[House Hearing, 108 Congress]
[From the U.S. Government Publishing Office]
S CORPORATION REFORMS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON SELECT REVENUE MEASURES
of the
COMMITTEE ON WAYS AND MEANS
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED EIGHTH CONGRESS
FIRST SESSION
__________
JUNE 19, 2003
__________
Serial No. 108-17
__________
Printed for the use of the Committee on Ways and Means
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_________________________________________________________________
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COMMITTEE ON WAYS AND MEANS
BILL THOMAS, California, Chairman
PHILIP M. CRANE, Illinois CHARLES B. RANGEL, New York
E. CLAY SHAW, JR., Florida FORTNEY PETE STARK, California
NANCY L. JOHNSON, Connecticut ROBERT T. MATSUI, California
AMO HOUGHTON, New York SANDER M. LEVIN, Michigan
WALLY HERGER, California BENJAMIN L. CARDIN, Maryland
JIM MCCRERY, Louisiana JIM MCDERMOTT, Washington
DAVE CAMP, Michigan GERALD D. KLECZKA, Wisconsin
JIM RAMSTAD, Minnesota JOHN LEWIS, Georgia
JIM NUSSLE, Iowa RICHARD E. NEAL, Massachusetts
SAM JOHNSON, Texas MICHAEL R. MCNULTY, New York
JENNIFER DUNN, Washington WILLIAM J. JEFFERSON, Louisiana
MAC COLLINS, Georgia JOHN S. TANNER, Tennessee
ROB PORTMAN, Ohio XAVIER BECERRA, California
PHIL ENGLISH, Pennsylvania LLOYD DOGGETT, Texas
J.D. HAYWORTH, Arizona EARL POMEROY, North Dakota
JERRY WELLER, Illinois MAX SANDLIN, Texas
KENNY C. HULSHOF, Missouri STEPHANIE TUBBS JONES, Ohio
SCOTT MCINNIS, Colorado
RON LEWIS, Kentucky
MARK FOLEY, Florida
KEVIN BRADY, Texas
PAUL RYAN, Wisconsin
ERIC CANTOR, Virginia
Allison H. Giles, Chief of Staff
Janice Mays, Minority Chief Counsel
______
SUBCOMMITTEE ON SELECT REVENUE MEASURES
JIM MCCRERY, Louisiana, Chairman
J.D. HAYWORTH, Arizona MICHAEL R. MCNULTY, New York
JERRY WELLER, Illinois WILLIAM J. JEFFERSON, Louisiana
RON LEWIS, Kentucky MAX SANDLIN, Texas
MARK FOLEY, Florida LLOYD DOGGETT, Texas
KEVIN BRADY, Texas STEPHANIE TUBBS JONES, Ohio
PAUL RYAN, Wisconsin
MAC COLLINS, Georgia
Pursuant to clause 2(e)(4) of Rule XI of the Rules of the House, public
hearing records of the Committee on Ways and Means are also published
in electronic form. The printed hearing record remains the official
version. Because electronic submissions are used to prepare both
printed and electronic versions of the hearing record, the process of
converting between various electronic formats may introduce
unintentional errors or omissions. Such occurrences are inherent in the
current publication process and should diminish as the process is
further refined.
C O N T E N T S
__________
Page
Advisories announcing the hearing................................ 2, 4
WITNESSES
U.S. Department of the Treasury, Gregory F. Jenner, Deputy
Assistant Secretary for Tax Policy............................. 15
______
American Institute of Certified Public Accountants, Robert A.
Zarzar; accompanied by Laura M. MacDonough..................... 31
Independent Community Bankers of America, and MidSouth National
Bank, C.R. ``Rusty'' Cloutier.................................. 38
National Cattlemen's Beef Association, and True Ranches, Dave
True........................................................... 46
S Corporation Association, and Liberty Enterprises, Kristen
Copham......................................................... 7
U.S. Chamber of Commerce, and Akin, Gump, Strauss, Hauer, & Feld,
LLP, Hon. David C. Alexander................................... 27
SUBMISSIONS FOR THE RECORD
Credit Union National Association, Inc., statement............... 59
Employee-Owned S Corporations of America, statement.............. 60
ESOP Association, J. Michael Keeling, statement.................. 62
McInnis, Hon. Scott, a Representative in Congress from the State
of Colorado, statement......................................... 62
Section of Taxation of the American Bar Association, statement... 63
Thompson & Knight, LLP, Dallas, TX, Mary A. McNulty, letter...... 87
Washington Council Ernst & Young, statement...................... 89
S CORPORATION REFORMS
----------
THURSDAY, JUNE 19, 2003
U.S. House of Representatives,
Committee on Ways and Means,
Subcommittee on Select Revenue Measures,
Washington, DC.
The Subcommittee met, pursuant to notice, at 12:35 p.m., in
room B-318, Rayburn House Office Building, Hon. Jim McCrery
(Chairman of the Subcommittee) presiding.
[The advisory and the revised advisory announcing the
hearing follow:]
ADVISORY
FROM THE
COMMITTEE
ON WAYS
AND
MEANS
SUBCOMMITTEE ON SELECT REVENUE MEASURES
CONTACT: (202) 225-1721
FOR IMMEDIATE RELEASE
June 19, 2003
SRM-2
McCrery Announces Hearing on
S Corporation Reforms
Congressman Jim McCrery (R-LA), Chairman, Subcommittee on Select
Revenue Measures of the Committee on Ways and Means, today announced
that the Subcommittee will hold a hearing on S Corporation reforms. The
hearing will take place on Thursday, June 19, 2003, in the main
Committee hearing room, 1100 Longworth House Office Building, beginning
at 10:00 a.m.
In view of the limited time available to hear witnesses, oral
testimony at this hearing will be from invited witnesses only. However,
any individual or organization not scheduled for an oral appearance may
submit a written statement for consideration by the Committee and for
inclusion in the printed record of the hearing.
BACKGROUND:
An S corporation is an incorporated business whose shareholders
enjoy limited liability from debts but also elect to be treated as a
pass-through entity, meaning that the business does not pay corporate
level tax. Instead, income, losses, and credits are generally taxed at
the individual shareholder level.
S corporations must comply with several restrictions, violations of
which can result in the loss of S corporation status. Those
restrictions include a limit on the number and type of shareholders, a
restriction to one class of stock, and from being a member of a
consolidated group. These restrictions can trap the unwary with serious
consequences to the business and to its shareholders.
Several bills have been introduced this Congress, which address
many of the problems S corporations and their shareholders face. These
bills include the following: H.R. 714, the ``Small Business and
Financial Institutions Tax Relief Act of 2003,'' introduced by Rep.
Scott McInnis (R-CO); H.R. 1498, the ``Small Business Opportunity and
Growth Act of 2003,'' introduced by Rep. Jim Ramstad (R-MN); and H.R.
1896, the ``Subchapter S Modernization Act of 2003,'' introduced by
Rep. E. Clay Shaw, Jr., (R-FL). This hearing will give the Subcommittee
a better understanding of this Subchapter in the U.S. Tax Code and
possible reforms to it.
In announcing the hearing, Chairman McCrery stated, ``As a
supporter of the President's plan to eliminate the double-taxation of
corporate dividends, I believe it would be preferable if the U.S. Tax
Code subjected corporate earnings to only one level of tax. Pass-
through entities, including Subchapter S corporations, achieve that
objective. However, the rules and restrictions on these entities may
unnecessarily inhibit their growth. This hearing will give the
Subcommittee an opportunity to explore the manner in which we regulate
these businesses and possible approaches to reform, like the ones
introduced by our colleagues on the Committee.''
FOCUS OF THE HEARING:
The focus of the hearing is to discuss proposals to simplify
Subchapter S and to allow S corporations greater flexibility to access
the capital markets.
DETAILS FOR SUBMISSION OF WRITTEN COMMENTS:
Please Note: Due to the change in House mail policy, any person or
organization wishing to submit a written statement for the printed
record of the hearing should send it electronically to
[email protected], along with a fax copy to
(202) 225-2610, by the close of business, Thursday, July 3, 2003. Those
filing written statements that wish to have their statements
distributed to the press and interested public at the hearing should
deliver their 200 copies to the Subcommittee on Select Revenue Measures
in room 1135 Longworth House Office Building, in an open and searchable
package 48 hours before the hearing. The U.S. Capitol Police will
refuse sealed-packaged deliveries to all House Office Buildings.
FORMATTING REQUIREMENTS:
Each statement presented for printing to the Committee by a
witness, any written statement or exhibit submitted for the printed
record or any written comments in response to a request for written
comments must conform to the guidelines listed below. Any statement or
exhibit not in compliance with these guidelines will not be printed,
but will be maintained in the Committee files for review and use by the
Committee.
1. Due to the change in House mail policy, all statements and any
accompanying exhibits for printing must be submitted electronically to
[email protected], along with a fax copy to
(202) 225-2610, in Word Perfect or MS Word format and MUST NOT exceed a
total of 10 pages including attachments. Witnesses are advised that the
Committee will rely on electronic submissions for printing the official
hearing record.
2. Copies of whole documents submitted as exhibit material will not
be accepted for printing. Instead, exhibit material should be
referenced and quoted or paraphrased. All exhibit material not meeting
these specifications will be maintained in the Committee files for
review and use by the Committee.
3. Any statements must include a list of all clients, persons, or
organizations on whose behalf the witness appears. A supplemental sheet
must accompany each statement listing the name, company, address,
telephone and fax numbers of each witness.
Note: All Committee advisories and news releases are available on
the World Wide Web at http://waysandmeans.house.gov.
The Committee seeks to make its facilities accessible to persons
with disabilities. If you are in need of special accommodations, please
call 202-225-1721 or 202-226-3411 TTD/TTY in advance of the event (four
business days notice is requested). Questions with regard to special
accommodation needs in general (including availability of Committee
materials in alternative formats) may be directed to the Committee as
noted above.
* * * NOTICE--CHANGE IN TIME AND LOCATION * * *
ADVISORY
FROM THE
COMMITTEE
ON WAYS
AND
MEANS
SUBCOMMITTEE ON SELECT REVENUE MEASURES
CONTACT: (202) 226-5911
FOR IMMEDIATE RELEASE
June 19, 2003
SRM-2-REVISED
Change of Time and Location for Hearing on
S-Corporation Reform
Congressman Jim McCrery (R-LA), Chairman of the Subcommittee on
Select Revenue Measures of the Committee on Ways and Means, today
announced that the hearing on S-Corporation Reform, previously
scheduled for Thursday, June 19, 2003, in the main Committee hearing
room, 1100 Longworth House Office Building, beginning at 10:00 a.m.,
will be held, instead in room B-318 Rayburn House Office Building,
immediately following the completion of the full Committee mark up of
H.R. 2351, the ``Health Savings Account Availability Act.''
All other details for the hearing remain the same. (See
Subcommittee Advisory No. SRM-2 released on June 12, 2003.)
Chairman MCCRERY. The hearing will come to order.
Good afternoon, everyone. I am sorry about the late start
of the hearing. We were delayed, of course, by the markup of
the full Committee, but we are now ready to begin. I have an
opening statement, which I will submit for the record in order
to save us a little time.
We do have one witness on the second panel who has some
time constraints with regard to her flight back home, so we are
going to allow her to be the first witness. She happens to be
from the State of Minnesota, so I am going to allow our
colleague on the Committee on Ways and Means, Mr. Ramstad, to
introduce her.
[The opening statement of Chairman McCrery follows:]
Opening Statement of the Honorable Jim McCrery, Chairman, and a
Representative in Congress from the State of Louisiana
Today, the Subcommittee on Select Revenue Measures will hear
testimony on the rules and regulations surrounding S corporations, an
organizational entity used by millions of small businesses.
Subchapter S of the Internal Revenue Code was originally enacted in
1958 and has been revised several times since then, most recently in
the Small Business Job Protection Act of 1996. Despite subsequent
improvements to this regulatory structure, questions have been raised
about whether Subchapter S has kept pace with the way businesses
structure themselves today and whether it inappropriately restricts the
growth and expansion of the small businesses it was meant to foster.
Unlike C corporations, businesses organized under Subchapter S are
considered ``pass-through'' entities. Income and losses are not taxed
at the corporate level. Instead, they are passed through directly to
shareholders who pay taxes on that income at individual income tax
rates.
Data provided by the Joint Tax Committee shows the rapid growth of
these entities primarily. In 1978, only 3% of business returns were
made by S corps. By 1989, that figure had doubled. And by 2000, it had
nearly doubled again, reaching 11%.
Despite the increasing popularity of this filing status, S corps
remain a favored entity for small businesses, though there are clearly
some large S corps and small C corporations.
The President's growth plan called for subjecting C corporation
earnings to only a single level of tax. And while the tax cut
eventually adopted fell short of that goal, it highlighted the
efficiency benefits of subjecting income to only one level of tax.
In that sense, pass-through entities, including partnerships and
businesses organized under Subchapter S, embody the President's goal of
taxing corporate income only one time.
Unfortunately, there are provisions in the tax code which place
unreasonable limits on Subchapter S corporations. This hearing will
give us an opportunity to review those provisions and to evaluate
whether the tax policy rationale for them justifies the shackles they
can place on growing businesses and entities which either are already
an S-corp or, particularly in the case of banks, which want to become S
corps.
For example, S corps may have only a limited number of
shareholders. They may not issue multiple classes of stock. Their stock
may be held by neither IRAs nor nonresident aliens.
Other rules represent traps for the unwary which may cause an S-
corp to lose that status.
These and other background issues were thoroughly presented in a
background memo prepared by the Joint Committee on Taxation, which was
distributed to all of the Members yesterday.
The document, number JCX-62-03, is available on the Joint
Committee's web page, and I commend it to anyone who wants a background
on Subchapter S.
This year, several of our colleagues on the Committee on Ways and
Means have introduced measures to reform these rules. Mr. Shaw and Mr.
McInnis have introduced bills which deal comprehensively with these
rules, and those measures will get extensive discussion today.
So, too, will a bill introduced by Mr. Ramstad which would address
the so-called ``built-in gains'' tax which S corps face if they sell an
asset acquired when it was organized as a C corporation. The bill would
waive the built-in gains tax if the S-corp reinvested the proceeds of
the sale.
Today's hearing will provide us with an opportunity to examine and
evaluate these proposals.
A fourth S corp bill which is not being discussed today but which
should be mentioned was introduced by the Chairman of the Oversight
Subcommittee, Amo Houghton. His bill would collapse the S-corp and
partnership tax systems.
While beyond the scope of this hearing, his suggested approach of
consolidating pass-through entities is something this Committee may
want to examine should we have an opportunity to make good on the
President's goal of eliminating double-tax on corporate earnings.
Helping us sort through these difficult issues will be a
distinguished panel of witnesses, including a fellow Louisianan, Rusty
Cloutier from Lafayette.
Before we get to our public witnesses, however, we will hear from
Greg Jenner, Deputy Assistant Secretary of the Treasury for Tax Policy.
I look forward to the Administration's analysis of this issue.
But before we hear from him, I yield to Mike McNulty, my friend and
the ranking member of the Subcommittee, for any opening statement he
wishes to make.
Mr. RAMSTAD. Thank you, Mr. Chairman. I would ask unanimous
consent that my statement also be included in full in the
record.
I just want to say, briefly, Mr. Chairman, I want to thank
you for holding this important hearing on proposed reforms to
Subchapter S of the Tax Code. You have been a true leader in
this area, and I appreciate your highlighting among the three
bills here today, the Small Business Opportunity and Growth
Act, H.R. 1498, which I have sponsored, along with several
other Committee on Ways and Means Members. This legislation
would relieve S corporations from the double tax, the built-in
gains, as long as the proceeds of the asset sale are driven
right back into the business.
It is a true stimulus. It would allow S corporations to
immediately unlock capital and to create jobs. It is important
legislation, and I am glad to welcome to the Subcommittee a
long-time friend of mine, a very highly respected person in the
business community of Minnesota, Kristen Copham, who is the
Director of Liberty Enterprises in Mounds View, Minnesota, on
behalf of the S Corporation Association (S-Corp).
It has been a true privilege working with Ms. Copham and
her father, David Copham, and others at Liberty Enterprises on
these issues, and I want to welcome you, Kristen, to the
Subcommittee hearing today. Thank you, Mr. Chairman.
[The opening statement of Mr. Ramstad follows:]
Opening Statement of the Honorable Jim Ramstad, a Representative in
Congress from the State of Minnesota
Mr. Chairman, thank you for holding this important hearing on
proposed reforms to Subchapter S of the tax code, which governs S
corporations. I salute Mr. Shaw and Mr. McInnis for their leadership on
these important issues. I also thank Kristen Copham, from Minnesota,
for testifying here today.
As you know, there are nearly 3 million S corporations in America,
most of which are small businesses. Small businesses are critical to
job growth. That's why we must remove shackles that prevent S
corporations from living up to their full potential and creating jobs.
I have introduced the Small Business Opportunity and Growth Act
(H.R. 1498), along with several other Ways and Means members. Several
of these cosponsors have co-signed a letter to you, Mr. Chairman, in
strong support of this legislation. I would ask that this letter be
made part of the hearing record.
Most of us think of S corporations as paying only one layer of tax,
at the shareholder level. But my legislation addresses an onerous
double tax on S corporations that is preventing many of them from
growing and creating jobs.
When C corporations convert to S corporation status, they are
trapped in a 10-year period in which any asset they held as a C
corporation is subject to an onerous ``built-in gains'' tax when they
sell it. The built-in gains tax combined with any applicable
shareholder taxes can push the effective tax rate on asset sales above
70% in some states. As a result, S corporations are forced to sit on
unproductive assets that could be better repositioned to build the
business and create jobs.
My legislation would relieve S corporations from the double tax of
built-in gains, as long as the proceeds of the asset sale are driven
right back into the business. This will allow S corporations to
immediately unlock capital, grow and create jobs.
An impressive coalition of groups with small business members has
endorsed H.R. 1498, including the S Corporation Association, National
Association of Manufacturers, U.S. Chamber of Commerce, National
Association of Realtors and Independent Community Bankers. Some of
these groups are represented here today, and I look forward to their
testimony.
I am also pleased that the Bush Administration earlier this year
proposed providing built-in gains relief through its proposal that
would have ended the double taxation of dividends. Although no built-in
gains relief was enacted in the dividend legislation that recently
passed Congress, I look forward to working with the Bush Administration
and my colleagues on ending unfair double taxation like the built-in
gains tax that is stifling job creation.
Thank you again, Mr. Chairman, for holding this important hearing.
Chairman MCCRERY. Thank you, Mr. Ramstad.
Ms. TUBBS JONES. Mr. Chairman, can I at least greet you on
behalf of the Democratic side?
Chairman MCCRERY. Sure.
Ms. TUBBS JONES. I have an opening statement that I will
submit for the record. Thank you, Mr. Chairman.
[The opening statement of Ms. Tubbs Jones follows:]
Opening Statement of the Honorable Stephanie Tubbs Jones, a
Representative in Congress from the State of Ohio
The Subcommittee on Select Revenue Measures is holding its second
hearing this year to examine proposals to change the tax law rules
applicable to ``S'' corporations. This form of tax structure allows a
business to elect to be treated as a pass-through entity, thus
providing that any profit or loss generated by the ``S'' corporation is
taxed at the individual shareholder level. Many older, small businesses
have incorporated as an ``S'' corporation for tax purposes. More
recently, firms have organized under a partnership arrangement such as
a limited liability corporation (LLC). Even with the increasing
popularity of LLCs, it is important that we continue to monitor the tax
rules for ``S'' corporations to insure that this valuable entity choice
works for our longstanding, family-owned small businesses.
The Subcommittee's hearing will give us an opportunity to discuss
the appropriateness of various corporate structures in today's economy
and the details of several pending bills to reform the tax rules for
``S'' corporations. The bills we will discuss are H.R. 714, the ``Small
Business and Financial Institutions Tax Relief Act of 2003,'' H.R.
