $100 income from the discharge of indebtedness is excluded from income. Thus, that $100 "suspended" loss should be eliminated in order to achieve a tax result that is consistent with the economics of the transaction in that the shareholder has no economic gain or loss from the transaction.

Thanks to the Job Creation Act, a shareholder's basis in S corporation stock does not increase and the corporation's suspended loss does not pass through to the shareholder. The tax consequences now reflect the economics of the situation and an S corporation shareholder will no longer be allowed to deduct a loss that he or she did not economically incur.

IN AND OUT
The election of S corporation status must be made by a qualified corporation, with the unanimous consent of the shareholders, on or before the 15th day of the 3rd month of its tax year in order for the election to be effective beginning with the year when made.

The election is made on Form 2553, "Election by a Small Business Corporation," and filed with the IRS Service Center where the corporation files its Form 1120S. Of course, the corporation must meet all of the eligibility requirements for the pre-election portion of the tax year and all persons who were shareholders during the pre-election period must also consent to the election. If these requirements are not met during the pre-election period, the election becomes effective the following year.

S corporation status is automatically terminated if any event occurs that would prohibit the corporation from making the election in the first place. The election is terminated as of the date on which the disqualifying event occurs. What's more, the termination can be planned by the shareholder, demanded by the IRS or inadvertent. It can also be retroactive to the date on which the disqualifying event occurs, despite when and by whom it is discovered.

Fortunately, if a corporation's S election is inadvertently terminated or inadvertently invoked, when made and the corporation makes a timely correction, the IRS can waive the termination or can permit the election. In such a case, the corporation must correct any condition that barred the corporation from qualifying as a small business corporation and must obtain the required shareholder consents. All shareholders must agree to make such adjustments as may be required by the IRS.

If an election is terminated or revoked, the corporation may not re-elect S corporation status without IRS consent until the 5th year after the year in which the termination or revocation became effective.

BUILT-IN GAINS
The tax on built-in gains is a corporate-level tax on S corporations that dispose of assets that appreciated in value during years when the corporation was a 'C' corporation. An S corporation may be liable for tax on its built-in gains if it was a C corporation prior to making its S corporation election and the S corporation election was made after 1986. The recapture period is the ten-year period beginning on the first day on which the corporation is an S corporation or acquires C corporation assets in a carryover basis transaction.

The tax is computed by applying the higher corporate income tax rate to the S corporation's net recognized built-in gains for the tax year. The amount of the net recognized built-in gain is taxable income to the sign operation, not the shareholder, the sign professional. The amount of recognized built-in gain passed through and taxed to shareholders is reduced by the tax imposed on the built-in gain and paid by the S corporation.

FRINGE BENEFITS AND S CORPORATIONS
Under our tax rules, only those fringe benefits received by employee-shareholders owning two percent or less of the S corporation stock are actually deductible by the sign operation as a business expense. Employee-shareholders owning more than two percent of the S corporation's stock are treated in the same manner as partners in a partnership.

Today, an employee-shareholder who owns more than two percent of the S corporation's stock and who is thus treated as a partner is entitled to deduct an amount equal to 70 percent of the amount paid for medical insurance for himself, his spouse and dependents. A 100-percent deduction is available in 2003 and thereafter. This amount is taken as an individual deduction on the owner/shareholder's personal income tax return -- along with the income and losses of the sign business operating as an S corporation.