Effect of Federal Small Business Job Protection Act on Pennsylvania S Coporations

The Small Business Job Protection Act of 1996 (P.L. 104-188) liberalized the rules for what corporations can qualify under Subchapter S of the Internal Revenue Code. Among other things, the Act:

Increased the number of permitted shareholders 35 from to 75.
Allows an “electing small business trust” with multiple beneficiaries to qualify as a S corporation shareholder.
Allows charitable organizations and qualified retirement plans (but not individual retirement accounts) to be S corporation shareholders.
Allows corporations with subsidiaries to become S corporations (and provided a special “qualified Subchapter S susbsidiary” election so that wholly owned subsidiaries could be considered part of the S corporation for federal income tax purposes.

The Pennsylvania Department of Revenue initally concluded that the various changes made in the federal tax law (increase in the number of shareholders, ability to own subsidiaries, etc.) would NOT apply for Pennsylvania purposes, so if a Pennsylvania Subchapter S corporation took advantage of the changes under federal law, it would cease to be a Pennsylvania Subchapter S corporation, and Subchapter S elections by corporations not eligible under the old law would not be recognized for Pennsylvania income tax purposes. See Pennsylvania Bulletin, Vol. 26, No. 52, page 6190 (12/28/96).

On May 7, 1997, Gov. Ridge signed HB 134 (Act 7 of 1997), which, among other things, allows Pennsylvania corporations that can qualify as S corporations under the new federal rules (the Small Business Job Protection Act changes) to qualify as S corporations for Pennsylvania income tax purposes.

For corporations previously ineligible to qualify as a Pennsylvania S corporation, this results in a reduction from the 9.9% corporate net income tax rate to the 2.8% personal income tax rate.

This change in law is retroactive to January 1, 1997.