1498, the ``Small Business Opportunity and Growth Act of 2003,'' and
H.R. 1896, the ``Subchapter S Modernization Act of 2003.''
There is bipartisan support for features of these bills. Further,
related proposals were included in the Senate-passed version of ``The
Jobs and Growth Tax Relief Reconciliation Act of 2003'' but dropped in
the conference agreement. I will be particularly interested in the
views of the Department of the Treasury as we proceed in considering
the proposals.
The bills under consideration today are being promoted as
simplification measures, reforms to improve access to capital by small
businesses, and changes to preserve family-owned businesses. These are
appropriate issues for the Subcommittee to consider. I commend
Subcommittee Chairman McCrery for holding this hearing. As always, I
look forward to followup discussions concerning these bills on a
bipartisan basis.
Chairman MCCRERY. Yes, ma'am. Thank you. Ms. Copham, you
have submitted to the Committee written testimony which will be
entered into the record. I would ask you now, in about 5
minutes, to summarize that statement. You may proceed.
STATEMENT OF KRISTEN COPHAM, LIBERTY ENTERPRISES, MOUNDS VIEW,
MINNESOTA, ON BEHALF OF THE S CORPORATION ASSOCIATION
Ms. COPHAM. Thank you, Chairman McCrery, and Members of the
Subcommittee. I appreciate you being flexible for me.
Good morning. I am Kristen Copham from Liberty Enterprises
testifying on behalf of the S-Corp. Liberty is headquartered in
Minnesota, and we provide financial institutions nationwide
with goods and services such as checks, marketing services, and
Internet banking.
My brother and I are both second-generation owners of
Liberty, and we hope that Liberty remains an S corporation for
generations to come. We are also lucky enough to be an
employee-owned company with over 600 employees who are proud to
call themselves employee owners through our employee stock
ownership plan (ESOP).
We are a founding member of S-Corp, which represents a
large and growing portion of the 2.9 million S corporations
around the country.
Thank you for holding this hearing to consider legislation
that will benefit S corporations, which tend to be small and
family-owned businesses. Congress created the Subchapter S
structure to promote entrepreneurship by linking corporate
taxes to owners, and S corporations have become American
success stories as a result.
S-Corp has two legislative priorities this Congress.
First, we support Congressman Ramstad's bill, and we
appreciate all of the work he has done with the Small Business
Growth and Opportunity Act, introduced with 11 co-sponsors. The
title sums up what this bill is all about: growth and
opportunity for the S corporations struggling under the built-
in gains tax burden that limits access to existing capital for
growth and job creation.
H.R. 1498 will allow S corporations to liquidate certain
unproductive assets and quickly reinvest the proceeds back into
our business. Under current law, businesses that convert from C
corporation to S corporation status are penalized for 10 years
if they sell any asset that has a built-in gain. This penalty
makes the sale and reinvestment of those assets prohibitively
more expensive for S corporations, effectively forcing our
businesses to retain those unproductive assets rather than face
a double-tax burden.
In some States, this burden consists of Federal and State
corporate taxes, plus Federal and State shareholder taxes, and
can exceed 70 percent of the gain. Clearly, this is
unsustainable and limits our cash flow, liquidity, and ability
to reinvest in order to grow the business and create jobs.
Members of the Committee who have co-sponsored Congressman
Ramstad's bill have signed a letter to Chairman McCrery in
support of built-in gains tax relief which I understand will be
included in the hearing record.
[The information follows:]
U.S. House of Representatives
Washington DC, 20515
June 18, 2003
The Honorable Jim McCrery
Chairman
Subcommittee on Select Revenue Measures
Ways and Means Committee
1135 Longworth
Washington, D.C. 20515
Dear Chairman McCrery:
Thank you very much for scheduling a Subcommittee hearing on S
corporation legislation on June 19. As cosponsors of H.R. 1498, the
Small Business Opportunity and Growth Act of 2003, we strongly support
Ways and Means Committee efforts to consider and approve legislation
that benefits S corporations this year.
As you know, H.R. 1498 will allow S corporations to liquidate
certain unproductive assets and quickly reinvest the proceeds back into
their businesses. Under current law, businesses that convert from C
corporation to S corporation status are penalized for a period of 10
years if they sell any of their pre-S corporation assets, even if the
proceeds are driven right back into the business. This ``built-in
gains'' tax penalty makes the sale and reinvestment of these assets
prohibitively expensive for these small companies. In some states, this
double-tax burden combined with state and federal shareholder taxes can
exceed 70% of the built-in gain.
Clearly, this is unsustainable. The built-in gains tax limits the S
corporation's cash flow, its liquidity, and its ability to invest in
order to grow its business and create jobs. The current tax code forces
these businesses to hold on to unproductive and inefficient assets or
face the double tax burden of the built-in gains tax.
At a time when Congress and the Administration have taken a stand
against ``double tax burdens'' by cutting taxes on dividends, we would
ask that you assist us in our efforts to remove this onerous double tax
penalty on S corporations so these small businesses can grow, create
jobs and help stimulate economic growth.
Thank you very much for your consideration of this important issue.
Sincerely,
Jim Ramstad
Member of Congress
Philip M. Crane
Member of Congress
Dave Camp
Member of Congress
Phil English
Member of Congress
Mark Foley
Member of Congress
We are grateful to these co-sponsors for their efforts on
behalf of S corporations. This year Congress and the
Administration have taken a stand against ``double tax
burdens'' by cutting taxes on dividends, and we would ask that
you also assist S corporations so we too can help stimulate
economic growth.
Second, S-Corp applauds Congressmen Shaw and Matsui for
again introducing H.R. 1896, which is the Subchapter S
Modernization Act. This bill would remove unnecessary and
obsolete restrictions to help small businesses grow and prosper
and also puts us on a level playing field with other entity
structures such as limited liability companies (LLCs).
S-Corp supports all of the provisions in H.R. 1896, but our
top priorities include:
Section 101 to count family members as one
shareholder, which helps family-owned S corporations plan for
the future without fear of termination of their S corporation
election.
Section 204 to modify passive income rules which
would improve capital formation opportunities and eliminate
unnecessary traps for S corporations.
Section 201 to permit S corporations to issue
qualified preferred stock. Current law permits us to have only
one class of stock, which presents a serious problem for
raising venture capital, for example.
Section 202 to permit S corporations to issue
debt that may be converted into stock of the corporation. All
other entity structures are allowed to access such types of
capital.
Section 205, relating to charitable giving,
places S corporations on par with other pass-through entities
and promotes charitable giving activities.
Title Four, we hope to see meaningful expansion
of the rules regarding S corporation eligibility for banks.
Many of these provisions I have described were included in
the Senate version of the Jobs and Growth Act, but were
unfortunately removed in conference. We are hopeful that
another viable tax vehicle can be found this year to enact
these positive changes.
Finally, there is one more very critical issue that S-Corp
wishes to bring to the attention of the Committee, and it may
eventually require a legislative solution.
In the 2001 Gross v. Commissioner of Internal Revenue case
in the Sixth Circuit, the Internal Revenue Service (IRS)
successfully retroactively changed stock valuation rules for S
corporations. These rules artificially increase the value of S
corporations for estate and gift tax purposes. The IRS position
in Gross overturns longstanding accepted valuation methods.
It has been estimated this change could unfairly raise, by
as much as 40 percent, the tax bill for many S corporation
owners. As the Committee knows, this estate tax burden could
result in small and family-owned businesses having to sell the
business just to pay the tax bill.
If the IRS continues to apply Gross in other circuits as a
mandate on S corporation valuations, all of the positive and
beneficial work done for S corporations by the Committee for
income tax purposes will be lost.
S-Corp will be approaching the U.S. Department of the
Treasury to determine if a moratorium on this decision is
possible and would appreciate the support of Congress in this
endeavor.
I thank the Committee for inviting me to testify this
morning and for being flexible, and S-Corp looks forward to
continuing to work with you. Thank you.
[The prepared statement of Ms. Copham follows:]
Statement of Kristen Copham, Liberty Enterprises, Mounds View,
Minnesota, on behalf of the S Corporation Association
Chairman McCrery, Ranking Member McNulty and Members of the
Subcommittee:
Good morning. I am Kristen Copham from Liberty Enterprises
testifying on behalf of the S Corporation Association (``S-CORP'').
Liberty Enterprises, headquartered in Mounds View, Minnesota, provides
financial institutions and their customers with a number of goods and
services including checks, financial supplies, market research, data
processing, Internet banking, and bill payment. Liberty partners with
more than 5,400 credit unions nationwide.
Liberty is a family and employee-owned company with over 800
employees. Liberty is a founding member of S-CORP which represents a
large and growing portion of the 2.9 million Subchapter S businesses
around the country.
I want to thank you for holding this hearing to consider
legislation that will benefit S corporations by removing rules and
restrictions that inhibit our growth. As you know, S corporations tend
to be small and family-owned businesses. Congress created the Sub S
structure to promote entrepreneurship by linking corporate taxes to
owners in the early 1950s, and S corporations have become major success
stories as a result.
S-CORP has two primary legislative priorities this Congress. First,
S-CORP members support Congressman Ramstad's bill, H.R. 1498, the Small
Business Growth and Opportunity Act, that he introduced on March 27th
along with eleven original cosponsors. I think the title aptly sums up
what this bill is all about providing for the S corporations struggling
under the built-in gains tax burden and providing an opportunity for
these businesses to access their existing capital for growth and job
creation.
H.R. 1498 will allow S corporations to liquidate certain
unproductive assets and quickly reinvest the proceeds back into our
businesses. Under current law, businesses that convert from C
corporation to S corporation status are penalized for a period of ten
years if they sell any asset that has built in gain as of the date of
conversion, even if the proceeds are driven right back into the
business. This ``built-in gains'' tax penalty makes the sale and
reinvestment of these assets prohibitively expensive for S
corporations, effectively forcing our businesses to retain unproductive
and inefficient assets rather than face a double-tax burden. In some
states, this double-tax burden (i.e., the federal and state corporate
level built-in gains tax plus the mandatory additional federal and
state shareholder taxes) can exceed 70% of the gain. Clearly, this is
unsustainable and limits the corporation's cash flow, liquidity, and
ability to invest in order to grow the business and create jobs.
The built-in gains tax also impacts the ability to keep privately-
held businesses in the hands of private buyers. Generally, because of
the tax, if a company is to change hands, the transaction must be
structured as a stock sale to minimize the seller's tax. More often
than not this results in a public company buyer.
Several of the Ways and Means Members who have cosponsored
Congressman Ramstad's bill have signed a letter to Chairman McCrery in
support of built-in gains tax relief which I would ask be included in
the hearing record. We are grateful to all of these cosponsors for
their efforts on behalf of S corporations. At a time when small
business has inordinate difficulty in raising and forming capital to
expand and create jobs, Congressman Ramstad's proposal would allow S
corporations to access the capital and assets that are already
available to the S corporation, without onerous tax burdens, and in a
targeted way that requires reinvestment in the business. This year
Congress and the Administration have taken a stand against ``double tax
burdens'' by cutting taxes on dividends. We would ask that you assist S
corporations so we too can help stimulate economic growth.
Second, S-CORP applauds the persistence of Congressmen Shaw and
Matsui to pass H.R. 1896, the Subchapter S Modernization Act, that they
have again introduced this Congress. This bill includes a number of
provisions to remove unnecessary and obsolete restrictions and help
small businesses grow and prosper. S-CORP supports all of the
provisions in H.R. 1896, but our top priorities include:
Section 204 to modify passive income rules. This section
would improve capital formation opportunities for small businesses,
preserve family-owned businesses and eliminate unnecessary and
unwarranted traps for taxpayers.
For example, one of our member companies, a small family-
owned hotel company in the San Francisco area, has been an S
corporation for twelve years and during that time has failed the excess
passive income tests at least twice. In 2002, the company failed the
excess passive income test as the result of a merger of a local bank
investment. The company realized a large capital gain as a result of
this merger and failed the excess passive income test even though they
had no control over the circumstances which resulted in the capital
gain. The significant detrimental effect of this example is not so much
the paying of the excess passive income tax, but the fear of failing
the test three years in a row and losing the company's Subchapter S
corporation election. A profit-making entity should not have to
regulate the nature of its profits for fear of losing S status. Because
the company was previously a Subchapter C corporation it is subject to
the excess passive income rules. The tax code is not consistent with
regard to the application of the excess passive income sections.
Corporations that elect Subchapter S status from their creation are not
subject to these tests or their resulting tax effects and losing their
Subchapter S status.
Other provisions we would like to highlight include:
Section 201 to permit S corporations to issue qualified
preferred stock. Under current law, an S corporation is permitted to
have only one class of stock. This presents a serious problem for S
corporations seeking venture capital.
Section 202 to permit S corporations to issue debt that
may be converted into stock of the corporation. All other entity
structures are allowed to access such types of capital. These
provisions would put S corporations on an equal footing.
Section 205 relating to charitable giving places S
corporations on par with other pass-through entities and promotes
charitable giving activities. S-CORP understands that Congress will
again consider charitable giving tax incentives this year and hopes
that changes can also be made on behalf of S corporations.
Title Four--we hope to see meaningful expansion of the
rules regarding S corporation eligibility for banks which the Committee
will hear/has heard more about from another witness testifying today.
Many of these provisions were included in the Senate version of the
Jobs and Growth Act, but were unfortunately removed in Conference. We
are hopeful that another viable tax vehicle can be found this year to
enact these positive changes for S corporations.
Finally, there is one more important issue that S-CORP wishes to
bring to the attention of the Committee that may eventually require a
legislative solution. In the 2001 case of Gross v. Commissioner of
Internal Revenue, 272 F. 3d 333 (6th Cir. 2001), the IRS successfully
retroactively changed stock valuation rules for S corporations which
would artificially increase the value of S corporations for estate and
gift tax purposes. The IRS position in Gross overturns longstanding
accepted valuation methods.
It has been estimated this change could unfairly raise--by as much
as 40 percent--the tax bill for many S corporation owners. As the
Committee knows, this estate tax burden could result in many small and
family-owned businesses having to sell the business just to pay the tax
bill.
The 6th Circuit upheld the IRS position and the Supreme Court
denied the Gross petition last year. S-CORP submitted a brief to the
Court in support of the petitioners and was joined in the brief by
numerous trade groups with S corporation members including the National
Association of Manufacturers (NAM) and the National Federation of
Independent Business (NFIB). S-CORP has learned that the IRS is seeking
to enforce Gross in other Circuits. S-CORP will be approaching the
Department of Treasury to determine if a moratorium to this decision is
possible and would appreciate the support of Congress in this endeavor.
If the IRS continues to apply Gross as a mandate on S-corporation
valuations, all the positive and beneficial work done for S
corporations by the Committee for income tax purposes will be lost to
the burdensome estate and gift tax regime.
I thank the Committee for inviting me to testify this morning and
S-CORP looks forward to continuing to work with you.
Chairman MCCRERY. Thank you, Ms. Copham. In the Ramstad
bill, there are some anti-abuse provisions. Can you just give
us a quick synopsis of what those are, and why do you think
they would ensure that C corporations do not convert to S
corporations solely to avoid the built-in gains taxes?
Ms. COPHAM. Thank you, Mr. Chairman. These provisions, this
bill has been carefully crafted to help avoid using these
changes just to pay dividends to the shareholders. For any
asset that is liquidated, that cash must be reinvested back
into the business, either through paying down debt and helping
the company in that way. A lot of S corporations have really
increased their debt over the last few years, and also through
purchasing other capital assets that would hopefully, of
course, create more jobs and would be plowed back into the
business.
They only have a year to do this, and if they don't do
this, then the tax would kick back in. They would also be given
a 10-percent penalty, as well as have to pay interest on that
tax, so it is pretty stiff.
Chairman MCCRERY. Thank you. Ms. Tubbs Jones?
Ms. TUBBS JONES. I will be very brief. Good afternoon. How
are you?
Ms. COPHAM. Fine. Thank you.
Ms. TUBBS JONES. Good. Good. In an earlier hearing--and if
you don't mind, Mr. Chairman, she is a small business--I am
just curious what do you do about health care for the people
who work for you?
Ms. COPHAM. Well, Liberty is extremely progressive, in
terms of health care. We have some of the best health care
available, even compared to Fortune 500 companies, and part of
that I think is because we, as a family, and the employees,
take such pride in the company, and you know the company is us,
essentially, and the employees have a very good understanding
of that.
We have a very good, we actually have two levels of health
insurance for our employees. So, they can elect to either pay
more up front or less up front, and that will affect what kind
of payment they will have to make as a deductible. Our plan, in
particular, is very strong and on par with Fortune 500
companies, and I think it is really a result of being the kind
of company we are.
Ms. TUBBS JONES. Is your status as a Subchapter S
corporation impacted at all by what you are able to offer to
your employees in a health care plan?
Ms. COPHAM. I believe it does. We basically----
Ms. TUBBS JONES. I hope that question came out right, but
anyway, go ahead.
Ms. COPHAM. I think the fact that we are an S corporation
gives us more flexibility and a longer term view, where we tend
to our employees again, the ESOP is a shareholder, and we need
to take care of our employees, with that long-term view in
mind, so we have among the best health care available.
Ms. TUBBS JONES. Is there anything else you would like to
say to this Committee? I am going to give you the rest of my
few minutes to talk about anything else you haven't had a
chance to talk about so far?
Ms. COPHAM. Well, I just want to thank you for considering
these provisions, and it is very important that the S
corporation legislation is updated and modernized. Also that
the provision is changed in terms of the built-in gains so that
we don't have double-tax burdens for those C corporations that
change to S corporations.
I just want you to know that we have been an S corporation
actually since our founding in 1985, when my father started
Liberty, so this is a provision that doesn't even affect us
directly. However, to level the playing field, I think it is
fair and important that it is equal for all S corporations. So,
I really appreciate the work done there, and I think it is the
right thing to do.
Chairman MCCRERY. Mr. Ramstad?
Mr. RAMSTAD. Very briefly, Mr. Chairman. Again, I want to
thank you for your courtesies, Mr. Chairman, with respect to
this witness, and thank you, again, Ms. Copham, for coming here
to testify.
In your testimony, you highlighted the importance of
addressing the onerous built-in gains tax, which we have been
discussing. Could you give us any specific illustrations or
examples of how the built-in gains tax has negatively impacted
S corporation businesses.
Ms. COPHAM. Thank you, Congressman Ramstad. Basically, if a
company switches from C corporation status to S corporation
status, they are going to have to pay these gains taxes on any
unproductive asset that they choose to liquidate for 10 years.
As a businessperson, I can tell you that assets tend to, on
occasion, need to be liquidated and updated, as technology
becomes available and whatnot. So, it becomes necessary to
liquidate those assets in order to modernize your facilities or
what have you.
So, it only makes sense that if a company has an
unproductive or inefficient asset, they would want to modernize
that, but they don't have to sell that, pay a double tax on the
gain because they are already paying the corporate taxes on
that gain, and then also pay a gains tax on that gain in order
to put it back into the business. So, they are actually
prohibited from making that sale.
Mr. RAMSTAD. It is quite clear to you, I am sure, that the
requirement of reinvestment in the bill would certainly work to
create jobs.
Ms. COPHAM. Oh, absolutely. I think there are two ways that
can happen. First of all, reinvesting that money in order to
pay down debt obviously helps free up moneys for making payroll
and those kinds of things; and, second, reinvesting in other
capital assets in order to expand the business and create more
jobs.
Mr. RAMSTAD. Thank you again for coming here to testify.
Thank you, Ms. Copham, for your leadership on behalf of S-Corp
businesses across America. Your business, and I am sure you
would invite not only the Chairman, but the Ranking Member here
today, to view your business, to talk to your employee owners.
I have never been to a business, I can honestly say to my
distinguished colleague, the Ranking Member here today, where
the employee owners feel more empowered, where they have the
dignity of ownership, and they feel they have a piece of the
rock, as one employee owner put it to me. The employee owners
are all equal, treated equally, and the benefits are as they
should be, and so I applaud not only your leadership, from a
policy standpoint, but your business leadership back home.
