When the Economic Recovery Tax of 1981, Congress increased the applicability of Subchapter S, the tax and legal provision that lets closely held companies combine the best features of partnership and incorporation (see INC., June 1982, page 104). Important as these changes were, further recent steps by Congress make Sub S even more attractive for many small companies.

The Internal Revenue Code's Sub S provisions are designed for small, closely held businesses looking to incorporate for legal reasons while remaining partnerships for tax purposes. As before, businesses most apt to find Sub S beneficial in light of the latest changes are start-up companies with anticipated early losses (which can be passed on to shareholders as tax deductions) and highly profitable companies with low capital spending needs and high dividend distributions.

Because the new rules widen eligibility requirements, eliminate some major tax traps, and substantially upgrade the permitted level of pension plan contributions, itis easier for businesses to be qualified for Sub S. Previously, for instance, businesses earning substantial income from passive investments couldn't elect Sub S. While there are still restrictions, the new law clears the way for what amount to Sub S investment firms -- companies not engaged in active trade or business at all.

But non-capital intensive service concerns that chose Sub S status for certain fringe-benefit advantages will have less reason to go this route. Fringe benefits for Sub S shareholders of more than 2% of the company's stock will now be limited to the lower levels allowed for partnerships.

Eligibility. Under ERTA, the maximum number of shareholders permitted for Sub S companies was raised to 25 from 15. Significantly, the new law increases the maximum number of shareholders in a Sub S corporation to 35 from 25, greatly increasing the ability of Sub S companies to attract capital from new investors. The new law also eliminates a rule that ended a corporation's Sub S status if more than 80% of its gross receipts came from outside the United States.

But one of the most important eligibility rules makes Sub S available for companies whose passive-investment income from such sources as stocks, bonds, and rental property exceeds 20% of gross receipts for any taxable year. Under the old rules, Sub S status ended if passive earnings exceeded 20% of gross revenues.

Congress didn't eliminate all restrictions for passive income. They have generally been eliminated except for those electing corporations that have earnings accumulated from pre-Sub S taxable periods. For those electing corporations with pre -- Sub S accumulated earnings, the rules have been substantially liberalized. But passive earnings in excess of 25% of gross receipts will be subject to normal federal corporate taxes at a 46% rate. A company's Sub S election will terminate only if the company's passive income exceeds 25% three years in a row.

There are important exceptions, however. Unlike a company that has accumulated earnings when it elects Sub S, a newly formed corporation can operate under Sub S from the start and be exempt from the passive-income limitation.

Simplification. Generally, the new law allows Sub S corporations to treat certain matters relating to income, deductions, and credits much as partners in partnerships do and not as shareholders in corporations do. For example, before, business losses in excess of shareholder basis (the total invested in stock and loans) couldn't be used as deductions past the fiscal year-end. For tax purposes, the losses were gone forever.

The new law allows losses to be carried forward by Sub S corporation shareholders indefinitely if the amount of the loss passed through to shareholders during the year tops the shareholders' basis. The loss carried forward can be deducted by individual holders as long as they provide new equity or loans to the corporation.

Elimination of traps. Under the old law, Sub S status could be revoked if a company broke one of several technical rules, even inadvertently. Having one too many shareholders, for instance, could invalidate a company's Sub S status. But now the lnternal Revenue Service can waive the automatic termination.

For example, an ineligible shareholder, such as a financial institution in a foreclosure, assumes the assets of a previous Sub S shareholder. Under the old law, such an event would have terminated the corporation's Sub S status, although very possibly shareholders would have been unaware of a violation. Even if the violation were quickly corrected, that might not have been sufficient: The old law didn't recognize any change in status unless shareholders took the necessary steps to restore the Sub S status.

In the past, the IRS came after Sub S companies for back taxes as regular corporations for the years when they were in technical violation of Sub S rules. But the statutory permission from Congress to waive inadvertent termination eliminates many of the unexpected and costly consequences to Sub S corporations.

Pensions. As to pension plans, the new rules permit Sub S shareholders to contribute the same $30,000 maximum permitted for regular corporate plans. Previously, Sub S holders were restricted to contributions of $15,000 for self-employedh persons, and for some this was a deterrent to electing Sub S. But when Congress passed the Tax Equity and Fiscal Responsibility Act of 1982, it created a parity between the pension plans of corporations and those of self-employed persons and Sub S shareholders.

Ultimately, all the new rules regarding Sub S may have limited impact on companies seeking to retain earnings for growth But for closely held businesses with earlyyear losses, or those that are profitable and distribute their earnings as dividends, it is time for a new look at Sub S.