[Congressional Bills 109th Congress]
[From the U.S. Government Publishing Office]
[H.R. 4421 Introduced in House (IH)]







109th CONGRESS
  1st Session
                                H. R. 4421

To amend the Internal Revenue Code of 1986 to provide for S corporation 
                    reform, and for other purposes.


_______________________________________________________________________


                    IN THE HOUSE OF REPRESENTATIVES

                           November 18, 2005

 Mr. Shaw (for himself and Mr. Ramstad) introduced the following bill; 
         which was referred to the Committee on Ways and Means

_______________________________________________________________________

                                 A BILL


 
To amend the Internal Revenue Code of 1986 to provide for S corporation 
                    reform, and for other purposes.

    Be it enacted by the Senate and House of Representatives of the 
United States of America in Congress assembled,

SECTION 1. SHORT TITLE, REFERENCE.

    (a) Short Title.--This Act may be cited as the ``S Corporation 
Reform Act of 2005''.
    (b) Amendment of 1986 Code.--Except as otherwise expressly 
provided, whenever in this Act an amendment or repeal is expressed in 
terms of an amendment to, or repeal of, a section or other provision, 
the reference shall be considered to be made to a section or other 
provision of the Internal Revenue Code of 1986.

SEC. 2. REDUCED RECOGNITION PERIOD FOR BUILT-IN GAINS.

    (a) In General.--Paragraph (7) of section 1374(d) (relating to 
definitions and special rules) is amended by striking ``10-year'' both 
places it appears and inserting ``7-year''.
    (b) Application to Regulated Investment Companies and Real Estate 
Investment Trusts.--For purposes of paragraph (1) of section 337(d) and 
the regulations thereunder, any reference to the 10-year recognition 
period under section 1374 shall be applied as if the reference were to 
a 7-year recognition period.
    (c) Effective Date.--
            (1) General rule.--The amendment made by this section shall 
        apply to any recognition period in effect on or after the date 
        of the enactment of this Act.
            (2) Special application to existing periods exceeding 7 
        years.--Any recognition period (as defined in section 
        1374(d)(7) of the Internal Revenue Code of 1986) which is in 
        effect on the date of the enactment of this Act and which is in 
        the 8th, 9th, or 10th year after the beginning of such period 
        shall end on the date of the enactment of this Act.

SEC. 3. ISSUANCE OF PREFERRED STOCK PERMITTED.

    (a) In General.--Section 1361 (defining S corporation) is amended 
by adding at the end the following new subsection:
    ``(f) Treatment of Qualified Preferred Stock.--
            ``(1) In general.--For purposes of this subchapter--
                    ``(A) qualified preferred stock shall not be 
                treated as a second class of stock, and
                    ``(B) no person shall be treated as a shareholder 
                of the corporation by reason of holding qualified 
                preferred stock.
            ``(2) Qualified preferred stock defined.--For purposes of 
        this subsection, the term `qualified preferred stock' means 
        stock which meets the requirements of subparagraphs (A), (B), 
        and (C) of section 1504(a)(4). Stock shall not fail to be 
        treated as qualified preferred stock merely because it is 
        convertible into other stock.
            ``(3) Distributions.--A distribution (not in part or full 
        payment in exchange for stock) made by the corporation with 
        respect to qualified preferred stock shall be includible as 
        ordinary income of the holder and deductible to the corporation 
        as an expense in computing taxable income under section 1363(b) 
        in the year such distribution is received.''.
    (b) Conforming Amendments.--
            (1) Paragraph (1) of section 1361(b) is amended by 
        inserting ``, except as provided in subsection (f),'' before 
        ``which does not''.
            (2) Subsection (a) of section 1366 is amended by adding at 
        the end the following new paragraph:
            ``(3) Allocation with respect to qualified preferred 
        stock.--The holders of qualified preferred stock (as defined in 
        section 1361(f)) shall not, with respect to such stock, be 
        allocated any of the items described in paragraph (1).''.
            (3) So much of clause (ii) of section 354(a)(2)(C) as 
        precedes subclause (II) thereof is amended to read as follows:
                            ``(ii) Recapitalization of family-owned 
                        corporations and s corporations.--
                                    ``(I) In general.--Clause (i) shall 
                                not apply in the case of a 
                                recapitalization under section 
                                368(a)(I)(E) of a family-owned 
                                corporation or S corporation.''.
            (4) Subsection (a) of section 1373 is amended by striking 
        ``and'' at the end of paragraph (1), by striking the period at 
        the end of paragraph (2) and inserting ``, and'', and by adding 
        at the end the following new paragraph:
            ``(3) no amount of an expense deductible under this 
        subchapter by reason of section 1361(f)(3) shall be apportioned 
        or allocated to such income.''.
    (c) Effective Date.--The amendments made by this section shall 
apply to taxable years beginning after December 31, 2005.