Thank you very much. Thank you, and I yield back, Mr. Chairman.
Ms. COPHAM. Thank you. I very much appreciate your time,
and if I can just add one last thing concerning the Gross
legislation; that will also be very important because we would
like to keep this in our family for years to come, and if
valuation, if my dad happens to pass way, Heaven forbid, but if
valuation is going to increase that tax burden by 40 percent, I
don't know that we will be able to keep this in our family any
longer. So, I appreciate the time.
Chairman MCCRERY. Sure. Thank you, Ms. Copham. We are going
to have at least one vote, maybe a couple votes on the floor,
three votes on the floor. Mr. Shaw, a Member of the Committee
on Ways and Means is here. Ms. Copham, thank you very much.
Ms. COPHAM. Thank you. I appreciate it.
Chairman MCCRERY. I hope you make your plane all right. Mr.
Shaw, a Member of the full Committee, is here and has done a
lot of work on this subject. I am going to recognize him for a
statement, and then we will probably let the representative
from the Department of the Treasury do his oral statement, and
then we will go vote. Mr. Shaw?
Mr. SHAW. Thank you, Mr. Chairman, I will be brief, and I
do want to compliment Ms. Copham and her family for putting the
right face on family owned businesses in this country.
Businesses do care about their employees, and I think it is
great testimony. We need, particularly where you have employee
stock options or something, we really need to expand this
subject or otherwise you can't do that.
By way of my statement, Mr. Chairman, I do want to thank
you for allowing me to sit with you for these few moments this
afternoon and allowing me to sit with you on the dais and
consider my bill, the Subchapter S Modernization Act of 2003,
and to other S corporation reform bills that will be before
you.
As you know, I introduced this bipartisan bill with Mr.
Matsui, Mr. McInnis, and Ms. Tubbs Jones as a comprehensive
reform package for the over 2.5 million businesses today that
pay taxes as S corporations, the vast majority of these being
small businesses. The bill is targeted to those small
businesses by improving their access to capital, preserving
family-owned businesses, and lifting obsolete and burdensome
restrictions that unnecessarily impede their growth. It will
permit them to keep growing and competing into the 21st
century.
Even after the relief provided in 1996, S corporations face
substantial obstacles and limitations not imposed on other
forms of entities. The rules governing S corporations need to
be modernized to bring them more on par with the partnerships
and C corporations.
For instance, the S corporations are unable to attract the
senior equity capital needed for their survival and growth. The
bill would remove this obsolete provision and also provide that
S corporations can attract needed financing through convertible
debt.
Additionally, the bill helps preserve family-owned
businesses by counting all family members as one stockholder
for purposes of S corporations--something that you will be very
pleased with--for the purposes of S corporation eligibility.
Also, nonresidents, aliens, would be permitted to be
shareholders under the rules like those now applicable to
partnerships. The bill would eradicate other outmoded
provisions, many of which were enacted in 1958.
In addition, as a certified public accountant (CPA), I am
working with the American Institute of Certified Public
Accountants (AICPA) on legislation to enable startup S
corporations to elect a fiscal year, rather than using the
current calendar year to file taxes. I believe this bill,
similar to the legislation introduced into the 104th Congress,
will provide these new businesses the flexibility they need in
their first year of business. I plan to introduce this bill
again in the near future.
I am looking forward to hearing from the witnesses today
and continuing to work with the Members of the Subcommittee on
this most important matter. Again, Mr. Chairman, I thank you
very much for allowing me to be part of your Subcommittee
today.
Chairman MCCRERY. Yes, sir. Thank you very much, Mr. Shaw.
Our first witness on the listed and published list of
witnesses will now testify before the Subcommittee. He is Greg
Jenner, the Deputy Assistant Secretary for Tax Policy for the
Department of the Treasury. Mr. Jenner, I understand you and
your staff have done quite a bit of work on the S corporation
issue, and we are looking forward to your testimony. If you
could summarize it in about 5 minutes, that would be great.
STATEMENT OF GREGORY F. JENNER, DEPUTY ASSISTANT SECRETARY FOR
TAX POLICY, U.S. DEPARTMENT OF THE TREASURY
Mr. JENNER. I will do so. Thank you very much, Mr.
Chairman, distinguished Members of the Subcommittee. My name is
Greg Jenner, and I am the Deputy Assistant Secretary for Tax
Policy of the Department of the Treasury. It is my pleasure to
be here today.
There is little dispute that small businesses are the
cornerstone of the American economy, and I can assure you the
entire Administration, including the IRS and the Department of
the Treasury, is committed to working with small businesses to
help them understand their tax obligations, ease unnecessary
restrictions, and reduce their compliance burdens.
Subchapter S is an important tool for small businesses. It
was designed to provide them with a single layer of tax similar
to that enjoyed by partnerships, while allowing them limited
liability in corporate form. Major reforms in 1982 and 1996
eased many of the restrictions on S corporation eligibility. I
won't go into the details of what those changes were.
These reforms, however, have enabled more businesses to
operate as S corporations. Our statistics show that between
1982 and 2000, the percentage of nonfarm businesses taxed as S
corporations rose from less than 4 percent to more than 11
percent. Although this trend is due, in part, to lowering of
individual tax rates, the S corporation reforms certainly
played an important role.
The S corporations, interestingly enough, are not the
predominant form of entity used by small businesses, however.
As of 1999, less than 8 percent of nonfarm businesses with
gross receipts under $250,000 operated as S corporations. The
vast bulk were sole proprietorships. We believe this is due to,
in no small measure to the relative simplicity of operating as
a sole proprietorship, rather than as a partnership or S
corporation. I will get to that concern in a moment.
It also appears, interestingly enough, that S corporations
are more attracted to large businesses than small businesses.
More than 37 percent of nonfarm businesses with gross receipts
over $1 million are S corporations, and more than 25 percent of
nonfarm businesses with gross receipts over $50 million are S
corporations.
The Administration has chosen to focus on broad-based tax
initiatives that are not dependent upon organizational
structure. We believe that tax should not play a significant
role in the form in which a business chooses to operate. Thus,
lowering income tax rates by 3 to 5 percentage points and
increasing expensing from $25,000 to $100,000, as was just
done, is far preferable, in our view.
Although these changes have provided much needed tax relief
and simplification, complexity of the tax law continues to be a
tremendous problem. Our laws have become devastatingly
complicated in recent years. Many small business owners are
unprepared to deal with this complexity and don't have the
resources to hire sophisticated tax counsel, such as Mr.
Alexander, to do so.
Tax compliance drains the time, energy and financial
resources of small business owners and diverts their attention
from the more important goals of building a business.
Subchapter S remains a simple, yet flexible, system in
which small businesses can operate and thrive, and we hope to
keep it that way. We recognize the importance of enhancing
flexibility wherever and whenever possible. We also believe,
however, that additional complexity is too high a price, in
many instances, to pay for such flexibility.
I would point out that Subchapter S is no longer the only
way that small businesses can obtain limited liability while
paying only a single level of tax. The LLCs can now be taxed as
partnerships and are a more flexible form of doing business
than S corporations. That avenue is always open to them.
It is interesting to note that, in spite of this
flexibility for LLCs, the number of S corporations grew faster
than LLCs from 1996 to 2000. We believe that this is
attributable directly to the complexity of the partnership
system, compared with S corporations. Although S corporations
have significantly more eligibility restrictions that don't
apply to LLCs, these eligibility restrictions allow for a much
simpler tax system for S corporations.
This should provide a cautionary note for all of us as we
consider changes to S corporations. We should be very hesitant
to support proposals that would move Subchapter S away from
this paradigm, and we should always ask whether the proposed
change would increase the complexity of Subchapter S and
whether the tradeoff is worth it.
Our written testimony to date goes into the detail of the
proposals that we support that are included in the three bills
under consideration. Those proposals would provide solid
technical reforms that are faithful to the goal that I have
just outlined. They would decrease taxpayer burden, while
offering increased flexibility.
Mr. Chairman, this concludes my prepared remarks. I would
be more than happy to answer any questions.
[The prepared statement of Mr. Jenner follows:]
Statement of Gregory F. Jenner, Deputy Assistant Secretary for Tax
Policy, U.S. Department of the Treasury
Mr. Chairman, Ranking Member McNulty, and distinguished Members of
the Subcommittee:
I am pleased to appear before you today to discuss the various
proposals to reform Subchapter S of the Internal Revenue Code.
The Benefits of Subchapter S
There is little dispute that small businesses are the cornerstone
of the American economy. The millions of individuals who spend their
time, energy, and resources pursuing ideas, taking risks, and creating
value are instrumental to job creation and the growth of our economy.
The entire Administration, including the IRS and the Department of the
Treasury, is committed to working closely with the small business
community and its representatives to help small businesses and the
self-employed understand their tax obligations, ease unnecessary
restrictions, and reduce their compliance burdens.
Subchapter S is an important tool for small businesses. Enacted in
1958, Subchapter S was designed to provide small businesses organized
as state law corporations with a single-layer tax system similar to
that enjoyed by partnerships. Major reforms in 1982 and 1996 moved the
tax treatment of S corporations closer to that of partnerships while
easing restrictions on S corporation eligibility. Among the 1996
reforms were: (1) increasing the number of S corporation shareholders
from 35 to 75; (2) allowing S corporations to own subsidiaries; (3)
allowing certain types of tax-exempt organizations and trusts to own S
corporation stock; (4) allowing banks to elect S corporation status;
(5) allowing an S corporation to create an employee stock ownership
plan; (6) allowing the IRS to provide relief for late or invalid S
corporation elections; and (7) exempting S corporations from the
unified audit and litigation procedures.
The 1982 and 1996 reforms appear to have enabled a greater number
of businesses to operate as S corporations. Between 1982 and 2000, the
percentage of non-farm businesses taxed as S corporations rose from
less than 4 percent to more than 11 percent. Although this trend is, in
all likelihood, due in part to the significant lowering of individual
tax rates, S corporation reforms certainly played an important role.
S corporations are not, however, the predominant form of entity
used by small businesses. As of 2000, less than 8 percent of non-farm
businesses with gross receipts under $250,000 were operating in S
corporation form. The vast majority (79 percent) were operating as sole
proprietorships, while the remaining 13 percent were operating as C
corporations, partnerships, and limited liability companies taxed as
partnerships. We believe that this is due in no small measure to the
relative simplicity of operating as a sole proprietorship rather than
as a partnership or S corporation.
Conversely, it also appears that the S corporation form is more
attractive to larger business than to small businesses. More than 37
percent of non-farm businesses with gross receipts over $1 million are
S corporations and more than 25 percent of non-farm businesses with
gross receipts over $50 million are S corporations.
The relative attractiveness of S corporations will, in all
likelihood, have diminished somewhat as a result of the recently-
enacted Jobs and Growth bill. Doing business as an S corporation, for
those businesses that qualified, offered the advantage of a single
layer of tax at the shareholder level. In contrast, C corporations were
taxed on their income at the corporate level, while their shareholders
were taxed a second time on dividends distributed by the C corporation.
By reducing the rate of tax on dividends to 15 percent, the Jobs and
Growth bill has lessened (but not eliminated) the double tax on
corporate income, thereby reducing (but again not eliminating) the tax
advantage offered by S corporations.
Recognizing that small businesses may choose a variety of
organizational forms, the Administration has chosen to focus on broad-
based tax initiatives that are not dependent on organizational
structure. It is our belief that tax should not play a significant role
in the selection of the form in which a business chooses to operate. As
a result, the President and Congress have worked together to reduce
income tax rates by 3 to 5 percent and to increase the amount of
investment that may be immediately deducted by small businesses from
$25,000 to $100,000. In the 2001 Act, Congress phased out the death
tax, allowing innovative entrepreneurs to pass the fruits of their
lives' work to their children rather than the government. These changes
will benefit 23 million small business owners, approximately 2 million
of which are S corporations, providing cash for further investment and
job creation. In addition, several regulatory changes have been made to
ease the burdens on small businesses.\1\
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\1\ The Administration's efforts to decrease burdens on small
business are not limited to legislative initiatives. For example, last
year, the IRS and Treasury issued a revenue procedure permitting
certain businesses with gross receipts of less than $10 million to use
the cash method of accounting. We expect that the revenue procedure
will eliminate most disputes concerning the use of the cash method by
small business taxpayers, allowing those taxpayers to focus on growth,
not tax compliance. Other recently implemented burden reduction
projects benefiting small businesses include:
1. Exempting 2.6 million small corporations from filing Schedules
L, M-1 & M-2, reducing burden by 61 million hours annually. (April
2002)
2. Reducing the number of lines on Schedules D, Forms 1040 and
1041, resulting in estimated burden reduction of 9.5 million hours for
22.4 million taxpayers. (January 2002)
3. Eliminating the requirement for filing Part III of Schedule D
(capital gains), Form 1120S for 221,000 S-Corporation taxpayers,
reducing burden by almost 600,000 hours. (November 2002)
The IRS has also streamlined many of its procedures to make
compliance less burdensome for small business taxpayers. A few examples
include:
1. The establishment of a permanent special group to work with
payroll services to resolve problems before notices are issued and
penalties are assessed against the individual small businesses serviced
by these bulk and batch filers. (October 2002)
2. Business filers can now e-file employment tax and fiduciary tax
returns, and at the same time, pay the balance due electronically by
authorizing an electronic funds withdrawal.
3. Business preparers can now e-file their clients' employment tax
returns.
4. The IRS has continued to improve its Web site to offer its
customers the ability to both order, and in many cases, utilize its
Small Business Products online.
It is the long-term and continuing goal of the IRS and the Treasury
to ease the burden of small businesses to the greatest extent
practical, consistent with the law as enacted by Congress. We look
forward to working with this committee on those efforts.
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Although these legislative and regulatory reforms have provided
much needed tax relief and simplification to small businesses, the
complexity of the tax laws continues to plague small business owners.
Our tax laws have become devastatingly complex in recent years. Many
small business owners are unprepared to deal with this complexity and
do not have the resources to hire sophisticated tax counsel to advise
them. Tax law compliance drains the time, energy, and financial
resources of small business owners and diverts their attention from the
more important goal of building a business.
It is our belief that Subchapter S remains a relatively simple, yet
flexible, system in which small businesses can operate and thrive. We
recognize the importance of enhancing its flexibility wherever and
whenever possible. We are also concerned, however, that such
flexibility should not be achieved at the cost of greater complexity.
As a result, we analyze proposed changes to Subchapter S by asking
whether the proposal would increase the complexity of Subchapter S and,
if so, is such increased complexity more than offset by the benefits of
the proposed change.
It is important to remember that Subchapter S is no longer the only
way small businesses can achieve limited liability while paying only a
single layer of tax. As a result of regulations issued in 1995, state
law limited liability companies can now be taxed as partnerships. Many
practitioners now tout the benefits of the more flexible limited
liability company entity over the more restrictive S corporation
entity.
Interestingly, however, between 1996 and 2000, growth in the number
of S corporations has exceeded growth in the number of limited
liability companies taxed as partnerships. We believe this is due in no
small measure to the complexity of the partnership system compared with
S corporations. Although S corporations must meet eligibility
restrictions that do not apply to limited liability companies, these
eligibility restrictions allow for a much simpler system of taxing S
corporation income. In particular, the inordinately complex systems for
determining a partner's shares of partnership income do not apply to S
corporations. In short, despite eligibility restrictions, an S
corporation is perhaps the only organizational form available to small
multi-member businesses that offers relative simplicity. Consequently,
we hesitate to support proposals that would add additional complexity
to Subchapter S.
H.R. 714, H.R. 1498, and H.R. 1896
Because of the large number of proposals included in the bills
under consideration today, our testimony does not set out Treasury's
views on each provision. Instead, our testimony identifies the
provisions that the Administration would not oppose on substance, and
sets out our views on those provisions. To reiterate, our basic goal is
to preserve the relative simplicity of Subchapter S while offering
additional flexibility to businesses taxed as S corporations. We
believe that these provisions are either consistent with, or not
contrary to, that basic goal. We would also point out the need to
exercise fiscal discipline in considering additional tax measures, and
that any tax bill inclusive of these or other tax provisions should not
increase the deficit further.
Allow shareholders of an S corporation to obtain the full benefit
of a charitable contribution of appreciated property by the corporation
(Section 11 of H.R. 714 and section 205 of H.R. 1896). In cases where
an S Corporation donates appreciated property to charity, a
shareholder's basis in their S corporation stock reflects the basis of
that appreciated property, whereas the amount contributed is the fair
market value of the appreciated property. Under current law, an S
corporation shareholder's charitable deduction is limited to his or her
stock basis. As a result, current law prevents some S corporation
shareholders from obtaining the full benefit of the charitable
contribution deduction. The proposal would allow an S corporation
shareholder to increase the basis of their S corporation stock by the
difference between the shareholder's share of the charitable
contribution deduction and the shareholder's share of the basis of the
appreciated property. This treatment is already provided to
partnerships and limited liability companies. Therefore, this proposal
would accomplish the twin goals of encouraging charitable giving and
equalizing the treatment of S corporations and partnerships.
Permit a bank corporation's eligible shareholders to include an IRA
and allow shares held in an IRA to be purchased by the IRA owner
(Section 103 of H.R. 1896). A corporation cannot elect S corporation
status if its stock is held by an IRA, and income of an S corporation
that is allocable to a tax-exempt entity generally is treated as
unrelated business taxable income. The only exception is for employee
stock ownership plans (ESOPs) which are themselves subject to special
strict rules mandated by EGTRRA. In addition, an IRA owner cannot
purchase assets held by the IRA without a special exemption. The
proposal would permit an IRA to be a permissible shareholder of a bank
S corporation. In addition, an IRA owner would be permitted to purchase
S corporation shares held by the IRA without the need for a special
exemption. These changes would only apply to shares held prior to
enactment of the provision. This proposal would result in some
additional complexity that it would be preferable to avoid. However, on
balance, we believe that this complexity is outweighed by the
flexibility that would be provided to IRAs currently owning bank
shares. Our support, however, is explicitly conditioned on the S
Corporation income earned in the IRA being treated as unrelated
business taxable income. We are concerned that, if enacted, subsequent
efforts will be made that would make such income not subject to UBIT
(as was done in the case of ESOPs), thus eliminating any and all tax on
such income.
Allow S corporation shareholders to transfer suspended losses on a
divorce (Section 302 of H.R. 1896). Under current law, losses that
exceed the shareholder's basis in S corporation stock are suspended and
may be carried over indefinitely and used when the shareholder acquires
sufficient basis in the S corporation stock. The losses, though, cannot
be transferred to another person. If, as a result of a divorce, a
shareholder must transfer S corporation stock to his or her former
spouse, the suspended losses associated with that stock are lost.
Section 302 would remedy this unduly harsh result by allowing suspended
losses to be transferred along with the S corporation stock transferred
incident to divorce.
Allow beneficiaries of qualified subchapter S trusts (QSSTs) to use
passive activity losses and at-risk amounts (Section 303 of H.R. 1896).
Generally, the current income beneficiary of a QSST is taxed on S
corporation income. Losses that flow through to the beneficiary from
the S corporation may be limited under the passive activity loss or at
risk rules. For most S corporation shareholders, losses that are
limited under the passive activity loss or at risk rules carry over
until the shareholder disposes of the activity generating the passive
loss or at risk amount. At that time, the shareholder may take any
remaining suspended passive activity and at-risk losses. Unfortunately,
the S corporation rules provide that the QSST and not the income
beneficiary is treated as the owner of the S corporation stock for
purposes of determining the tax consequences of a disposition of the S
corporation stock. Because the beneficiary is treated as the owner of
the S corporation stock for income reporting purposes, but not for
purposes of gain or loss on the disposition of S corporation stock, it
is unclear whether losses flowing through to a QSST beneficiary that
are suspended under the passive activity loss or at risk rules may be
used on the disposition of the S corporation stock. This proposal would
clarify that, for purposes of applying the passive activity loss and at
risk rules, the disposition of S corporation stock by a QSST will be
treated as the disposition of the stock by the income beneficiary of
the QSST.
