Owners of closely held businesses in the United States have long sought to blend the best of two worlds: the legal protections of a corporation and the tax benefits associated with partnerships. Even before Congress passed the Economic Recovery Tax Act of 1981 (ERTA) last summer, the solution for about 500,000 owner-run firms has been to file under Subchapter S of the Internal Revenue Code. It's not hard to see why. A Sub S corporation is every bit a corporation legally, but from a tax standpoint, it's a different animal in that it seldom pays any federal corporate income tax. Instead, earnings -- or losses -- flow to the individual shareholders and are taxed, or written off, at the individual's rate.

Clearly, this exemption from "double taxation" -- in which a company's earnings are taxed first on the corporate level and once again when individuals receive the dividends -- has always been a strong lure of Sub S. Now, thanks to ERTA, this feature has been made all the more attractive. Indeed, starting this year the maximum individual tax rate has been cut from 70% to 50%, so Sub S shareholders' aftertax distributions are worth more to individuals in high tax brackets.

ERTA also liberalized other areas of the tax code in ways that made Sub S more enticing to owners. Sub S companies are now permitted to have a larger number and new types of shareholders, and may contribute more generously to retirement plans. But before rushing in, remember that the appeal of Sub S is far from universal. "If annual corporate earnings are needed for business expansion -- and this includes start-ups which are now in the black -- you may have outgrown the benefits of Sub S," explains David Wheeler, a manager with Touche Ross & Co. "You should probably consider becoming a regular corporation," because you can retain earnings for expansion without subjecting shareholders to tax on distributions.

While there are always exceptions, the types of businesses most likely to benefit from Sub S are fairly well defined. The principal categories are:

* Start-up companies, including those with heavy research and development expenditures, in which anticipated early losses can be passed on to shareholders as tax deductions.

* Mature companies that are highly profitable, but have little need for earnings accumulation because capital spending requirements are low. This is especially true where shareholders need to receive dividend distributions.

* Noncapital-intensive service companies, such as consulting and other businesses.

Tax specialists generally agree that for businesses falling into these classes at least, the case for electing Sub S is apt to be stronger than ever, providing the business earns at least $100,000. (Below that, corporate tax rates are probably low enough to make "double taxation" far less of a burden.) However, understanding the ways ERTA has improved matters bears closer examination.

LOWER INDIVIDUAL TAX RATES. In the past, with individual tax rates as high as 70%, shareholders of Sub S corporations were required to pay stiff taxes on the firm's earnings whether they were actually distributed or not. For those in the highest bracket, the net income after tax could have been as little as 30 cents for every dollar distributed. While not many businesses with minimal new capital needs avoided Sub S for this reason, the new lower rates, with the individual ceiling at 50%, should be a leading attraction for those considering Sub S.

MORE AND NEW TYPES OF SHAREHOLDERS. Before ERTA, a Sub S corporation was permitted to have up to 15 shareholders. In keeping with what tax experts see as an ongoing interest by Congress to make it easier for Sub S companies to raise capital, ERTA loosened the statutory requirements. While corporate entities and partnerships are still excluded, now it's possible to have 25 shareholders. The increase permits closely held companies with larger capital needs to draw new investors.

Although it's common practice for Sub S companies to have several family members owning shares as a means of spreading the firm's income and reducing the overall tax liability among the individuals, trusts have traditionally been excluded. Under ERTA, the rules on trusts are still strict and complex, but a trust that has only one beneficiary at a time is now permitted to own stock in a Sub S corporation as long as the trust distributes its income currently to that beneficiary. This new provision for "qualified Subchapter S trusts" makes it even easier for owners of closely held businesses to have their children receive business income while they are still taxed in their lower tax brackets.

UPGRADED RETIREMENT BENEFITS. Previously, Sub S corporations were permitted to establish retirement benefits, such as Keogh plans, for employees. But the top yearly contribution per owner-employee was 15% of the first $50,000 of gross salary (or 7 1/2% of $100,000) -- to a maximum of $7,500. Generally, this was much less than regular corporations were allowed to pay their owner-employees. ERTA doubled the annual ceiling amount for a Sub S corporation to $15,000 per owner-employee, with the greatest benefit clearly going to owners working at the company and earning more than $50,000. Indeed, the IRS now permits Sub S companies to use $200,000 -- twice last year's top figure -- as the new maximum gross salary for calculating retirement benefits. Since the IRS requires that employers apply the same contribution percentage to all employees, this permits owner-employees to contribute the yearly limit of $15,000 -- or just 7 1/2% of $200,000 -- to themselves and the highest-paid executives, while applying the same 7 1/2% across the board to lower-paid employees.

A significant but often overlooked advantage for owners to keep in mind is that Sub S companies can choose their own fiscal years like any other corporation. This allows shareholders to delay reporting their share of Sub S income until their own individual tax becomes due. If, for example, a Sub S elects a fiscal year ending January 31, the following scenario could take place: Business income received by the company for the tax year ending January 31, 1982, would not have to be reported by shareholders operating on calendar tax years until April 15, 1983 -- more than 14 months later. "This may allow shareholders to invest money for the whole period until the tax is due," notes Edward D. Maggio, tax manager in Seidman & Seidman's Washington, D.C., office.

Like any good tax strategy, Sub S has some pitfalls. A common difficulty is insufficient cash-flow in the business, particularly at the end of the firm's fiscal year. A problem occurs, for example, if a Sub S company fails to distribute earnings to shareholders within 2 1/2 months after the end of the year in which they were earned, and then decides to terminate its Sub S status.Under the rules, the individual shareholders have a tax liability for the year the income was earned, even though this income was not distributed. In this case, when the Subchapter S status is terminated, these previously taxed earnings become "locked in" the company, and upon their distribution, tax must be paid once again. To guard against this danger, advises Murray Alter, a manager at Deloitte Haskins & Sells in New York, Sub S corporations should "play it safe" and when in doubt distribute their earnings within 2 1/2 months of the corporation's year-end, even if it means borrowing to cover cash-flow needs.

Sub S shareholders should also keep in mind that their losses can be deducted only to the extent of their investment, or basis, which consists of their capital contribution plus actual loans to the business. Unlike regular corporations (where losses can be carried back 3 years and forward for 15 years), shareholder losses in a Sub S company are confined to single tax years. Any loss not used is gone forever.

There is a way out, however. If a shareholder's loss exceeds his or her investment, it's possible to lend additional money to the corporation before the end of the year in order to make legal use of the loss.

When Sub S no longer suits shareholders' needs, one rather drastic tactic is available at any time: Shareholders can revoke the election. According to authorities, it is done most simply by breaking a rule. For instance, adding one too many shareholders or accepting an investment from an unauthorized trust even as late as, say, the end of December would terminate the election for the entire preceding year. Another way to revoke Sub S status is to issue an additional class of stock, thereby creating two levels of shareholders. On some occasions, the IRS has even considered debt to be a second class of stock in a Sub S and on these grounds has acted to terminate Sub S status. Congress is considering changes in the debt/equity rules.

As easy as revocation may be, experts warn you not to take the action lightly: Make sure you have looked carefully at both your own needs and those of the company. Once a Sub S election has been terminated, you won't be able to reinstate it for another five years.