SEC. 4. SAFE HARBOR EXPANDED TO INCLUDE CONVERTIBLE DEBT.

    (a) In General.--Subparagraph (B) of section 1361(c)(5) (defining 
straight debt) is amended by striking clauses (ii) and (iii) and 
inserting the following new clauses:
                            ``(ii) in any case in which the terms of 
                        such promise include a provision under which 
                        the obligation to pay may be converted 
                        (directly or indirectly) into stock of the 
                        corporation, such terms, taken as a whole, are 
                        substantially the same as the terms which could 
                        have been obtained on the effective date of the 
                        promise from a person which is not a related 
                        person (within the meaning of section 
                        465(b)(3)(C)) to the S corporation or its 
                        shareholders, and
                            ``(iii) the creditor is--
                                    ``(I) an individual,
                                    ``(II) an estate,
                                    ``(III) a trust described in 
                                paragraph (2),
                                    ``(IV) an exempt organization 
                                described in paragraph (6), or
                                    ``(V) a person which is actively 
                                and regularly engaged in the business 
                                of lending money.''.
    (b) Effective Date.--The amendment made by this section shall apply 
to taxable years beginning after December 31, 2005.

SEC. 5. REPEAL OF EXCESSIVE PASSIVE INVESTMENT INCOME AS A TERMINATION 
              EVENT.

    (a) In General.--Section 1362(d) (relating to termination) is 
amended by striking paragraph (3).
    (b) Conforming Amendments.--
            (1) Section 1362(f)(1) is amended by striking ``or (3)''.
            (2) Clause (i) of section 1042(c)(4)(A) is amended by 
        striking ``section 1362(d)(3)(C)'' and inserting ``section 
        1375(b)(3)''.
    (c) Effective Date.--The amendments made by this section shall 
apply to taxable years beginning after December 31, 2005.

SEC. 6. MODIFICATIONS TO PASSIVE INCOME RULES.

    (a) Increased Limit.--
            (1) In general.--Paragraph (2) of section 1375(a) (relating 
        to tax imposed when passive investment income of corporation 
        having accumulated earnings and profits exceeds 25 percent of 
        gross receipts) is amended by striking ``25 percent'' and 
        inserting ``60 percent''.
            (2) Conforming amendments.--
                    (A) Subparagraph (J) of section 26(b)(2) is amended 
                by striking ``25 percent'' and inserting ``60 
                percent''.
                    (B) Clause (i) of section 1375(b)(1)(A) is amended 
                by striking ``25 percent'' and inserting ``60 
                percent''.
                    (C) The table of sections for part III of 
                subchapter S of chapter 1 is amended by striking ``25 
                percent'' in the item relating to section 1375 and 
                inserting ``60 percent''.
    (b) Repeal of Passive Income Capital Gain Category.--
            (1) In general.--Subsection (b) of section 1375 (relating 
        to tax imposed when passive investment income of corporation 
        having accumulated earnings and profits exceeds 60 percent of 
        gross receipts), as amended by subsection (a), is amended by 
        striking paragraphs (3) and (4) and inserting the following new 
        paragraph:
            ``(3) Passive investment income defined.--
                    ``(A) In general.--Except as otherwise provided in 
                this paragraph, the term `passive investment income' 
                means gross receipts derived from royalties, rents, 
                dividends, interest, and annuities.
                    ``(B) Exception for interest on notes from sales of 
                inventory.--The term `passive investment income' shall 
                not include interest on any obligation acquired in the 
                ordinary course of the corporation's trade or business 
                from its sale of property described in section 
                1221(a)(1).
                    ``(C) Treatment of certain lending or finance 
                companies.--If the S corporation meets the requirements 
                of section 542(c)(6) for the taxable year, the term 
                `passive investment income' shall not include gross 
                receipts for the taxable year which are derived 
                directly from the active and regular conduct of a 
                lending or finance business (as defined in section 
                542(d)(1)).
                    ``(D) Treatment of certain dividends.--If an S 
                corporation holds stock in a C corporation meeting the 
                requirements of section 1504(a)(2), the term `passive 
                investment income' shall not include dividends from 
                such C corporation to the extent such dividends are 
                attributable to the earnings and profits of such C 
                corporation derived from the active conduct of a trade 
                or business.
                    ``(E) Coordination with section 1374.--The amount 
                of passive investment income shall be determined by not 
                taking into account any recognized built-in gain or 
                loss of the S corporation for any taxable year in the 
                recognition period. Terms used in the preceding 
                sentence shall have the same respective meaning as when 
                used in section 1374.''.
            (2) Conforming amendments.--Section 1375(d) is amended by 
        striking ``subchapter C'' both places it appears and inserting 
        ``accumulated''.
    (c) Effective Date.--The amendments made by this section shall 
apply to taxable years beginning after December 31, 2005.