Permit an electing small business trust (ESBT) to claim an income
tax deduction for any interest incurred to purchase S stock (Section
304 of H.R. 1896). This proposal would eliminate an existing
distinction between an individual purchaser of S corporation stock and
a trust purchaser, and would make the ESBT more attractive. Under
current law, the only permissible deductions against an ESBT's income
are its administrative expenses, such as costs incurred in the
management and preservation of the trust's assets; interest incurred to
acquire S corporation stock is not deductible. Treasury does not oppose
this proposal, but we believe that the interest deduction should be no
more generous to an ESBT purchaser of S corporation stock than the
interest deduction available to an individual purchaser of that stock.
We would be pleased to work with the Subcommittee to achieve that
result.
Disregard unexercised powers of appointment in determining the
potential current beneficiaries of an ESBT (Section 305 of H.R. 1896).
This proposal would significantly improve the ESBT rules by removing a
technical impediment that currently prevents many trusts from making
the ESBT election. Many existing trusts grant to an individual the
ability to name additional persons and entities as trust beneficiaries
(for example, as substitute beneficiaries in the event of the death of
a current beneficiary, or a change in circumstances that renders a
current beneficiary ``unworthy'' of receiving benefits from the trust).
Usually, the group of permissible appointees is described as an
identified class of persons or entities, such as the descendants of the
grantor's grandparents or any charitable organizations. Such a class of
permissible appointees has an almost unlimited number of members.
Current law limits the number of shareholders of an S corporation to
75, and all of the members of the class of potential appointees count
toward that 75-person limit. As a result, if an ESBT election is made
for a trust that grants such a power of appointment, the S election of
the corporation will be terminated, even though that power of
appointment may never be exercised. This proposal would disregard such
powers so long as they were not exercised.
Allow the S corporation's charitable contributions to be deducted
from its gross income (Section 307 of H.R. 1896). Under current law, an
individual S corporation shareholder may claim an income tax charitable
deduction for his or her share of a charitable contribution made by the
S corporation. However, because of the rules regarding charitable
deductions of trusts, a shareholder whose S corporation stock is held
in a trust will receive no comparable tax benefit from that
contribution. Section 307 would explicitly add charitable contributions
to the items that can be deducted in computing the ESBT's income tax on
its S corporation income. This proposal would encourage charitable
giving by S corporations and would eliminate a significant difference
in the tax treatment of an S corporation's individual and non-
individual shareholders. We suggest that this Subcommittee consider
expanding the application of this provision to other pass-through
entities making charitable contributions. This could be accomplished by
amending the trust rules to provide that trusts may deduct charitable
contributions made by all types of pass-through entities in a way that
is comparable to the charitable deduction available to individuals (and
subject to the same limitations).
Allow banks to exclude investment securities income from passive
investment income (Section 3 of H.R. 714 and section 401 of H.R. 1896).
S corporations with accumulated C corporation earnings and profits are
subject to a corporate-level tax on passive investment income that
exceeds 25 percent of the corporation's gross receipts for any year.
Additionally, a corporation's S corporation status is terminated if the
25 percent limit is exceeded for three consecutive years. Gross
receipts derived in the ordinary course of a banking business are not
considered passive investment income for this purpose. Income from
investment assets, however, is treated as derived in the ordinary
course of a banking business only if the investment assets are needed
for liquidity or loan demand. The amount of investment assets needed
for liquidity or loan demand may be subject to disagreement. This
provision would eliminate this uncertainty by providing that passive
investment income would not include any interest income earned by a
bank, bank holding company, or qualified subchapter S subsidiary (in
the case of H.R. 1896 only) or dividends on assets required to be held
by such bank, bank holding company, or qualified subchapter S
subsidiary (in the case of H.R. 1896 only) to conduct a banking
business. We recommend that this proposal be clarified to apply only to
a bank, bank holding company, or a qualified subchapter S subsidiary of
a bank or a bank holding company.
Allow a bank to recapture its bad debt reserves on either its first
S corporation or its last C corporation return (Section 6 of H.R. 714
and section 403 of H.R. 1896). Under current law, banks that use the
reserve method of accounting are ineligible to make the S corporation
election. If a bank makes an S corporation election, the bank is
automatically switched to the specific charge-off method of accounting
for bad debts. This change in accounting method results in recapture of
the bad debt reserve over four years. The recapture of the reserve by
the bank S corporation is treated as built-in gain subject to a special
corporate-level tax. Under the built-in gain provisions, tax on the
built-in gain must be paid both at the corporate and shareholder level
in the year of recognition. In contrast, a C corporation would pay tax
on the recapture amount at the corporate level but the shareholders
would not have to pay tax on that amount until the C corporation paid
dividends. By allowing banks to take the recapture of the bad debt
reserves into account in the last C corporation year, rather than the
first S corporation year, the proposal would eliminate the current
imposition of a second layer of tax. This provision is similar to a
provision of the Code designed to recapture LIFO reserves on the
conversion of a C corporation to an S corporation. Under that
provision, the LIFO recapture amount is taken into account in the year
before the conversion to S corporation status, but the corporation is
allowed to pay the tax on the recapture amount over 4 years. We
recommend that similar principles be applied to address the recapture
of bad debt reserves and would be happy to work with this Subcommittee
to draft an appropriate provision.
Allow the IRS to provide relief for inadvertently invalid qualified
Subchapter S subsidiary (QSub) elections and terminations (Section 501
of H.R. 1896). Section 1362(f) authorizes the Secretary to provide
relief for inadvertent invalid S corporation elections and inadvertent
terminations of S corporation elections. This provision has saved
hundreds of taxpayers from the consequence of procedural mistakes;
invalid elections and inadvertent terminations are common because S
corporations and their shareholders are often unfamiliar with the
technical requirements of eligibility. Under current law, however,
there is no comparable relief available for QSubs. Allowing the
Secretary to grant relief for inadvertent invalid QSub elections and
terminations would prevent shareholders from suffering significant
negative consequences for mere procedural errors.
Provide that a sale of an interest in a QSub is treated as a sale
of a pro rata share of the QSub's assets, followed by a contribution of
those assets to a cor- poration (Section 503 of H.R. 1896). A QSub must
be wholly owned by a single S corporation. Under current law, if an S
corporation sells more than 20 percent of the stock of a QSub, the S
corporation will recognize gain and loss on all of the assets of the
QSub. The proposal would change this to align the treatment of the sale
of an interest in a QSub with the treatment of the sale an interest in
a limited liability company that is treated as a disregarded entity.
Eliminate the earnings and profits earned by a corporation as an S
corporation prior to 1983 (Section 601 of H.R. 1896). Prior to 1983,
income earned by an S corporation gave rise to earnings and profits.
Concluding that it was inconsistent with the modern view of S
corporations to continue to view pre-1983 S corporation income as
giving rise to earnings and profits, in 1996 Congress eliminated pre-
1983 earnings and profits for any corporation that was an S corporation
prior to 1983, but only if the corporation was an S corporation in its
first taxable year beginning after December 31, 1996. Section 601 would
eliminate pre-1983 earnings and profits arising during an S corporation
year, regardless of whether the corporation was an S corporation in its
first taxable year beginning after December 31, 1996. In our view,
relief from pre-1983 S corporation earnings and profits should not be
dependent on whether the corporation continued to be an S corporation
after 1996.
Allow charitable contribution carryforwards and foreign tax credit
carryforwards to offset the corporate-level tax on built-in gains
(Section 603 of H.R. 1896). Under current law, an S corporation may use
net operating loss carryforwards and capital loss carryforwards to
offset the tax on built-in gains under section 1374. It is our view
that charitable contribution carryforwards and foreign tax credit
carryforwards should also be available to offset section 1374 built-in
gains.
Expand the number of permissible S Corporation shareholders
(Section 4 of H.R. 714 and section 104 of H.R. 1896). These proposals
would increase the number of permissible S Corporation shareholders
from 75 to 150. Treasury cannot support such a dramatic increase, which
we believe would run counter to the goal of maintaining Subchapter S as
the simplest of systems for businesses with more than one owner.
Increasing the number of shareholders will, inevitably, bring increased
pressure to liberalize other facets of Subchapter S which will, in
turn, increase the complexity of the provisions. It is important to
keep in mind that the number of permissible shareholders was more than
doubled, from 35 to 75, just a few years ago. For these reasons, we
urge this Subcommittee to refrain from dramatic expansion of these
rules.
* * *
We believe that the proposals outlined here could provide solid
technical reforms that would be faithful to the spirit of subchapter S.
Consistent with the goal of subchapter S to provide simple rules for
small business, these rules would decrease taxpayer burden, while
offering increased flexibility. We would be pleased to work with the
Committee to develop these or other S corporation reform proposals.
This concludes my prepared statement. I would be pleased to answer
any questions the Subcommittee may have.
Chairman MCCRERY. Thank you, Mr. Jenner. I am going to
recess the hearing so that the Members can go vote, and when we
return, we will allow the Members to ask questions of you.
Mr. JENNER. Thank you very much.
Chairman MCCRERY. The hearing is in recess.
[Recess.]
Chairman MCCRERY. The hearing will come to order. We have
been advised by the Democratic staff that we may proceed, and
they will not object. So, we shall proceed and hope that they
do not object. So, Mr. Jenner, I have a series of questions I
would like to put to you, and then if one of my Democratic
colleagues shows up, certainly give him or her the opportunity
to do the same.
In 1996, Congress allowed, for the first time, banks to
elect S corporation status. However, many small community banks
are prevented from converting to S corporations because their
employees hold bank shares in their individual retirement
accounts (IRAs). Mr. Shaw's bill and Mr. McInnis' bill would
allow two forms of relief for this situation.
Number one, they would waive the prohibited transaction
rules which prevent IRAs from selling shares to the holder of
the IRA; and, number two, their bills would allow IRAs to hold
S corporation stock if the IRA paid unrelated business income
tax on income flowing from the bank. I understand, from talking
with some of the bankers, that this is important because some
of the holders of the IRAs may not have the cash to buy the
shares from the IRA.
What is the Department of the Treasury's views on these
provisions?
Mr. JENNER. Mr. Chairman, we are generally supportive of
the provisions. We would be concerned if the shares that were
sold were not sold at fair-market value, and we think that we
can address that concern.
The other cautionary note that we would raise is any
subsequent effort to eliminate the unrelated business income
tax. We note that there was a proposal, very similar, done a
few years ago relating to ESOPs, where originally the unrelated
business income tax was imposed and was later repealed, and we
would urge you, if you are going to do this, to make sure that
the unrelated business income tax stays in place for shares
held by IRAs.
Chairman MCCRERY. Now, our first witness today representing
the S-Corp talked about a recent decision in the Sixth Circuit,
the Gross decision, which changed the stock valuation rules for
S corporations. Can you give us the Department of the
Treasury's view on this case.
Mr. JENNER. Yes, Mr. Chairman. The facts of the Gross case
were that the tax court, and later the Sixth Circuit, basically
weighed in on a battle of expert opinions between the IRS and
the taxpayer. It was a very fact-specific opinion. While there
is some precedential value to it, again, all valuations are
very fact specific. So, with all due respect to the previous
witness, we would argue that there is not a serious concern
with respect to the Gross opinion, and it may very well never
apply in particular fact situations.
Chairman MCCRERY. Witnesses on the next panel will testify
that Mr. Ramstad's bill has anti-abuse rules to prevent C
corporations from converting to Subchapter S merely to avoid
the built-in gains taxes. Have you reviewed the Ramstad view,
and do you have a view on the efficacy of these anti-abuse
rules?
Mr. JENNER. We have reviewed the bill, Mr. Chairman. We
have serious reservations about Mr. Ramstad's bill,
notwithstanding the fact that efforts have been made to place
anti-abuse rules. One of the difficulties, of course, is that
cash is cash, and even though you can say that you can't use
the cash for certain reasons, if the corporation has other cash
that can be used for that very reason, then it doesn't matter
which pool of cash you are drawing from.
We also think that providing a limited window of
opportunity to eliminate the built-in gains tax is unfair. It
is similar, I hate to use the word ``amnesty,'' but it is a
temporary relief provision, and we have very great concerns
about opening a window of opportunity and then closing it
again.
Chairman MCCRERY. Also, on the next panel, the National
Cattlemen's Beef Association (NCBA) expresses a desire for a
one-time election for an S corporation to convert to a LLC
status. What is your view on that proposal?
Mr. JENNER. Again, Mr. Chairman, we have serious
reservations about that. We think that there is a substantial
possibility of abuse, as well as the elimination of tax that
should be paid if, as a result, the S corporation was
originally a C corporation, and you have the built-in gains
tax. There are real serious concerns with the proposals.
Chairman MCCRERY. If we want banks to become S
corporations, why do we enforce a one-class-of-stock-only rule
because, as you know, banks often have director's shares. They
are required to under the regulations, and so if we want them
to convert or if we want to give them the opportunity to
convert, why would we insist on this one-class-of-stock-only
rule?
Mr. JENNER. Well, we are concerned that if you allow
director's shares, there is a potential for abuse and
manipulation, that the amounts paid on account of director's
shares would be treated as debt. It would be income to the
recipient, but again it is uncontrolled by any sort of equal
allocation rule with other shareholders.
We do understand the Office of the Comptroller of the
Currency (OCC) has said that such requirements should be in
place. What I suggested to your staff is that we would be happy
to sit down with our colleagues at the OCC to see whether or
not we can come up with a creative solution that perhaps
alleviated the requirement of director's shares and, thus,
didn't implicate the tax system at all, and we will do that.
Chairman MCCRERY. Yes. It seems to me that there ought to
be a way to skin this cat. So, I would urge you to do as you
suggested and figure out a way to make it work.
Mr. JENNER. We will do that, Mr. Chairman.
Chairman MCCRERY. You noted that the passage of the growth
bill by Congress, which reduces the double tax of the earnings
of C corporations, makes S corporations relatively less
attractive than they were before, from a tax standpoint. Has
the Department of the Treasury done any research or seen any
evidence suggesting how much this will change businesses'
decisionmaking between the corporate structures?
Mr. JENNER. We have not done any specific research, and we
think it is a little early to tell yet. There is no question
that the relative advantage has been reduced, but there are a
lot of advantages that flowed from the S corporation form of
doing business that are not necessarily tax related, and
therefore it is unclear whether there is going to be a dramatic
shift.
Chairman MCCRERY. You said in your testimony that there
were a number of reforms in the bills that we were looking at
in this Subcommittee that the Department of the Treasury
thought were appropriate. Could you just tick off a few of them
for us?
Mr. JENNER. Certainly. I can begin at the beginning of my
testimony:
Allowing shareholders of an S corporation to
obtain the full benefits of a charitable contribution of
appreciated property;
As we mentioned before, allowing IRAs to hold
bank shares;
Allowing S corporations to transfer suspended
losses on a divorce;
Allowing beneficiaries of qualified Subchapter S
trusts to use passive activity losses in that risk amounts;
Permitting and electing small business trusts
(ESBT) to claim an income tax deduction for interest used to
purchase S corporation stock;
Disregarding unexercised powers of appointment in
determining potential beneficiaries of an ESBT;
Allowing an S corporation's charitable
contribution to be deducted from its gross income;
Allowing banks to exclude investment securities
income from passive investment income;
Allowing a bank to recapture its bad debt
reserves on either its first S corporation year or its last C
corporation year;
Allowing the IRS to provide relief for
inadvertent and valid qualified S corporation subsidiary (QSub)
elections and terminations;
Providing that a sale of an interest in a QSub is
treated as a sale of a pro rata share of the QSub's assets;
Eliminating the earnings and profits earned by a
corporation as an S corporation prior to 1983;
Allowing corporation contribution carry-forwards
and charitable contribution carry-forwards and foreign tax
carry-forwards to offset corporate-level tax on built-in gains;
And, in certain circumstances, expanding the
number of permissible S corporation shareholders.
Chairman MCCRERY. What about the proposals to allow
multiple generations of a family to be one shareholder?
Mr. JENNER. I am afraid we have some serious reservations
about that proposal. Ironically, I actually worked on it when I
was in private practice. It has some serious complexity and
administratability issues that we think cannot be overcome.
Plus, I think that there are probably ways to deal with it.
Chairman MCCRERY. So, your preferred approach to solving
the problem would be to increase the number of allowable
shareholders, generally.
Mr. JENNER. To a certain point. We are concerned about a
dramatic increase. Again, as I indicated in my verbal
testimony, one of the things that we are trying to do is
preserve S corporations, the paradigm of Subchapter S, which is
small business and a small number of owners, and we think we
are concerned about expanding the number of shareholders to too
large an amount.
Chairman MCCRERY. Thank you very much. Ms. Tubbs Jones,
would you like to inquire of Mr. Jenner?
Ms. TUBBS JONES. You were hoping I wasn't coming back so
you could run out of here.
Mr. JENNER. That is absolutely not true.
[Laughter.]
Ms. TUBBS JONES. Thanks, I won't be long. What happens if
when, in an S corporation, the prior witness said that she was
worried about the estate tax problems for her and her brother,
what happens when her father dies? I am not trying to say he is
getting ready to die, so nobody should take that out of here,
but if her father dies?
Mr. JENNER. If the father owns the S corporation stock,
which I assume he does, that stock will be included in his
estate for estate tax purposes, and depending upon whether or
not the estate is valued at more than the unified credit
amount, plus an additional amount for small business, that
excess could be taxed. Again, it depends on valuation, and the
concern that the previous witness was raising was one about
valuation--how do you actually value closely held businesses--
and she was concerned about this court case.
Ms. TUBBS JONES. You are here from the Department of the
Treasury, but I am assuming you are a tax lawyer; is that a
fair statement?
Mr. JENNER. Unfortunately, yes, it is, ma'am.
Ms. TUBBS JONES. Wait a minute. I am a lawyer. I am not a
lawyer basher. I love lawyers.
[Laughter.]
Mr. JENNER. No, but a tax lawyer, we get a lot of kidding.
Ms. TUBBS JONES. They all love lawyers when they need one,
though, so that is the way we have to look at it, that
perspective.
Mr. JENNER. That is true.
Ms. TUBBS JONES. Is there an advantage, from your
perspective, of being an S corporation versus the more flexible
LLC--and you might have answered this before I came in. If you
did, I apologize--LLC structure or weigh them for me and tell
me, in 2 minutes or less, the advantage of one over the other.
Mr. JENNER. I am going to sound like an economist. It
depends.
Ms. TUBBS JONES. Uh-huh, Alan Greenspan. Go ahead.
[Laughter.]
Mr. JENNER. The S corporations provide a relatively simple
system of taxation. On the other hand, eligibility for S
corporation status is more restricted. If you can qualify for S
corporation status, you are probably better off, if you want a
simple system. The LLCs are taxed as partnerships, and I
remember one of my tax professors at New York University (NYU),
which is a premier tax school in the country, saying----
Ms. TUBBS JONES. I like Case Western Reserve, personally,
but go ahead.
[Laughter.]
Mr. JENNER. It is a great school, no question about it.
This professor was saying that he never understood partnership
tax, and if one of the professors at NYU doesn't understand it,
it is complicated. It is very, very complicated.
Ms. TUBBS JONES. What have you, in your experience, are S
corporations more ``mom and pop'' type of operations or do they
also include, well, in small business we talk about a dollar
value in order to qualify as a small business? What about S
corporations?
Mr. JENNER. Well, they run the gamut. Many of them are
small, but you tend to see some pretty big ones too. Some
statistics, from one of my colleagues, there are 2 out of every
1,000 that have 20 or more shareholders. So, that means 5,000
out of 2.8 million S corporations have more than 20
shareholders. Many of them tend to be small, but I can tell you
from private practice experience that there are some really big
ones, too, and I probably can name them if you ask me, name
some of them. They are huge.
Ms. TUBBS JONES. I won't put you through that.
Mr. JENNER. Thank you.
Ms. TUBBS JONES. Mr. Chairman, I am going to yield back the
balance of my time, in the name of us getting out of here.
[Laughter.]
Chairman MCCRERY. Thank you, Mr. Jenner, very much for your
testimony and for your patience as we complete our duties on
the floor. We look forward to having you back at a later date
for further discussion of a most interesting topic.
Mr. JENNER. Thank you very much, Mr. Chairman, Ms. Tubbs
Jones.
Ms. TUBBS JONES. I have to say, Mr. Jenner, it is not often
that I get to be Ranking Member, and this is my first time on
the Committee on Ways and Means. So, I have to take advantage
of making a record of it.
Mr. JENNER. Well, I am privileged to be a part of it.
[Laughter.]
Chairman MCCRERY. There you go. At this time, I would call
the second, and last panel of the hearing. Hon. Donald C.
Alexander, on behalf of the U.S. Chamber of Commerce; Mr.
Robert A. Zarzar; Laura M. MacDonough; Rusty Cloutier,
President and chief executive officer, MidSouth Bank,
Lafayette, Louisiana; and David True, Owner of True Ranches in
Casper, Wyoming, on behalf of the NCBA.
I should have said Mr. Cloutier is here on behalf of the
Independent Community Bankers of America (ICBA). Ms. MacDonough
is here as a Member of the S Corporation Taxation Technical
Resource Panel, and Mr. Zarzar is here on behalf of or as a
Member of the Tax Executive Committee of the AICPA. So, we have
a very distinguished panel, and we look forward to hearing your
testimony.
Now, before I begin with Mr. Alexander, I would like to
welcome my Louisiana neighbor from down South, as you might
guess from his name, Mr. Cloutier, spelled C-l-o-u-t-i-e-r. He
is not from Shreveport. He is from Lafayette, Louisiana and a
distinguished banker in his community. He is also a very civic-
minded individual who has helped me with some statewide
projects that we both hope will come to fruition to improve
economic conditions in our State. So, welcome, Mr. Cloutier.
Mr. CLOUTIER. Thank you very much, Congressman.
Chairman MCCRERY. We will begin with the Honorable Donald
C. Alexander. Welcome.
STATEMENT OF THE HONORABLE DONALD C. ALEXANDER, AKIN, GUMP,
STRAUSS, HAUER, & FELD, LLP, ON BEHALF OF THE U.S. CHAMBER OF
COMMERCE
Mr. ALEXANDER. Thank you, Mr. Chairman, and thank you,
Ranking Member. I am glad to be here to talk with you about
Subchapter S. I request that my statement be entered into the
record because I am not going to read it.
Chairman MCCRERY. Without objection.
Mr. ALEXANDER. It was interesting to hear the Department of
the Treasury testify and to read their statement. They are
quite concerned about complexity, and they want to eradicate
complexity by keeping the Subchapter S rules as rigid as they
are today, with some exceptions that the Deputy Assistant
Secretary spelled out to you, Mr. Chairman.
I don't think that works very well. You have an overly
rigid law, and Subchapter S, enacted 45 years ago in 1958, has
now outlived some of the requirements that the Deputy Assistant
Secretary was discussing. The Assistant Secretary, before she
became Assistant Secretary, made a statement that I think is
worth considering. She said the repeal of many of the
restrictions in Subchapter S, one class of stock, a small
number of stockholders and the like, would simplify the law,
rather than make the law more complex.
Now, in my statement, I have a couple of examples of just
that. If a law is too rigid, rigidity does not promote
simplicity because people have to find a way, due to business
needs, to try to get around the rigidity of the written law,
and that is exactly what happened in a couple of instances
involving the limitation on the number of stockholders and
involving preferred stock.
In the partnership regulations, there is a provision that
says it is fine for a Subchapter S corporation to set up a
partnership with a nonresident alien stockholder or, let us
say, the 76th stockholder. That is great. You can do that. You
can do it through the back door, not the front door.
If it is so easy, according to the Department of the
Treasury at least, to get around the restriction, why have the
restriction in the first place? Well, the reason that it is
there in the first place is that it is not easy. Somebody has
to know about that partnership regulation provision, somebody
has to advise how to use it, and somebody has to advise using
two vehicles to serve the place of one.
Second, preferred stock. There is a way, according to a
Department of the Treasury official, to get around the
prohibition against the use of mezzanine capital. Preferred
stock is a great way to attract capital into a small business,
and you look to your stockholders for additional capital
without diluting the voting and economic interests of the other
common stockholders, generally, the second generation.
You can do it if you are willing to drop some entity below
the Subchapter S corporation and divide that entity between
preferred interests going to the people that would be preferred
stockholders and the Subchapter S corporation, consisting of a
limited number of common stockholders.
So, we have vast complexity, but we just don't have it in
the Subchapter S provisions of the Internal Revenue Code. We
have it in the operation of those provisions. To me, that makes
no sense. To me, the Shaw bill, the McInnis bill, and I am also
in favor of the Ramstad bill, although it is more limited in
its scope, would permit Subchapter S to be a truly competitive
vehicle for the carrying on of small, and independent and
family businesses without the shackles that we now have and
without having to jump through hoops to get around those
shackles. Thank you.
[The prepared statement of Mr. Alexander follows:]
Statement of the Honorable Donald C. Alexander, Akin, Gump, Strauss,
Hauer, & Feld, LLP, on behalf of the U.S. Chamber of Commerce
I am appearing this morning on behalf of the U.S. Chamber of
Commerce (``the Chamber'') to discuss S Corporation reform. The United
States Chamber of Commerce is the world's largest business federation
representing more than three million businesses and organizations of
every size, sector and region, with substantial membership in all 50
states.
My topic is the need for reform and simplification of the
restrictive rules, enacted 45 years ago, that still shackle the more
than 2,500,000 Subchapter S corporations in the United States. While a
number of constructive changes were made in 1996, much remains to be
done to permit family-owned businesses to utilize an entity that
provides limited liability and passes income through the entity to its
owners.
The massive changes that have recently been made in the taxation of
business income call for reconsideration of the rigid rules governing
Subchapter S taxpayers. The huge reduction in the rate of tax on
dividend income means that the tax imposed on C corporations and that
transmission of income (whether or not subjected to corporate tax) to
the stockholders is now much lower than it was last year. The tax
imposed on the owner of a pass-through business entity, whether
Subchapter S, Subchapter K or a sole proprietorship, has been reduced
only slightly thanks to acceleration of phased-in rate reductions.
Therefore, the perceived advantage of conducting a business through an
entity which passes through its income to its owners for tax purposes
has been reduced, and the fact of this reduction should not be
disregarded in determining whether restrictions imposed in an entirely
different tax world should be lifted today.
Years ago Subchapter S corporations were the entity of choice if
the owner of a small business wished to obtain the benefits of
operating through the corporate form (limited liability) without
suffering the detriment of double taxation on the business's earnings.
However, after the Treasury's blessing of the limited liability
company, plus the Treasury's adoption of check-the-box rules,
partnership tax treatment (correctly called ``tax nirvana'') has been
conferred upon entities that were not formerly treated as partnerships.
Limited liability companies are clearly preferable to Subchapter S
corporations from the Federal tax standpoint; examples of favored
treatment are the partnership basis rules (partner's basis includes
partnership debt) and liberal rules permitting disproportionate
allocation of income and loss among partners. It is no wonder the
recent wave of aggressive tax shelters typically used a partnership as
the vehicle to transfer tax benefits. But some entities, like banks,
must conduct their businesses in corporate form and others are required
to do so by state laws or other rules. They must use Subchapter S.
Moreover, many Subchapter S corporations are locked in to elections
made years ago; while they would prefer to adopt the tax-favored
partnership form, they cannot without a heavy tax toll charge.
Subchapter S corporations are found on Main Street, not Wall Street.
They are not asking for the famous ``level playing field'', i.e., the
favored tax treatment granted to partnerships. Instead, they are simply
asking that some of the fetters imposed in another era be removed.
Treasury officials have not been responsive to the proponents of
Subchapter S reform. Among the reasons for opposition is the notion
that while it is fine for partnerships to seek and obtain tax
advantages through a sea of complexity, Subchapter S must be kept
simple for simple people. By confusing rigidity with simplicity, this
notion creates complexity. Examples are the rules prohibiting a
nonresident alien from being a stockholder in a Subchapter S
corporation and limiting the number of Subchapter S stockholders.
Example 2 of Reg. Sec. 1.701-2(d) shows that a nonresident alien (or
the 76th stockholder) can participate in a Subchapter S corporation's
business by becoming a partner with the Subchapter S corporation. A
further example deals with preferred stock. A Treasury official
suggested that a Subchapter S corporation could create the equivalent
of preferred stock by dropping assets into a limited liability
corporation that would issue a preferred-like interest to preferred
holders. Why require these complex maneuvers? Why not permit the
nonresident alien, or the 76th stockholder, or the preferred
stockholder, to come through the front door?
When she testified for the American Bar Association Tax Section
before the House Committee on Small Business on the impact of the
Code's complexity, now Assistant Secretary Pamela Olson said:
The definition of an ``S corporation'' contained in section 1361
establishes a number of qualification criteria. To qualify, the
corporation may have only one class of stock and no more than seventy-
five shareholders. Complex rules provide that the shareholders must be
entirely composed of qualified individuals or entities. On account of
state statutory changes and the check-the-box regulations, S
corporations are disadvantaged relative to other limited liability
entities, which qualify for a single level of Federal income taxation
without the restrictions. The repeal of many of the restrictions would
simplify the law and prevent inadvertent disqualifications of S
corporation elections.
The Impact of Complexity in the Tax Code on Small Businesses:
Hearing Before the House Subcomm. on Tax, Fin. and Exp. of the Comm. on
Small Bus., 106th Cong. (statement of Pamela F. Olson).
Ms. Olson was right. S corporations are indeed disadvantaged, these
restrictions are extremely complex, and their removal would greatly
simplify the law for Main Street businesses.
These simplifications should include, at least, the following:
1. S corporations should have access to senior equity by the
issuance of preferred stock, as well as bank directors' qualifying
shares. Payments to owners of such stock or shares should be treated as
an expense to the S corporation and ordinary income to the
shareholders.
2. The number of S corporation eligible shareholders should be
increased from 75 to 150, thus helping community banks to broaden their
ownership and Subchapter S corporations to provide equity to key
employees. Members of a family should be treated as one stockholder, as
they are for other purposes of the Code.
3. Capital gains should be excluded from classification as passive
income. Long term capital gains would be subject to a maximum 15
percent rate at the shareholder level, thus conforming to the general
treatment of such gains as well as their treatment under the personal
holding company rules.
4. The restrictive rules on excess passive income should be
modified as recommended by Joint Committee on Taxation Staff, and
interest and dividends on investments maintained by a bank for
liquidity and safety and soundness purposes should not be treated as
passive income.
5. Nonresident aliens should be permitted to own Subchapter S
stock, subject to the limitations applicable to partnerships.
6. Subchapter S corporations should be permitted to issue
convertible debt.
Most of the improvements listed above are contained in
Representative Shaw's bill, H.R. 1896. As Representative Shaw stated on
introduction of a similar bill:
Today over two million businesses pay taxes as S corporations and
the vast majority of these are small businesses. The Subchapter S
Revision Act of 1999 is targeted to these small businesses by improving
their access to capital preserving family-owned businesses, and lifting
obsolete and burdensome restrictions that unnecessarily impede their
growth. It will permit them to grow and compete in the next century.
Cong. Rec. E196 (Feb. 10, 1999) (statement of Rep. Shaw).
As I understand it, three bills reforming and revising Subchapter S
are now before this Subcommittee for consideration. The most
comprehensive is H.R. 1896, proposed by Mr. Shaw, which would make a
number of needed changes, including an increase in the number of
permitted stockholders, treating family members as one stockholder, and
permitting the issuance of preferred stock. Mr. McInnis' bill, H.R.
714, contains many similar provisions. Both would assist banks to
operate as Subchapter S corporations. Mr. Ramstad's bill, H.R. 1498, is
focused on tempering the current built-in gains tax. While all these
bills have merit, the broader the action, the better.
S corporations operate in every business sector of every state.
Typically, they are family-owned and operated businesses or otherwise
closely-held organizations that have been reliable engines of job
growth and productivity for the domestic economy. The rules adopted in
1958 when S corporations were created, and as subsequently amended, are
out of sync with modern economic realities. The S corporation reforms
we propose would address the troubling gap between the antiquated laws
established over forty years ago and the operating and capital needs of
S corporations today. These reforms were developed after careful and
thorough study. In short, these reforms would provide the boost, at a
critical time, that thousands of small businesses in America need to
continue the growth of American entrepreneurship and competitiveness,
and they have the strong support of the United States Chamber of
Commerce and other business organizations.
Chairman MCCRERY. Thank you, Mr. Alexander. Each of you
should know that your prepared testimony that you submit will
be in the record in their entirety. Now, Mr. Zarzar, if you
would summarize yours in about 5 minutes, we would appreciate
it.
STATEMENT OF ROBERT A. ZARZAR, CHAIR, TAX EXECUTIVE COMMITTEE,
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS; ACCOMPANIED
BY LAURA M. MACDONOUGH, PAST CHAIR, S CORPORATION TAXATION
TECHNICAL RESOURCE PANEL, AMERICAN INSTITUTE OF CERTIFIED
PUBLIC ACCOUNTANTS
Mr. ZARZAR. Thank you, Mr. Chairman, Ranking Member. The
AICPA appreciates this opportunity to present testimony on the
importance of modernizing the laws that govern Subchapter S of
the Internal Revenue Code. My name is Robert Zarzar and I am
Chair of the Tax Executive Committee. Ms. Laura MacDonough, a
past Chair of the AICPAs S Corporation Technical Resource
Panel, is here with me.
The AICPAs members assist S corporations and their
shareholders of all sizes and in all industries nationwide with
choice of entity decisions; organizational, transactional and
acquisitive structuring; operational and distribution planning;
return preparation; and many other services required daily by S
corporation clients.
It is from decades of close involvement with these small,
mid-size and large clients that we have developed insight into
a list of needs required to enable S corporations to do what
they were intended to do all along: that is, provide a vehicle
for small-scale entrepreneurs to grow and achieve success in
their business endeavors.
Perhaps the greatest characteristics of S corporations have
always been the one level of tax imposed, the familiar and
time-tested corporate structure, and the ability to write off
operational losses of a shareholder's tax return, primarily in
the startup years.
Without digressing significantly from today's topic, we
note that this Subcommittee's colleague, the Honorable Mr. Amo
Houghton, has introduced legislation that would move entities
toward Subchapter K and would do so with some very promising
features, such as providing a means for all nonpublicly traded
businesses to be taxed only at the end user level.
Now, because the emphasis of H.R. 22 is on the largely
common law partnership and the untested and less structured
LLC, the typical S corporation owner's zone of comfort has been
stripped away, and the bill fails to entice small business
entrepreneurs relatively happy with the structure of S
corporation world. In the current climate, there exists a
strong need to expand Subchapter S so that it will grow with
the businesses created under its auspices.
Expanding this comfortable, and familiar, single-tax entity
makes particular sense in light of the Administration's desire
to see taxes imposed primarily on the end user.
In our written testimony, we have provided a more detailed
list of recommendations with explanations as to why various
changes are needed. Today I would like to highlight just a few
of those items.
First in the category of reforms we might characterize as
technical corrections, the new suggestion based on the recent
Jobs and Growth Tax Relief and Reconciliation Act of 2003 (P.L.
108-27) is changed to the personal holding company and
accumulated earnings taxes that reduced the tax rate to 15
percent. We believe that because the passive investment income
provisions of section 1375 were intended to serve a similar
function, the rate imposed on such earnings should likewise be
reduced.
Second in that category, we believe that while significant
progress has been made since 1996 in making ESBTs useable,
Sections 304 and 305 of H.R. 1896 clarify two critical points
and will significantly expand their use.
First, when an ESBT purchases S corporation stock by
borrowing money, the trust should be able to deduct the related
interest expense, as would any other type of taxpayer. There
simply is no policy reason for this provision. Statutory
authority for this deduction must be made clear. There is no
apparent policy reason for its disallowance.
Second, routine powers of appointment contained in trusts
that make an ESBT election run the serious risk of blowing an S
corporation election simply because of the overly expansive
definition of the potential current beneficiaries and the
difficulty of modifying existing trust documents. If the powers
are unexercised, they should be disregarded for this purpose,
thus, allowing trust drafters and other users to get some sleep
at night.
Next, we strongly recommend that the statute clarify that
QSub elections were intended to be kept simple, without the
needless trap for the unwary that the step transaction doctrine
can present in unexpecting circumstances. Section 504 of H.R.
1896 takes care of this easy issue.
Other provisions of Congressman Shaw's excellent bill, such
as Section 205 that encourages S corporations to make
charitable contributions, H.R. 714 includes a similar
provision, and Section 302 that can significantly increase the
value of S corporation stock transferred as part of a divorce
decree by allowing an ex-spouse to utilize otherwise unusable
suspended losses. This provision would be even more family-
friendly if it were even expanded to cover other Section 1041
spousal transfers, which don't happen to be incident to
divorce.
Section 309 is important because it recognizes, by allowing
an increase in basis to a shareholder/lender's S corporation
indebtedness, that S corporations are frequently financed by
shareholders who in turn borrowed the money from somewhere
else, such as a related S corporation. Current law does not
allow such a basis increase because the loan is not traced
directly to the shareholder. Restructuring of such loans to
pass muster under current law is the subject of substantial
litigation and remains a major trap for the unwary. The AICPA
strongly supports Section 309.
Finally, we understand that Mr. Shaw is considering the
introduction of legislation that would remove one of the many
entry barriers facing startup and growing S corporations and
other small businesses; the current inability to elect to
operate on a natural business year other than a calendar year.
Such flexibility will provide young S corporations an
additional tool to navigate its start-up life cycle, and we
strongly support enactment of that legislation.
Mr. Chairman, time today does not permit us to adequately
praise the merits of the many provisions under consideration
today. We sincerely thank you for your time. Ms. MacDonough and
I would be happy to answer any questions you may have, and we
would be happy to work with you and your staffs as you look to
implement these important provisions. Thank you.
[The prepared statement of Mr. Zarzar follows:]
Statement of Robert A. Zarzar, Chair, Tax Executive Committee, American
Institute of Certified Public Accountants
The American Institute of Certified Public Accountants (AICPA)
appreciates the time and effort invested by the House Ways & Means
Subcommittee on Select Revenue Measures to explore the need to
modernize Subchapter S of the Internal Revenue Code. We strongly
believe that such a need exists and offer below our thoughts and
suggestions on H.R. 1896, The Subchapter S Modernization Act of 2003,
which we generally support.
The Small Business Job Protection Act of 1996 and subsequent
legislation has been very helpful in facilitating the use of S
corporations. However, a number of additional reform measures are
needed to: (1) clarify or correct existing legislation, or (2)
recognize and remove the anti-competitive limitations on the growth of
existing S corporations. Many of the needed changes have been addressed
in the above-mentioned bill, but some have not.
H.R. 1896, The Subchapter S Modernization Act of 2003
Sections 101 and 104: Members of family treated as 1 shareholder;
Increase in number of eligible shareholders to 150. Both Sections 101
and 104 increase the number of permissible shareholders in an S
corporation. Section 101 accomplishes this by providing that under
certain circumstances, all members of a family are treated as a single
shareholder. Section 104 simply increases the numeric limit.
We believe that an increase in the limit on the number of
shareholders either numerically or through attribution to make
Subchapter S more broadly available is generally a good policy.