SEC. 7. EXPANSION OF S CORPORATION ELIGIBLE SHAREHOLDERS TO INCLUDE 
              IRAS.

    (a) In General.--Clause (vi) of section 1361(c)(2)(A) (relating to 
certain trusts permitted as shareholders) is amended to read as 
follows:
                            ``(vi) A trust which constitutes an 
                        individual retirement account under section 
                        408(a), including one designated as a Roth IRA 
                        under section 408A.''.
    (b) Sale of Stock in IRA Relating to S Corporation Election Exempt 
From Prohibited Transaction Rules.--Paragraph (16) of section 4975(d) 
(relating to exemptions) is amended to read as follows:
            ``(16) a sale of stock held by a trust which constitutes an 
        individual retirement account under section 408(a) to the 
        individual for whose benefit such account is established if
                    ``(A) such sale is pursuant to an election under 
                section 1362(a) by the issuer of such stock,
                    ``(B) such sale is for fair market value at the 
                time of sale (as established by an independent 
                appraiser) and the terms of the sale are otherwise at 
                least as favorable to such trust as the terms that 
                would apply on a sale to an unrelated party,
                    ``(C) such trust does not pay any commissions, 
                costs, or other expenses in connection with the sale, 
                and
                    ``(D) the stock is sold in a single transaction for 
                cash not later than 120 days after the S corporation 
                election is made.''.
    (c) Effective Date.--The amendments made by this section shall take 
effect on the date of the enactment of this Act.

SEC. 8. ADJUSTMENT TO BASIS OF S CORPORATION STOCK FOR CERTAIN 
              CHARITABLE CONTRIBUTIONS.

    (a) In General.--Paragraph (1) of section 1367(a) (relating to 
adjustments to basis of stock of shareholders, etc.) is amended by 
striking ``and'' at the end of subparagraph (B), by striking the period 
at the end of subparagraph (C) and inserting ``, and'', and by adding 
at the end the following new subparagraph:
                    ``(D) the excess of the amount of the shareholder's 
                proportionate share of any charitable contribution made 
                by the S corporation over the shareholder's 
                proportionate share of the adjusted basis of the 
                property contributed.''.
    (b) Effective Date.--The amendments made by this section shall 
apply to taxable years beginning after December 31, 2005.

SEC. 9. NONRESIDENT ALIENS ALLOWED TO BE SHAREHOLDERS.