However, Section 101 is fairly complex and its benefits are narrower in
scope relative to Section 104. It is not uncommon for a corporation to
exceed the current limitation on the number of shareholders as a result
of employee ownership; thus, while we are supportive of both
provisions, we believe that Section 104 should be given precedence over
Section 101. If an increase in the permissible number of shareholders
to 150 does not meet the needs of those interested in the family
shareholder provision, we suggest that the number be increased as
appropriate, or in the alternative, that the limit on the number of
eligible shareholders be removed entirely.
Sections 102, 201 and 202: Nonresident aliens allowed to be
shareholders; Issuance of preferred stock permitted; Safe harbor
expanded to include convertible debt. Each of these provisions is
important because they would fundamentally change the way some S
corporations raise funds to expand operations, hire employees, and
expand research capacity for new product development. S corporations
would find it easier to attract needed capital without complex
structuring or loss of S status. To help achieve this goal, proposed
Section 202(a) should be expanded to ensure that a loan from a venture
capital firm or similar business can qualify for the straight debt safe
harbor, even if such firm is primarily engaged in making equity
investments.
Allowing nonresident aliens to be S corporation shareholders, or
even holders of qualified preferred stock as defined in proposed
Section 201(a), would eliminate a financing barrier that would have
little cost to the government due to the extension of the partnership
withholding rules, yet would help border state (and other) S
corporations tremendously.
Sections 103, 401, 402 and 403: Expansion of bank S corporation
eligible shareholders to include IRAs; Exclusion of investment
securities income from passive income test for bank S corporations;
Treatment of qualifying director shares; Recapture of bad debt
reserves. The AICPA generally supports these provisions.
Sections 203 and 204: Repeal of excessive passive investment income
as a termination event; Modifications to passive income rules.
Termination of an S election simply because (1) the corporation has
earnings and profits remaining from its history as a C corporation,
regardless of whether the E&P was generated from passive income of the
type prohibited by IRC section 1375, and (2) it earns too much passive
income too often, does not further any rational policy goal. Consistent
with the personal holding company (PHC) rules of section 541 of the
Internal Revenue Code and following, the only penalty for generating
the ``wrong'' kind of income should be an additional tax on the
prohibited income, assuming a penalty must be imposed at all.
Terminating the S election would be paramount to a double penalty that
simply is not warranted. Repealing this terminating event will simplify
the Code and S corporation record keeping.
Increasing to 60 percent of gross receipts the amount of passive
investment income an S corporation may receive without being subject to
the passive investment income tax further and appropriately conforms
this tax to the PHC regime. Additionally, we support the removal of
capital gains on the sale of stocks and securities from the category of
passive investment income, which hasn't been a part of the PHC regime
for about 40 years.
We also suggest that IRC section 1375(a) be changed to lower the
tax rate on passive investment income to 15 percent, rather than tying
it to the highest rate in IRC section 11(b). We believe this was an
oversight in recently enacted Section 302(e) of the Jobs and Growth Tax
Relief and Reconciliation Act,\1\ where the rates for both the PHC and
the accumulated earnings tax were similarly reduced.
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\1\ P.L. 108-27.
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Section 205: Adjustment to basis of S corporation stock for certain
charitable contributions. We strongly support Section 205, which allows
a stock basis increase for appreciated property contributed to a
charity by an S corporation. Under current law, the Internal Revenue
Service's position is that an S corporation shareholder must reduce his
or her basis in the S corporation by the amount of any charitable
contribution deduction flowing through from the S corporation to the
shareholder. Thus, if an S corporation claims a fair market value
deduction for a contribution of appreciated property, the S corporation
shareholder must reduce his or her basis in the S corporation by such
value. In the case of a partnership, the Internal Revenue Service has
ruled that a partner's basis in his or her partnership interest should
be reduced by his or her pro rata share of the partnership's basis in
the property contributed. We believe that partnerships and S
corporations should be treated similarly with respect to charitable
contributions of property. Allowing a stock basis increase for
appreciated property contributed to a charity by an S corporation would
produce such a result and have the effect of preserving the intended
benefit of a fair market value deduction for the contributed
appreciated property, without recognition of the appreciation upon a
subsequent sale of the stock. Section 205 would encourage charitable
giving and remove a trap for unwary taxpayers who do not realize that
gifting appreciated property through an S corporation effectively
results in recognition of the gain inherent in the property when the
stock of the S corporation is disposed of in a taxable transaction.
Section 301: Treatment of losses to shareholders. Subsection (a)
provides that when an S corporation shareholder recognizes a loss upon
the liquidation of the corporation, the portion of the loss that does
not exceed the ordinary income basis of the shareholder's stock in the
S corporation shall be treated as an ordinary loss. This provision
appears to have the objective of allowing a shareholder to claim an
ordinary loss upon liquidation of an S corporation to the extent that
his or her basis in the S corporation is attributable to amounts
reported as ordinary income as a result of the complete liquidation.
This provision is certainly taxpayer favorable, because an ordinary
loss can offset ordinary income, which is generally subject to tax at a
significantly higher rate as compared to capital gain income, and is
also not subject to the limitations on the use of capital losses.
However, it is important to note that the provision may have the effect
of overriding certain ordinary income provisions that were enacted to
address concerns about receiving capital gains benefits for amounts
previously claimed as ordinary deductions (e.g., depreciation recapture
under IRC section 1245).
Subsection (b) clarifies that a shareholder's ability to deduct
suspended passive activity losses in any given year is not dependent on
the fact that an S corporation is generally not permitted to carry
items forward or back. This provision should be enacted, as it will
reduce litigation regarding the use of passive activity losses upon
conversion to S status.\2\
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\2\ See St. Charles Investment Co. v. Commissioner, 23 F.3d 773
(10th Cir. 2000).
---------------------------------------------------------------------------
Section 302: Transfer of suspended losses incident to divorce. IRC
section 1366(d)(2) treats a shareholder's portion of S corporation
suspended losses as incurred by the corporation with respect to that
shareholder in the succeeding tax year. Under regulation section
1.1366-2(a)(5), the suspended losses are personal to a shareholder and
cannot, in any manner, be transferred to another person. Thus, if a
shareholder transfers 100 percent of his or her stock, his or her
suspended losses are permanently disallowed. Accordingly, if, under IRC
section 1041(a)(2), a shareholder transfers all of his or her stock in
an S corporation to his or her former spouse as a result of divorce,
any suspended losses or deductions with respect to such stock cannot be
used by the spouse and, thus, disappear. This result is inequitable,
unduly harsh, and needlessly complicates property settlement
negotiations.
We support Section 302 because it allows for the transfer of a pro
rata portion of the suspended losses when S corporation stock is
transferred, in whole or in part, incident to divorce. We further
support the expansion of Section 302 to cover all IRC section 1041
transfers to encourage legitimate tax-free transactions between
spouses.
Section 303: Use of passive activity loss and at-risk amounts by
qualified subchapter S trust income beneficiaries. IRC section
1361(c)(2) limits the types of trusts permitted to be S corporation
shareholders. A qualified subchapter S trust (QSST) is one such
permitted shareholder. For purposes of the IRC section 678(a) grantor
trust rules, IRC section 1361(d)(1)(B) treats the QSSTs current income
beneficiary as the owner of the portion of the trust consisting of S
corporation stock. In effect, this causes the S corporation's items of
income, loss, deduction and credit to flow directly to the income
beneficiary.
When the QSST disposes of the S corporation stock, however,
regulation section 1.1361-1(j)(8) treats the QSST, and not the income
beneficiary, as the owner of the stock for purposes of determining and
attributing the tax consequences of the disposition. This regulation is
troublesome when the income beneficiary's flow-through losses are
suspended under the IRC section 469 passive activity loss rules. Under
IRC section 469(g), these suspended losses are freed up when a
taxpayer's entire interest in a passive activity is transferred to an
unrelated person in a fully taxable transaction. Because the income
beneficiary is the taxpayer who is entitled to the suspended passive
losses under the Code, but the trust is the taxpayer bearing the tax
consequences of the gain on the stock sale under the regulations,
current law is unclear about whether the QSST, the income beneficiary,
or neither benefits from the suspended losses after the QSST disposes
of the S stock. A similar problem arises where the losses are suspended
under the IRC section 465 at-risk rules.
Section 303 treats the income beneficiary as the taxpayer that
disposes of the stock and thus enables the beneficiary to utilize the
suspended passive losses at least when the disposition of the S
corporation stock represents a disposition of the beneficiary's entire
passive activity. It also has the effect of increasing the income
beneficiary's at-risk amount with respect to the S activity by the
amount of gain recognized by the QSST on a disposition of S stock.
The AICPA supports this provision because the suspended losses
would be freed up and utilized at the income beneficiary level and the
QSST would have the proceeds of the sale to pay tax on the gain.
Sections 304, 305, 306 and 307: Deductibility of interest expense
incurred by an ESBT to acquire S corporation stock; Disregard
unexercised powers of appointment in determining potential current
beneficiaries of ESBT; Clarification of ESBT distribution rules;
Allowance of charitable contributions deduction for electing small
business trusts. Under IRC section 641(c)(2)(C), the S portion of an
ESBT's taxable income is computed taking into account only (1) items
required to be taken into account under IRC section 1366; (2) gains or
losses from the disposition of S corporation stock; and (3) to the
extent provided in regulations, state and local income taxes or
administrative expenses allocable to items (1) or (2).
Current regulations provide that interest expense incurred by an
ESBT to acquire stock in an S corporation is allocable to the S portion
of the trust, but is not deductible because it is not an administrative
expense of the trust. While the position taken in the regulations may
be technically supportable, tax policy cannot support this result. All
other taxpayers are entitled to deduct interest incurred to acquire an
interest in a passthrough entity and to disallow an ESBT a deduction
for such interest is patently unfair. There is no indication that
Congress intended to place ESBTs at a disadvantage relative to other
taxpayers. Section 304 appropriately remedies this significant problem,
greatly reducing the barriers to using these family trusts. We note,
however, that a retroactive effective date should be applied to this
provision to enable interest deductions on amended returns of taxpayers
unaware of this trap at the time they structured purchases of such
stock.
In addition, the current definition of ``potential current
beneficiary'' is generally troublesome. In the context of powers of
appointment, typical provisions in such trusts, such definition
literally threatens the very use of ESBTs as S corporation
shareholders. A typical example of the problem it creates follows:
M creates a trust for the benefit of A. A also has a current power
to appoint income or principal to anyone except A, A's creditors, A's
estate, and A's estate's creditors. The potential current beneficiaries
of the trust will be A and all other persons except for A's creditors,
A's estate, and A's estate's creditors. This number will clearly exceed
the numerical shareholder limit, whether it remains at 75 or increases
to any finite number.
Section 305 removes the instability and trepidation of using ESBTs
that contain powers of appointment to plan for the succession of
family-owned S corporations. Nevertheless, we question whether there
exists a need for eligibility restrictions on using ESBTs since the
ESBT is taxed at the highest marginal rate, currently 35 percent, thus
minimizing abuse to which they might otherwise be susceptible.
Section 306 conforms the ESBT distribution rules as they apply to
the S and non-S portions of this unique trust to normal Subchapter J
concepts regarding the treatment of separate shares.
It appears that Section 307 is intended to allow the S portion of
an ESBT to claim a charitable contribution deduction for gifts of S
corporation stock. It is unclear as to whether or not Section 307
accomplishes this and we believe that it may be necessary to modify the
language to ensure the desired result and avoid unanticipated results.
We would be happy to work with you in drafting appropriate revisions to
this language.
Section 309: Back to back loans as indebtedness. The AICPA strongly
supports Section 309. This provision removes a significant trap for the
unwary, especially shareholders of small S corporations. IRC section
1366(d)(1) limits the amount of a shareholder's pro rata share of
corporate losses that may be taken into account to the sum of (1) the
basis in the stock, plus (2) the basis of any shareholder loans to the
S corporation. The debt must run directly to the shareholder for the
shareholder to receive basis for this purpose; the creditor may not be
a person related to the shareholder. It is not uncommon for the
shareholders of an S corporation to own related entities. Often times,
loans are made among these related entities. Under current law, it is
extremely difficult for the shareholders of an S corporation to
restructure these loans in order to create basis in the S corporation
against which losses of the S corporation may be claimed. The ability
to create loan basis through the restructuring of related party loans
has been the subject of substantial litigation and is an area of much
uncertainty. Section 309 will protect these taxpayers from an unfair
and unwarranted fate by providing that true indebtedness from an S
corporation to a shareholder increases IRC section 1366(d) basis,
irrespective of the original source of the funds to the corporation.
Section 501: Relief from inadvertently invalid qualified subchapter
S subsidiary (QSub) elections and terminations. Under IRC section
1362(f), the IRS has authority to grant relief if a taxpayer
inadvertently terminates its S corporation election or inadvertently
makes an invalid S corporation election. The proposed QSub regulations
would have allowed taxpayers to seek similar relief in the case of
inadvertent terminations of QSub status. However, the final QSub
regulations eliminated this relief because of IRS concerns about the
scope of its statutory authority. It is virtually certain that
taxpayers will inadvertently make invalid QSub elections or terminate
QSub status. Section 501 will be very helpful because it permits the
Service appropriate discretion to grant relief in such cases, applying
standards similar to those currently used in the case of inadvertently
invalid S corporation elections and terminations.
Section 503: Treatment of the sale of interest in a qualified
subchapter S subsidiary. Under current law, an S corporation may be
required to recognize 100 percent of the gain inherent in a QSub's
assets if it sells anywhere between 21 and 100 percent of the QSub
stock. Many taxpayers that sell less than 100 percent will be
unpleasantly surprised by this trap for the unwary. This result is
counter to sound tax policy because the S corporation, in effect, is
required to recognize gain on assets without making any disposition of
those assets. The QSub regulations include an example suggesting that
this result can be avoided by merging the QSub into a single member LLC
prior to the sale, then selling an interest in the LLC (as opposed to
stock of the QSub). The law should be simplified to remove this trap
and to eliminate needless restructuring to avoid an inappropriate tax
result. Section 503 causes an appropriate percentage of gain to be
recognized while removing the complicated and needless restructuring
requirement.
Section 504: Exception to application of the step transaction
doctrine for restructuring in connection with making qualified
subchapter S subsidiary elections. The intent of Congress seemed clear
in 1996 when it explained ``[U]nder the provision, if an election is
made to treat an existing corporation . . . as a qualified subchapter S
subsidiary, the subsidiary will be deemed to have liquidated under IRC
sections 332 and 337 immediately before the election is effective.''
\3\ This ``guarantee'' of tax-free QSub elections is expected by S
corporation taxpayers who are not accustomed to the complex judicial
doctrines of Subchapter C and, if respected, would eliminate a trap
created from the Service's interpretation of the statute. We note that
while there may be technical justification for application of the step
transaction doctrine, congressional intent, simplicity concerns
inherent in S corporations, and the fact that most S corporation
taxpayers would unintentionally subject their transactions to
significant and avoidable taxation, warrants the statutory
clarification proposed in Section 504.
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\3\ See H.R. Rep. No. 104-586 at 89 (1996)
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Section 601: Elimination of all earnings and profits attributable
to pre-1983 years. Section 1311 of the Small Business Job Protection
Act of 1996 eliminated certain pre-1983 earnings and profits of S
corporations that had S corporation status for their first tax year
beginning after December 31, 1996. This provision should apply to all
corporations (C and S) with pre-1983 S earnings and profits without
regard to when they elect S status. There seems to be no policy reason
why the elimination was restricted to corporations with an S election
in effect for their first taxable year beginning after December 31,
1996.
Section 602: No gain or loss on deferred intercompany transactions
because of conversion to S corporation or qualified subchapter S
subsidiary. We support this provision because it is consistent with the
policy behind the consolidated return provisions relating to
intercompany transactions, which is that the gain should be deferred
until property leaves the economic unit consisting of the consolidated
group. Simply electing S corporation or QSub status should not cause a
triggering of these gains. We note, however, that a modification to IRC
section 1374, relating to the built-in gain tax, may be warranted to
ensure that such gains do not inappropriately escape corporate level
taxation.
Other Legislative Recommendations
H.R. 1896, if enacted, would address many of the issues currently
faced by S corporations and corporations desiring to elect S
corporation status. However, there are other concerns that are not
addressed by the legislation. Two of these concerns are discussed
below.
Elimination of LIFO Recapture Tax. Often times the most significant
hurdle faced by a corporation desiring to elect S corporation status is
the LIFO recapture tax under IRC section 1363(d). In many cases, this
tax makes it cost-prohibitive for a corporation to elect S status. The
LIFO recapture tax was enacted in 1987 in response to concerns that a
taxpayer using the LIFO method of accounting, upon conversion to S
corporation status, would avoid corporate level tax on LIFO layers
established while the corporation was a C corporation. While this may
be a legitimate policy concern, to require the inclusion of the LIFO
reserve into income upon conversion to S status to address this concern
appears unwarranted. We recommend that IRC section 1363(d) be repealed
and that IRC section 1374 be amended to provide that the ten year
recognition period not apply with respect to any LIFO inventory held by
a corporation on its date of conversion to S status.
Expansion of post-termination transition period to include filing
of amended return. We also suggest that the post-termination transition
period of IRC section 1377(b)(1) be expanded to include the filing of
an amended return for an S year. We recognize that there is no
statutory provision permitting the filing of an amended return; such a
return is a ``creature of administrative origin and grace.'' If it is
not possible to codify the above recommendation, the bill should
require the Secretary of the Treasury to prescribe this result by
regulation. To prevent abuses, it may be advisable to limit the amount
of losses that may be taken into account under IRC section 1366(d)(3)
and the amount of distributions that may be taken into account under
IRC section 1371(e) to the net increase in a shareholder's basis
resulting from the adjustments made on the amended return giving rise
to the post-termination transition period.
Ability to elect fiscal years. We recognize the difficulties--
particularly in today's economic environment--for start-up businesses
to make it through the first several years of their existence. A very
substantial percentage of those new businesses are S corporations. One
of the barriers to efficient operation of these start-ups is the
artificial requirement that, generally, all such new S corporations
(and partnerships) must use a calendar year as their tax year,
regardless of what their ``natural'' business year would be.
Therefore, we would like to call your attention to, and express our
appreciation for, the efforts of Congressman Shaw, to promote
legislation that proposes to give most small business start-ups an
additional tool to successfully navigate its start-up life cycle by
providing the flexibility to adopt any fiscal year-end from April
through December. Such flexibility would (1) allow start-ups to spread
their workloads and ease recordkeeping burdens; (2) maximize their
access to professional advisors; and (3) provide them with additional
operating resources. With the continued interest that small businesses
have in electing S corporation status and with the important progress S
corporations will achieve with the enactment of the H.R. 1896
provisions, allowing S corporations fiscal year flexibility will
likewise enhance small business survival.
* * * * *
Thank you for taking the time to request and consider our input as
a part of today's hearing on S Corporation Modernization. The AICPA
would be happy to work with this Subcommittee and its staff as it
explores the possibility of moving these important changes forward. You
may contact Robert Zarzar, Chair of the Tax Executive Committee at
(202) 414-1705 or [email protected]; Kenneth N. Orbach, Chair of
the S Corporation Taxation Technical Resource Panel at (561) 297-2779
or [email protected]; or Marc A. Hyman, AICPA Technical Manager at (202)
434-9231 or [email protected].
Chairman MCCRERY. Thank you, Mr. Zarzar. I am told that Ms.
MacDonough is not going to testify, that being from Ernst &
Young, she is just here to keep an eye on Pricewaterhouse.
[Laughter.]
Mr. ZARZAR. Well said, but she will provide some technical
support to some questions you may have. Thank you.
Chairman MCCRERY. Yes, sir. Mr. Cloutier?