    (a) Nonresident Aliens Allowed to Be Shareholders.--
            (1) In general.--Paragraph (1) of section 1361(b) (defining 
        small business corporation) is amended--
                    (A) by adding ``and'' at the end of subparagraph 
                (B),
                    (B) by striking subparagraph (C), and
                    (C) by redesignating subparagraph (D) as 
                subparagraph (C).
            (2) Conforming amendments.--
                    (A) Paragraph (4) and (5)(A) of section 1361(c) 
                (relating to special rules for applying subsection (b)) 
                are each amended by striking ``subsection (b)(1)(D)'' 
                and inserting ``subsection (b)(1)(C)''.
                    (B) Clause (i) of section 280G(b)(5)(A) (relating 
                to general rule for exemption for small business 
                corporations, etc.) is amended by striking ``but 
                without regard to paragraph (1)(C) thereof''.
    (b) Nonresident Alien Shareholder Treated as Engaged in Trade or 
Business Within United States.--
            (1) In general.--Section 875 is amended--
                    (A) by striking ``and'' at the end of paragraph 
                (1),
                    (B) by striking the period at the end of paragraph 
                (2) and inserting ``, and'', and
                    (C) by adding at the end the following new 
                paragraph:
            ``(3) a nonresident alien individual shall be considered as 
        being engaged in a trade or business within the United States 
        if the S corporation of which such individual is a shareholder 
        is so engaged.''.
            (2) Pro rata share of s corporation income.--The last 
        sentence of section 1441(b) (relating to income items) is 
        amended to read as follows: ``In the case of a nonresident 
        alien individual who is a member of a domestic partnership or a 
        shareholder of an S corporation, the items of income referred 
        to in subsection (a) shall be treated as referring to items 
        specified in this subsection included in his distributive share 
        of the income of such partnership or in his pro rata share of 
        the income of such S corporation.''.
            (3) Application of withholding tax on nonresident alien 
        shareholders.--Section 1446 (relating to withholding tax on 
        foreign partners' share of effectively connected income) is 
        amended by redesignating subsection (f) as subsection (g) and 
        by inserting after subsection (e) the following new subsection:
    ``(f) S Corporation Treated as Partnership, Etc.--For purposes of 
this section--
            ``(1) an S corporation shall be treated as a partnership,
            ``(2) the shareholders of such corporation shall be treated 
        as partners of such partnership,
            ``(3) any reference to section 704 shall be treated as a 
        reference to section 1366, and
            ``(4) no withholding tax under subsection (a) shall be 
        required in the case of any income realized by such corporation 
        and allocable to a shareholder which is an electing small 
        business trust (as defined in section 1361(e)).''.
            (4) Conforming amendments.--
                    (A) The heading of section 875 is amended to read 
                as follows:

``SEC. 875. PARTNERSHIPS; BENEFICIARIES OF ESTATES AND TRUSTS; S 
              CORPORATIONS.''.

                    (B) The heading of section 1446 is amended to read 
                as follows:

``SEC. 1446. WITHHOLDING TAX ON FOREIGN PARTNERS' AND S CORPORATION 
              SHAREHOLDERS' SHARE OF EFFECTIVELY CONNECTED INCOME.''.

            (5) Clerical amendments.--
                    (A) The item relating to section 875 in the table 
                of sections for subpart A of part II of subchapter N of 
                chapter 1 is amended to read as follows:

``Sec. 875. Partnerships; beneficiaries of estates and trusts; S 
                            corporations.''.
                    (B) The item relating to section 1446 in the table 
                of sections for subchapter A of chapter 3 is amended to 
                read as follows:

``Sec. 1446. Withholding tax on foreign partners' and S corporation 
                            shareholders' share of effectively 
                            connected income.''.
                    (C) Permanent establishment of partners and s 
                corporation shareholders.--Section 894 (relating to 
                income affected by treaty) is amended by redesignating 
                subsection (c) as subsection (d) and by inserting after 
                subsection (b) the following new subsection:
    ``(c) Permanent Establishment of Partners and S Corporation 
Shareholders.--If a partnership or S corporation has a permanent 
establishment in the United States (within the meaning of a treaty to 
which the United States is a party) at any time during a taxable year 
of such entity, a nonresident alien individual or foreign corporation 
which is a partner in such partnership, or a nonresident alien 
individual who is a shareholder in such S corporation, shall be treated 
as having a permanent establishment in the United States for purposes 
of such treaty.''.
    (c) Application of Other Withholding Tax Rules on Nonresident Alien 
Shareholders.--
            (1) Section 1441.--Section 1441 (relating to withholding of 
        tax on nonresident aliens) is amended by redesignating 
        subsection (g) as subsection (h) and by inserting after 
        subsection (f) the following new subsection:
    ``(g) S Corporation Treated as Partnership, Etc.--For purposes of 
this section--
            ``(1) an S corporation shall be treated as a partnership,
            ``(2) the shareholders of such corporation shall be treated 
        as partners of such partnership, and
            ``(3) no deduction or withholding under subsection (a) 
        shall be required in the case of any item of income realized by 
        such corporation and allocable to a shareholder which is an 
        electing small business trust (as defined in section 
        1361(e)).''.
            (2) Section 1445.--Section 1445(e) (relating to special 
        rules relating to distributions, etc., by corporations, 
        partnerships, trusts, or estates) is amended by redesignating 
        paragraph (6) as paragraph (7) and by inserting after paragraph 
        (5) the following new paragraph:
            ``(6) S corporation treated as partnership, etc.--For 
        purposes of this section--
                    ``(A) an S corporation shall be treated as a 
                partnership, and
                    ``(B) the shareholders of such corporation shall be 
                treated as partners of such partnership, and
                    ``(C) no deduction or withholding under subsection 
                (a) shall be required in the case of any gain realized 
                by such corporation and allocable to a shareholder 
                which is an electing small business trust (as defined 
                in section 1361(e)).''.
    (d) Additional Conforming Amendments.--
            (1) Section 1361(c)(2)(A)(i) is amended by striking ``who 
        is a citizen or resident of the United States''.
            (2) Section 1361(d)(3)(B) is amended by striking ``who is a 
        citizen or resident of the United States''.
            (3) Section 1361(e)(2) is amended by inserting ``(including 
        a nonresident alien)'' after ``person'' the first place it 
        appears.
    (e) Effective Date.--The amendments made by this section shall 
apply to taxable years beginning after December 31, 2005.