STATEMENT OF C.R. ``RUSTY'' CLOUTIER, PRESIDENT AND CHIEF
EXECUTIVE OFFICER, MIDSOUTH BANK, LAFAYETTE, LOUISIANA, ON
BEHALF OF AND CHAIRMAN, INDEPENDENT COMMUNITY BANKERS OF
AMERICA
Mr. CLOUTIER. Mr. Chairman, Ranking Member, Ms. Tubbs
Jones, and Members of the Subcommittee, my name is Rusty
Cloutier. I am Chairman of the ICBA and President of MidSouth
Bank, a $400 million community bank located in Lafayette,
Louisiana. I am pleased to appear today on behalf of the ICBA
to share with you our views to reform and simplify Subchapter S
corporation rules.
For generations, independent banking institutions have
played a special role in American communities and in thousands
of neighborhoods. The bulk of our Nation's commercial banks are
community banks. Community-based banks remain the underpinning
of millions of consumers' family-owned business, local
merchants, manufacturers, and family farms which depend on the
availability of local bank lending for their credit needs.
Importantly, community banks serve as a key source of
credit and other financial services to small business, the most
prolific job creation sector of our economy. Allowing community
banks to operate more efficiently as Subchapter S enables them
to improve their viability and helps prevent the punitive of
double taxation of income, a goal of a sound tax and economic
policy.
The recent tax relief bill passed by Congress and signed
into law by President Bush made great strides in reducing
punitive double taxation of corporation income by reducing the
tax on dividends.
As our Nation continues to debate tax policy options to
foster economic growth, enhance savings, and job opportunities,
the ICBA believes reforming the onerous Subchapter S rules will
be greatly beneficial.
The ICBA has researched and has recommended several S
corporation simplification measures for consideration that we
believe will improve the viability of more small businesses and
community-based banks. We are delighted that many of these
simplification measures have been introduced in the 108th
Congress. The ICBA supports the important Subchapter S reform
bills being examined here today, especially H.R. 714, the Small
Business and Financial Institution Tax Relief Act, introduced
by Representative Scott McInnis. The ICBA urges the Committee
on Ways and Means Members to support this much-needed reform
legislation to help ensure its enactment in the current
Congress.
Community banks only recently were able to avoid punitive
double taxation by electing Subchapter S. In 1996, Congress
passed the Small Business Job Protection Act (P.L. 104-188)
that allowed small banks to be eligible to elect Subchapter S
corporations status for the first time.
For example, since 1997, 23 of the 147 commercial banks in
my State of Louisiana had elected the benefits of Subchapter S
tax structure. Unfortunately, Mr. Chairman, many small
community banks have been obstructed from converting to S
corporation status and benefited from Congress's intended
relief because of the complex rules that we would like to have
addressed with tax simplification.
This conclusion was further supported by a comprehensive
U.S. General Accounting Office study in June 2000. Notably, an
additional 16 percent of all small community banks surveyed
indicated that they are interested in making the declaration of
Subchapter S election, pending resolution of the various
Subchapter S glitches that prohibit this tax status.
Currently, before making the S corporation election, many
community banks must first overcome some difficult obstacles
not faced by other corporate tax structures such as limited
liability partnerships (LLPs) or LLCs.
The obstacles most often outlined by community bankers
include the existing limitations on the types of shareholders,
existing limitations on the number of shareholders, limitations
on options for raising capital, specifically the inability to
issue preferred stock, and uncertainty regarding the passive
income tax investment rules and the uncertainty regarding the
treatment of director's shares.
The ICBA strongly supports H.R. 714 and other excellent
Subchapter S reform bills now pending in Congress because they
would help reduce many of the ambiguities and obstacles in the
current law. Passing H.R. 714 would enhance the ability of
community banks to be able to utilize Subchapter S status as
intended by Congress.
The ICBA's top S corporation reform recommendations to this
Committee include allowing IRA shareholders to be eligible as
Subchapter S corporation shareholders. Many community banks
have been caught in the unintended trap of having the law
passed in 1996 when they had existing IRA shareholders. We
would recommend that the shares people owned before 1997 be
allowed.
The ICBA recommends allowing community bank S corporations
to issue certain preferred stock. We also recommend reforming
the treatment of bank director shares, and we recommend
increasing the number of Subchapter S corporation shareholders
to 150 and counting family members as one shareholder.
In conclusion, the Tax Code simplification in the S
corporation area would go a long way in allowing community-
based banks to convert to an S corporation status, as Congress
intended.
We enthusiastically support the bipartisan Subchapter S
reform bills H.R. 714, H.R. 1896, and H.R. 1498. Each of these
bills would help community banks better utilize Subchapter S
status and improve their ability to provide the needed capital
and credit in their communities.
Mr. Chairman, ICBA looks forward to working with you on
this legislation and are happy to answer any questions today.
Thank you.
[The prepared statement of Mr. Cloutier follows:]
Statement of C.R. ``Rusty'' Cloutier, President and Chief Executive
Officer, MidSouth Bank, Lafayette, Louisiana, on behalf of and
Chairman, Independent Community Bankers of America
Mr. Chairman, Ranking Member McNutly, and members of the Committee,
my name is Rusty Cloutier. I am Chairman of the Independent Community
Bankers of America (``ICBA'') \1\ and President of MidSouth National
Bank, a $400 million community bank located in Lafayette, Louisiana. I
am pleased to appear today on behalf of the Independent Community
Bankers of America to share with you our views on ways to reform and
simplify subchapter S corporation rules. Allowing small businesses to
operate as Subchapter S entities helps prevent the punitive double
taxation of income, a key goal of sound tax policy.
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\1\ ICBA is the primary voice for the nation's community banks,
representing some 4,600 institutions with 17,000 locations nationwide.
Community banks are independently owned and operated and are
characterized by attention to customer service, lower fees and small
business, agricultural and consumer lending. ICBA's members hold more
than $526 billion in insured deposits, $643 billion in assets and more
than $402 billion in loans for consumers, small businesses and farms.
For more information visit www.icba.org.
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The Independent Community Bankers of America greatly appreciates
the opportunity to contribute several Code simplification suggestions
for consideration that we believe will improve the viability of more
small businesses and community-based banks. These simplifications
measures have been adopted from a comprehensive ICBA/Grant Thornton LLP
tax study and focus on simplification of restrictive S corporations
rules.\2\ We are delighted that many of these simplification measures
have been drafted into legislation pending in the 108th Congress. ICBA
supports these important subchapter S reform bills, which include:
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\2\ ``Community Bank Tax Relief and Simplification Options,'' a
study prepared for the Independent Community Bankers of America by
Grant Thornton LLP, 2003.
The ``Small Business and Financial Institutions Tax
Relief Act of 2003,'' H.R. 714, introduced by Rep. Scott McInnis (R-CO)
of the House Ways and Means Committee.
The ``Subchapter S Modernization Act of 2003,'' H.R.
1896, introduced by Rep. Claw Shaw (R-FL) and Rep. Bob Matsui (D-CA) of
the Ways and Means Committee.
The ``Small Business Opportunity and Growth Act of
2003,'' H.R. 1498, introduced by Rep. Jim Ramstad (R-MN).
We applaud these excellent legislative efforts to simplify the
current onerous and restrictive subchapter S corporation rules so that
small businesses can benefit from a more user-friendly tax code. The
ICBA urges the Ways and Means Committee members to support these much-
needed reform measures and to help ensure they are enacted in the
current Congress.
Background
In 1996, Congress passed the Small Business Job Protection Act of
1996 that allowed small banks to be eligible to elect S Corporation
status for the first time starting in tax year 1997.\3\
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\3\ Public Law 104-188.
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Unfortunately, many community banks have been obstructed from
converting to S corporations and benefiting from Congress's intended
relief because of technical rules and community-bank specific
regulations that could be addressed with tax simplification measures.
This conclusion was further supported by a comprehensive General
Accounting Office study in June, 2000.\4\
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\4\ U.S. General Accounting Office, ``Banking Taxation,
Implications of Proposed Revisions Governing S-Corporations on
Community Banks,'' June 2000. (GAO/GGD-00-159).
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Notably, an additional 16 percent of all the small banks recently
surveyed indicated that they were interested in making the S
Corporation election pending resolutions of the various subchapters S
glitches that prohibit using this tax status.\5\
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\5\ Grant Thornton LLP, Ninth Annual Survey of Community Bank
Executives.
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Currently, before making the S Corporation election community banks
must first overcome some difficult obstacles not faced by other
corporate tax structures such as Limited Liability Partnerships (LLPs)
or Limited Liability Corporations (LLCs) while attempting to avoid
disrupting their operations or disenfranchising many of their existing
shareholders.\6\ The obstacles most often outlined by community bankers
include:
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\6\ Ibid.
Existing limitations on the types of shareholders,
Existing limitations on the number of shareholders,
Limitations on the options for raising capital (e.g.,
inability to issue preferred stock),
Uncertainty regarding the possible application of the
passive investment income tax, and
Uncertainty regarding the treatment of director's shares.
The excellent subchapter S reform bills now pending in Congress
would help reduce many of these ambiguities and obstacles in the
current law and would enhance the ability of community banks to be able
to utilize S Corporation status as intended by Congress.
ICBA Recommended Subchapter S Reforms
Allow IRAs as Eligible S Corporation Shareholders
Current law severely restricts the types of individuals or entities
that may own S Corporation stock.\7\ For tax years beginning after
December 31, 1997, acceptable S Corporation shareholders generally
include:
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\7\ Internal Revenue Code Sec. 1361(b)(1).
Any individual, except for a nonresident alien;
Estates;
Certain trusts;
Certain tax-exempt organizations; and
Employee stock ownership plans (ESOPs).
Individual Retirement Accounts (IRAs) are not eligible S
Corporation shareholders. Many community banks have been caught in an
unintended trap because they had IRA shareholders prior to the 1996 law
change that allowed banks to choose subchapter S status the first time
in tax year 1997. Eliminating ineligible classes of stock and
ineligible shareholders prior to the beginning of the first S
Corporation tax year has been a significant barrier to community banks
otherwise interested in making the S election. IRAs often hold
significant portions of bank stock, thereby limiting banks' ability to
elect S Corporation status. In many cases, banks find it virtually
impossible to eliminate the significant amount of stock owned by IRAs
due to capital constraints.
To address this community bank IRA shareholder glitch that prevents
the viable use of subchapter S, ICBA recommends allowing IRAs to hold S
Corporation stock. Specifically, ICBA recommends grandfathering
existing community bank IRA shareholders in place as of 1997 and not
taxing IRA shareholders on the S Corporation earnings allocated to the
IRA shareholders in a manner consistent with the treatment of S
Corporation earnings allocated to ESOPs.
ICBA believes this reform will grant more community banks, now
obstructed from making the S Corporation election, the added
flexibility they need to have in dealing with IRA shareholders.
Community banks interested in making the S Corporation election would
no longer need to compel IRA shareholders to either sell their shares
to the community bank or to third parties who are eligible S
Corporation shareholders. In many cases, eliminating IRA shareholders
proves an impossible task or in some cases, buyout costs puts a severe
strain on community bank capital.
ICBA believes including IRA shareholders as eligible S Corporation
shareholders by grandfathering existing bank IRA shares would provide
significant relief to community banks and eliminate the high cost of
eliminating bank stock held in IRAs
Exempt Sale of Community Bank Stock by IRA to IRA Owner from
Prohibited Transaction Treatment
Another alternative recommended reform to address the IRA
shareholder problem that often prevents converting to subchapter S is
to exempt the sale of community bank IRA-held stock from prohibitive
transaction tax treatment. Under current law, the sale of IRA assets to
a ``disqualified party'' is a prohibited transaction.\8\ Prohibited
transactions are defined in Internal Revenue Code Sec. 4975.\9\
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\8\ Internal Revenue Code Sec. 4975(c)(1)(A).
\9\ Internal Revenue Code Sec. 408(e)(2)(A).
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However, the owner of the IRA is a disqualified party and is
prohibited from purchasing the community bank's stock from the IRA. The
sale of plan assets to a disqualified party is prohibited no matter
what price the owner is willing to pay the IRA for the stock. The
penalty to an IRA for entering into a prohibited transaction is harsher
than that applied to a prohibited transaction by a qualified plan. IRAs
that participate in prohibited transactions taint the entire fund and
the tax exemption is lost. The account ceases to be an IRA on the first
day of the taxable year in which the prohibited transaction occurs.\10\
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\10\ Internal Revenue Code Sec. 408(e)(2).
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IRAs frequently hold community bank stock, resulting in a
significant obstacle to banks that desire to make the S Corporation
election. Only ``qualified'' plans, not IRAs, can be shareholders in an
S Corporation. Accordingly, if a community bank decides to convert to S
Corporation status, it must re-purchase the stock from the IRA. Often,
the owner of the IRA does not want to give up the future benefit of
stock ownership, and would like to purchase the stock from the IRA
rather than having the community bank redeem the stock. The Department
of Labor has granted exemptions, on a case-by-case basis, from the
prohibited transaction rules when the IRA wanted to sell stock to a
disqualified party.\11\ However, applications must be submitted for
each individual case and are time consuming and expensive.
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\11\ (PTE 98-59) 63 FR 69326, 12/16/98 (25 BPR 2673, 11/16/98).
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ICBA recommends allowing owners of IRAs holding the stock of a
community bank making the S Corporation election to purchase the
subject securities from the IRAs. This can be accomplished by amending
IRC Sec. 4975 or IRC Sec. 408 to alleviate the penalty associated with
an IRA selling one of its assets to its owner.
This reform would make it easier for community banks interested in
making the S Corporation election to eliminate ineligible IRA
shareholders. Community banks will not have to drain valuable resources
to buy back stock held in IRAs. Therefore, more community banks will be
able to make the S Corporation election and improve their competitive
position by avoiding the double taxation of income that applies to C
Corporation banks.
Allow Community Bank S Corporations to Issue Certain Preferred Stock
Current law only allows S Corporations to have one class of stock
outstanding.\12\ C Corporations that want to make the S Corporation
election must eliminate any second class of stock prior to the
effective date of the S Corporation election. Issuing a second stock
class by the S Corporation terminates its S Corporation status.
Community banks must maintain certain minimum capital ratios to be
considered a well-capitalized institution for regulatory purposes. As a
community bank grows in size, its earnings alone may not provide
sufficient capital to fund its growth. Banks needing more capital can
raise additional capital by issuing common stock, preferred stock, or,
in some cases, trust-preferred securities.
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\12\ Internal Revenue Code Sec. 1361(b)(1)(D).
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Many community banks avoid issuing additional common stock to fund
growth so that they can protect their status as an independent
community bank and serve their local community lending needs. Instead,
they frequently use preferred stock to fund growth and retain control.
However, S Corporation banks are not allowed to issue preferred stock
because preferred stock is considered a second class of stock. This
prevents small community banks from having access to an important
source of capital vital to the economic health and stability of the
bank and the community it serves.
ICBA recommends exempting convertible or ``plain vanilla''
preferred stock from the ``second class of stock'' definition used for
S Corporation purposes. This would help more community banks become
eligible to make the S Corporation election as well as help those that
currently have preferred stock outstanding would choose S Corporation
status. Allowing bank S Corporations to issue preferred stock would
allow them to reduce the burden of double taxation and, at the same
time, fund future growth.
Reform the Treatment of Director Qualifying Stock for Purposes of the
S Corporation and QSSS Elections
Because an S Corporation may have only one class of stock
outstanding,\13\ in most cases, the S Corporation election is
terminated if the bank issues a second class of stock. A director of a
national bank is generally required to own stock in the bank to assure
that the individual has a sufficient financial interest in the bank to
be vigilant in protecting the bank's interests.\14\ A number of states
have similar requirements for state chartered banks. In some cases, the
state may require bank directors to hold bank subsidiary stock.
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\13\ Internal Revenue Code Sec. 1361(b)(1)(D).
\14\ 12 U.S.C. section 72.
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In some cases, stock issued by community banks or their holding
companies to bank directors may not convey all of the economic
interests conveyed to other shareholders. This type of director
qualifying stock is issued solely to comply with the federal or state
regulatory requirements. However, in this situation, the IRS may still
determine that director qualifying stock is a second class of stock due
to economic restrictions. Such an action by the IRS makes the bank
ineligible to make the S Corporation election. Current rules are
ambiguous as to whether director-qualifying stock, subject to
substantial economic restrictions, held at the bank subsidiary level
prevents the parent from making the Qualified Subchapter S Subsidiary
(QSSS) election.\15\ Consequently, many banks with restricted
director's stock have undoubtedly been weary of making the S
Corporation election given the uncertainty surrounding the treatment of
director qualifying stock. A number of banks are waiting for definitive
IRS guidance on this issue. The results of a Grant Thornton's survey of
community bank executives indicated that the uncertainty of the
treatment of director qualifying stock is a significant obstacle for
over 6 percent of the banks that are considering making the S
Corporation election.\16\
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\15\ The Small Business Job Protection Act added IRC
Sec. 1361(b)(3) that allows an S corporation to own a qualified
subchapter S subsidiary (QSSS). A subsidiary qualifies as a QSSS if:
the subsidiary would be eligible to elect subchapter S
status if its stock were owned directly by the shareholders of its S
corporation parent;
the S corporation parent owns 100 percent of the
subsidiary's stock; and
the parent elects to treat the subsidiary as a QSSS.
If the QSSS election is made, the subsidiary is not treated as a
separate taxable entity, and all the assets, liabilities, and items of
income, deduction, and credit of the subsidiary are treated as the
assets, liabilities, and items of income, deduction, and credit of the
parent S corporation.
\16\ ``Community Banks: A Competitive Force,'' Sixth Annual Survey
of Community Bank Executives, Grant Thornton LLP.
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ICBA recommends not treating director-qualifying stock, subject to
substantial economic restrictions, when issued by bank S Corporations
or by bank subsidiaries of an S Corporation bank holding company, as
stock for S Corporation purposes. Additionally we recommend excluding
bank director shares required by bank regulations from inclusion in the
number of shareholders subject to the limitation under subchapter S
rules. ICBA believes more banks will be able to make the S Corporation
election when the uncertainty surrounding the treatment of director
qualifying stock is eliminated.
Increase Maximum Number of S Corporation Shareholders to 150 and Count
Family Members as One Shareholder
When the S Corporation rules were first enacted, the maximum number
of shareholders was 10.\17\ Throughout the period 1976-1982 Congress
made a series of legislative changes to increase the number to 35. The
Small Business Job Protection Act increased the maximum number of
eligible S Corporation shareholders from 35 to 75 for tax years
beginning after December 31, 1996.\18\
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\17\ See former Internal Revenue Code Sec. 1371(a)(1), as in effect
for taxable years starting before January 1, 1977.
\18\ Internal Revenue Code Sec. 136(b)(1)(A).
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In many cases community banks have made a decision to assure that
their institutions are widely owned, often by members of the
communities they serve. The provision of the S Corporation rules
limiting the number of shareholders to no more than 75 often forces
community banks that wish to become an S corporation to disenfranchise
shareholders, severely limit ownership and its ability to raise capital
in the future. Additionally, other corporate structures such as a LLP
or LLC do not have any limitation on the number of shareholders.
Unfortunately, community banks with more than 75 shareholders that
decide that making the S Corporation election is beneficial must
somehow force out some of their shareholders--even when they would
prefer to be more broadly held. Efforts to force shareholders out
through a reverse stock split or through the formation of a new holding
company is generally a very thorny and expensive alternative.
ICBA recommends increasing the maximum number of allowable S
Corporation shareholders to 150 and counting family members that are
not more than three generations removed from a common ancestor as one
shareholder for purposes of the shareholder limitation. ICBA believes
that increasing the number of allowable shareholders will allow more
community banks to make the S Corporation election and, at the same
time, continue to be widely owned by members of their communities.
Exclude Bank Income from Passive Investment Income Tax
S Corporations with accumulated C Corporation earnings and profits
are subject to a 35 percent tax on ``passive investment income''
exceeding 25 percent of gross receipts for any year.\19\ Additionally,
a company's S Corporation status is terminated if the 25 percent limit
is exceeded for three consecutive years.\20\ Passive investment income
generally includes:
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\19\ Internal Revenue Code Sec. 1375(a).