SEC. 10. INADVERTENT INVALID ELECTIONS OR TERMINATIONS.

    (a) In General.--Subsection (f) of section 1362 (relating to 
inadvertent invalid elections or terminations) is amended to read as 
follows:
    ``(f) Inadvertent Invalid Elections or Terminations.--
            ``(1) In general.--If--
                    ``(A) an election under subsection (a), section 
                1361(b)(3)(B)(ii), or section 1361(c)(1)(A)(ii) by any 
                corporation--
                            ``(i) was not effective for the taxable 
                        year for which made (determined without regard 
                        to subsection (b)(2)) by reason of a failure to 
                        meet the requirements of section 1361(b) or to 
                        obtain shareholder consents, or
                            ``(ii) was terminated under paragraph (2) 
                        or (3) of subsection (d), section 
                        1361(b)(3)(C), or section 1361(c)(1)(D)(iii),
                    ``(B)(i) the Secretary determines that the 
                circumstances resulting in such ineffectiveness or 
                termination were inadvertent, and
                    ``(ii) such circumstances occurred in a taxable 
                year for which a claim for credit or refund under 
                section 6511 has expired as of the date of discovery 
                referred to in subparagraph (C),
                    ``(C) no later than a reasonable period of time 
                after discovery of the circumstances resulting in such 
                ineffectiveness or termination, steps were taken--
                            ``(i) so that the corporation for which the 
                        election was made or the termination occurred 
                        is a small business corporation or a qualified 
                        subchapter S subsidiary, as the case may be, or
                            ``(ii) to acquire the required shareholder 
                        consents, and
                    ``(D) the corporation for which the election was 
                made or the termination occurred, and each person who 
                was a shareholder in such corporation at any time 
                during the period specified pursuant to this 
                subsection, makes all adjustments (necessary and 
                consistent with the treatment of such corporation as an 
                S corporation or a qualified subchapter S subsidiary, 
                as the case may be)--
                                    ``(i) for purposes of subparagraph 
                                (B)(i), as may be required by the 
                                Secretary with respect to such period, 
                                or
                                    ``(ii) for purposes of subparagraph 
                                (B)(ii), as if the corporation was a S 
                                corporation or a qualified subchapter S 
                                subsidiary for each taxable year for 
                                which a claim for credit or refund 
                                pursuant to section 6511 has not 
                                expired at the time of the discovery in 
                                paragraph (3) of this subsection,
                then, notwithstanding the circumstances resulting in 
                such ineffectiveness or termination, paragraph (2) 
                shall apply.
            ``(2) Period for which treated as s corporation.--If this 
        paragraph applies to a corporation by reason of paragraph (1), 
        such corporation shall be treated as an S corporation or a 
        qualified subchapter S subsidiary, as the case may be--
                    ``(A) for purposes of paragraph (1)(B)(i), during 
                the period specified by the Secretary, and
                    ``(B) for purposes of paragraph (1)(B)(ii), for 
                each taxable year for which a claim for credit or 
                return pursuant to section 6511 has not expired at the 
                time of the discovery referred to in paragraph 
                (1)(C).''.
    (b) Effective Date.--The amendments made by this section shall 
apply to taxable years beginning after December 31, 2005.
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