\20\ Internal Revenue Code Sec. 1362(d)(3)(A).
Royalties
Rents
Dividends
Interest
Annuities, and
Gains on sales of stock and securities.\21\
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\21\ Internal Revenue Code Sec. 1362(d)(3)(C)(i).
Passive investment income does not include gross receipts directly
derived from the active and regular conduct of a lending or finance
business.\22\ Gross receipts directly derived in the ordinary course of
a trade or business of lending or financing include gains (as well as
interest income) from loans originated in a lending business. Interest
earned from the investment of idle funds in short-term securities,
however, does not constitute gross receipts directly derived in the
ordinary course of business.\23\ IRS Notice 97-5 generally provides
that gross receipts directly derived in the ordinary course of a
banking business are not passive investment income for purposes of the
passive investment income tax. Income from the following assets are
considered part of the active and regular conduct of a banking
business:
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\22\ Internal Revenue Code Sec. 1362(d)(3)(C)(iii).
\23\ Treas. Reg. Sec. 1.1362-2(c)(5)(iii)(B)(2).
Loan, participations, or REMIC regular interests; \24\
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\24\ All loans and REMIC regular interests owned, or considered to
be owned, by the bank regardless of whether the loan originated in the
bank's business. For these purposes, securities described in section
165(g)(2)(C) are not considered loans.
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Equity investments needed to conduct business (FHLB stock
etc.); \25\
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\25\ Assets required to be held to conduct a banking business (such
as Federal Reserve Bank, Federal Home Loan Bank, or Federal
Agricultural Mortgage Bank stock or participation certificates issued
by a Federal Intermediate Credit Bank which represent nonvoting stock
in the bank).
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Assets pledged to a 3rd party to secure deposits or
business; \26\ and
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\26\ Assets pledged to a third party to secure deposits or business
for the bank (such as assets pledged to qualify as a depository for
federal taxes or state funds).
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Investment assets needed for liquidity or loan
demand.\27\
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\27\ Investment assets (other than assets specified in the
preceding paragraphs) that are held by the bank to satisfy reasonable
liquidity needs (including funds needed to meet anticipated loan
demands).
As a result, income and gain from these assets will not be
considered subject to the passive investment income limitation
applicable to S Corporations.
Treasury and the IRS believe that the special provisions of the
Internal Revenue Code that apply to banks should apply only to the
specific state-law entity that qualifies as a bank under IRC Sec. 581.
They believe that the special bank treatment of items should not apply
to nonbanks, even if the nonbank is affiliated with a bank and the
parent makes the Qualified Subchapter S Subsidiary (QSSS) election with
respect to all of its subsidiaries.\28\
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\28\ The Small Business Job Protection Act added IRC
Sec. 1361(b)(3) permitting an S Corporation to own a qualified
subchapter S Subsidiary (QSSS). A subsidiary qualifies as a QSSS if (1)
the subsidiary would be eligible to elect subchapter S status if its
stock were owned directly by the shareholders of its S Corporation
parent; (2) the S Corporation parent owns 100 percent of the
subsidiary's stock; and (3) the parent elects to treat the subsidiary
as a QSSS. If the QSSS election is made, the subsidiary is not treated
as a separate corporation for tax purposes, and all the assets,
liabilities, and items of income, deduction, and credit of the
subsidiary are treated as the assets, liabilities, and items of income,
deduction, and credit of the parent S Corporation.
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The amount of investment assets needed for liquidity or loan demand
can be very subjective, with most banks not wanting to gamble that an
IRS agent may disagree with their estimates. Banks find this
uncertainty regarding the possible application of the passive
investment income tax (and possible S Corporation termination) to be
problematic and many have delayed or discarded their decision to make
the S Corporation election.
ICBA recommends excluding bank income from the passive investment
income tax imposed by IRC Sec. 1375, effective for tax years beginning
after December 31, 1996. Bank income would be defined as all income
from any corporate entities that qualify as a bank under IRC Sec. 581
and from any 100 percent owned subsidiaries of a bank.
ICBA believes that reforming the onerous passive income rules will
eliminate the uncertainty of the unintended application of the passive
investment income tax (and possible S Corporation termination). Banks
no longer will have the potentially significant and uncertain treatment
of passive investment income hanging over their decision-making
process. By treating all bank income as earned from the active and
regular conduct of a banking business, banks will no longer face the
conundrum of evaluating investment decisions based on tax
considerations rather than on more important safety and economic
soundness issues.
Conclusion
Tax code simplification in the S corporation area would go a long
way in allowing community-based banks to convert to S corporation
status as Congress intended in 1996. Many community banks and small
businesses find that current technical barriers to making the
conversion from a C Corporation to an S Corporation are too great to
overcome. Current restrictions and complicated rules for S Corporation
status make the conversion from C Corporation status unattainable for
many community banks, thwarting Congress's intended relief from
punitive double taxation. ICBA believes reforming and simplifying
onerous subchapter S corporation rules will create a tax code that is
small-business friendly and improve community banks' ability to meet
the lending needs in their local communities
Restrictions on S Corporation stock ownership and the shareholder
limit are, in general, some of the most difficult hurdles for community
banks to overcome. These S corporation restrictions do not apply to
other corporate forms of business. The limit on the number of S
Corporation shareholders continues to pose a significant barrier to
many community banks. Often, community bank ownership has passed from
generation to generation, expanding with each generation. It does not
take many generations of family growth for community banks to exceed
the S Corporation stockholder limit.
The ICBA recommends several subchapter S Corporation rule changes
that would greatly simplify the ability for community banks to elect
Subchapter S status as Congress intended. These include, grandfathering
bank IRA shareholders as eligible S corporation shareholders, allowing
community bank S corporations to issue preferred stock, reforming
onerous director's share rules, increasing the allowable number of S
Corporation shareholders to 150, treating family members as one
shareholder, and reforming the application of passive income rules.
The ICBA is delighted to see the Ways and Means Committee examining
the reform options presented in the solid subchapter S reform bills now
pending in the 108th Congress. We enthusiastically support the
bipartisan subchapter S reform bills: H.R. 714, H.R. 1896, and H.R.
1498. Each of these bill would help community banks better utilize
subchapter S tax status and improve their ability to provide needed
capital and credit in their local communities.
Thank you Mr. Chairman for the opportunity to appear before you
today. ICBA looks forward to working with you and the committee to
ensure the enactment of beneficial S corporation reforms.
Chairman MCCRERY. Thank you, Mr. Cloutier. Mr. True?
STATEMENT OF DAVE TRUE, OWNER, TRUE RANCHES, CASPER, WYOMING,
ON BEHALF OF THE NATIONAL CATTLEMEN'S BEEF ASSOCIATION
Mr. TRUE. Thank you very much, Mr. Chairman and Ranking
Member of this Subcommittee, for the opportunity to be here
with you today.
My name is Dave True and I, with my family, own True
Ranches, a calf and cattle-feeding operation in the Eastern
third of Wyoming. In addition to this cattle operation, our
family is actively involved in a few other businesses. We are
engaged in the energy industry, through the operations of
exploration and production of oil and gas, drilling rigs,
trucking services, pipelines, oil field supply, and marketing
services.
Additionally, our family owns a community bank with $300
million in footing. So, the proposed Subchapter S modifications
affecting banking, especially the qualified director's shares
provision, are of interest to us also.
I am here today representing the NCBA and our nearly
250,000 members and affiliate members nationwide. The NCBA
follows a very simple and straightforward mission of working to
increase profit opportunities for cattle and beef producers by
enhancing the business climate and building consumer demand.
Obviously, Subchapter S laws materially affect the cattle
industry business climate. Despite the fact that many of the
fundamental aspects of raising cattle are the same as they were
100 years ago. The modern climate for conducting today's beef
operations means that business structure and operation
principles are often just as important as the selection of the
herd sire.
The NCBA believes that there are a number of actions this
body can take that will help to create an environment that
allows producers to establish a business model that will work
today and on into the future. Providing a wider range of
workable and flexible options for producers in their business
structure may be one of the most critical components in
building successful operations.
One such option would be to allow S corporations to change
to a noncorporate form of business without incurring the tax
costs typically imposed on a corporate liquidation.
One of the most important decisions for a founder of a
business is the choice of entity. In today's business climate,
the ability to adapt to changes in economic conditions is also
becoming critical. For the family business, the choice is
inseparable from the owner's preference as to how he wants to
deal with other family co-owners.
For all of these reasons, choice of entity is therefore
potentially one of the most important aspects of business
planning. Until the rise of the LLC in the mid 1990s, the S
corporation remained, for all practical purposes, the sole
means for these producers to obtain the benefit of limited
liability without the complex corporate laws.
Although the first LLC statute was passed in Wyoming in
1977, the Federal income tax characterization of the entity was
uncertain. Following the IRS issuance of Revenue Ruling 88-76,
which made clear that limited liability is not, per se, a
barrier to partnership tax status, interest in LLCs increased
substantially.
Unfortunately, the sea change in choice of entity laws has
provided little value to owners of S corporations because of
the tax on a conversion to a noncorporate form of business.
Partnerships and entities taxed as partnerships have been able
to take advantage of the latest developments in this area of
law, generally, without adverse tax effects, while S
corporations are hobbled with corporate formalities.
Lessening these formalities is extremely important, and
consequently we are very supportive of the legislation that is
in front of this Subcommittee today. An S corporation and its
shareholders could benefit from a window in time within which
to convert to an LLC, but without incurring the tax costs of
liquidation.
In summary, the S corporation election itself and
improvements over the years have been giant strides in removing
tax consideration in choice of entity. In addition to ongoing
improvements to Subchapter S laws, the next step in the process
is allowing these S corporations that can be more efficiently
functioning as an LLC the one-time opportunity to make the
conversion without tax cost being the controlling factor.
Until these conversions can be accomplished, the task of
reducing the role of taxes in choosing a business form or in
adapting to changing economic conditions will remain
unfinished.
Mr. Chairman, on behalf of NCBA and myself, I am very
grateful for the opportunity to be here in front of you today.
Thank you.
[The prepared statement of Mr. True follows:]
Statement of Dave True, Owner, True Ranches, Casper, Wyoming, on behalf
of the National Cattlemen's Beef Association
Thank you, Mr. Chairman, and members of the Subcommittee for this
opportunity to testify today. My name is Dave True and I, along with my
family, own True Ranches, a cow/calf and cattle feeding operation in
the eastern third of Wyoming, headquartered in Casper. I am here today
representing the National Cattlemen's Beef Association (NCBA) and our
nearly 250,000 members and affiliate members nationwide. NCBA follows a
very simple and straight forward mission of ``Working to increase
profit opportunities for cattle and beef producers by enhancing the
business climate and building consumer demand.'' Our testimony today
will focus on several concerns we see in the future and some solutions
that we have identified to address concerns of the past--all focused on
creating a business climate that allows producers to be more
profitable.
Industry Overview
Today's beef cattle operation is much different than that of our
ancestors. Despite the fact that many of the fundamental aspects of
raising cattle and producing beef, are the same as they were hundreds
of years ago, the modern climate for conducting today's beef enterprise
means that business structure and operating principals are often just
as important to successful operations as the herd sire used.
The beef industry is the largest segment of agriculture in the
United States with beef production taking place in every state. U.S.
beef production is the largest segment of American agriculture and
accounts for more than 27 percent of the United States' $100 billion
agricultural economy. According to the USDA's Economic Research
Service's Economic Trade Update, the U.S. beef industry exports $5.3
billion in beef and veal products and imports some $4.8 billion in live
animals and beef products, making us a truly international industry.
Despite the decrease in the number of operations in our industry,
overall productivity is increasing and continues to set record levels.
That increase in productivity is the result of innovation and
technology as well as producers that have found the need to prove that
they are determined to make the changes necessary to be successful
producers of beef.
Many modern ranchers operate as single proprietorships, much like
other small businesses, as discussed later in our testimony, a great
number do not. Additionally, many ranches that have reorganized their
business structure in the past several decades have outgrown their
original plans and are in much need of a business model that allows
them to grow and prosper for years to come. For ranchers, like many in
the small business community, modernizing their operations for the
future or growing to meet new business opportunities mean that changes
to the laws governing business structure will make that transition more
profitable and increase the likelihood of success.
A growing number of agriculture operations are becoming involved in
value added beef businesses or further processing ventures. Just ten
years ago only a handful of alliance or certification programs even
existed. Even fewer beef value added operations existed. Today there
are dozens of successful alliance programs and a number of growing
value added beef businesses that range in participation from a few to
several hundred producers within the new business structure. Early
ventures were structured as conventional or new generation
cooperatives; however, changes in some state laws make it necessary for
producers to look for other business structures to retain the ability
to bring in outside capital or modern capital financing systems.
These new and promising business models are not without risk, and
the cost of building a processing plant that may cost hundreds of
millions of dollars can seldom be shouldered by a small number of
producers, as permitted under current S corporation law. As an example,
nearly 1,000 Iowa producers have pooled resources and committed some
200,000 head of cattle to their own processing facility with the hopes
of creating additional profit for their producer owners. They will
begin operations in their new facility by the end of the summer--but
without the benefit of every possible business structure available to
them and their members for establishing this creative enterprise.
Summary
Cattlemen seldom come to Congress with requests for assistance and
we are one of the few in agriculture that operate without a ``safety
net'' of price supports and subsidies. We much prefer that Congress
take actions that allow us the ability to grow our business by creating
a business environment that is prepared for today and tomorrow.
NCBA believes there are a number of actions this body can take
which will help to do just that--create an environment that allows
producers to create a business model that will work today and in the
future. Economic Research Service reports that analyze the risk in
production agriculture show that farm and operator risks are a primary
factor that lenders evaluate when considering their relationship. NCBA
believes that providing a wider range of workable and flexible options
for producers in their business structure may be one of the most
critical components in building a successful operation, both today and
tomorrow.
H.R. 1896, the ``Subchapter S modernization Act of 2003'' and H.R.
1498, the ``Small Business Opportunity and Growth Act of 2003'' will
significantly improve the environment that surrounds S corporations.
H.R. 1498 specifically accomplishes many of the points that we discuss
in our testimony. H.R. 714, the ``Small Business and Financial
Institutions Tax Relief Act of 2003'' seems to be a strong step forward
in allowing our capital providers the flexibility they need in today's
world. Improved community and rural banks will strengthen the ability
of all sizes and types of cattlemen to access capital markets.
Thousands of corporations, including farm and ranch corporations,
have elected subchapter S status since President Eisenhower signed into
law the Technical Amendments Act of 1958, which added subchapter S to
the code. Although the legislative history makes clear that the purpose
of subchapter S was to offer simplified tax rules for the small and
family-owned business operating in the corporate form, S corporations
have become a common form of business for larger producers as well.
Until the rise of the LLC in the mid 1990's the S corporation
remained, for all practical purposes, the sole means for these
producers to obtain the benefits of limited liability without the
complex corporate tax. For many years, a change to another form of
business was relatively easy. But by the time an alternative to the S
corporation became widely available, this avenue had been foreclosed by
changes to the tax code. Thus thousands of S corporations are saddled
with the cumbersome and inflexible rules of the corporate form.
One of the most important decisions for the founder of a business
is ``choice of entity''--that is, whether to operate the business
through a corporation, partnership, limited liability company or other
form of business. This choice is plainly important for reaching
business goals, and may be critical to the survival of the business. In
today's business climate, the ability to adapt to changes in economic
conditions is also becoming critical. For the family business, the
choice is inseparable from the owner's preferences as to how the owner
wants to relate to family co-owners. For all of these reasons, choice
of entity is therefore potentially one of the most important aspects of
business planning.
The law concerning choice of entity has changed enormously in the
last fifteen years, particularly with the widespread adoption of laws
authorizing the limited liability company (LLC). As a result, business
owners have more flexibility in this area than ever before. Even so,
older family businesses operated as S corporations may be ``locked''
into the corporate form, simply because of the tax cost of changing to
another form. These businesses are thus unable to take advantage of the
recent advancements in choice of entity. NCBA would propose to allow a
one-time election for an S corporation to change to another form of
business without incurring the normal tax cost of doing so.
Historical Perspective
Prior to the Tax Reform Act of 1986, a corporation could escape the
corporate form by liquidating under Section 333 of the Internal Revenue
Code of 1954. That section provided for nonrecognition of gain or loss
(with limited exceptions) upon the complete liquidation of a domestic
corporation within one calendar month. Limited recognition applied to
previously untaxed earnings and profits, and distributions of cash and
securities.
Utilizing Section 333, the shareholders of a corporation could
liquidate the corporation and distribute the assets to the
shareholders. The former shareholders could then contribute those
assets to another corporation (or an entity taxed as a corporation) or
to a partnership (or an entity taxed as a partnership) without
recognition of gain or loss. As a practical matter, Section 333 was
most useful to smaller corporations because of the requirement that all
of the corporation's property be transferred within one calendar month.
Section 333 was repealed by the Tax Reform Act of 1986, and other
corporate liquidation provisions were amended. Under the new regime,
the shareholders of a liquidating corporation recognize gain or loss
upon the liquidation as if there were a sale or exchange of the assets
at fair market value. This is true even if the assets are immediately
contributed to another business entity and the trade or business
continues to be operated by the same owners without interruption. The
tax cost can be especially high for businesses with valuable but
depreciated plant and equipment and family farms with highly-
appreciated agricultural land.
When the Tax Reform Act of 1986 was passed, the limited liability
company was little known. Wyoming passed the first limited liability
company enabling act in 1977. As members of this Committee are clearly
aware, the entity closely resembles a partnership but its owners are
protected from unlimited personal liability. Nevertheless, the Federal
income tax characterization of the entity was uncertain. The
fundamental issue for tax purposes was whether an unincorporated
organization can be taxed as a partnership even though its owners are
not personally liable for the organizations debts.
In 1982, the Internal Revenue Service formed a study group on
LLC's. After six years, the group's work culminated in Revenue Ruling
88-76, 1988-2 C.B. 360. The ruling made clear that limited liability is
not a per se barrier to partnership tax status. Interest in limited
liability companies increased dramatically after the release of Revenue
Ruling 88-76 and by 1996, all fifty states, the District of Columbia
and Guam had enacted LLC statutes.
Revenue Ruling 88-76 had another effect. Once LLC's were in place
and the IRS confirmed their tax characterization, state legislatures
began experimenting with other partnership-like entities. The result
has been an alphabet soup of limited liability partnerships and other
entities of various kinds, most of them taxed as partnerships.
Consistent with Revenue Ruling 88-76, the Internal Revenue Service
has taken the position that a general partnership may be converted into
an LLC that is taxed as a partnership, generally without tax effects,
Revenue Ruling 95-37, 1995-17 IRB 10. Indeed, it is now generally
accepted that any entity taxed as a partnership may convert its form to
another such entity, generally without tax effects.
The Internal Revenue Service has aided taxpayers in adapting to
these changes-- indeed has contributed to the accelerated pace of these
changes--by promulgating the so called ``check the box'' classification
regime. Effective January 1, 1997, each domestic entity (other than one
organized pursuant to a corporate or joint stock statute) determines
its own tax status simply by checking or not checking a box.
Furthermore, unless an unincorporated organization elects otherwise, it
will be taxed as a partnership, 26 C.F.R. Sec. 301.7701-3.
Under these regulations, the tax status of an unincorporated
organization no longer depends on any analysis of the organization's
structure or the legal rights of the owners. With tax classification
constraints removed, LLC varieties have and will continue to
proliferate. Governance structures will be custom-designed for the
needs of the owners, with great flexibility for the rights and roles of
LLC members in the organization.
Recommended Changes
The sea change in choice of entity law has provided little value to
owners of S corporations. Because of changes to the Internal Revenue
Code made by the Tax Reform Act of 1986, a corporation may not convert
to an LLC without all the tax effects of liquidation. This is
particularly unfortunate for S corporations, which are already taxed in
a manner very similar to partnerships and which are typically used for
small and family-owned businesses. Partnerships and entities taxed as
partnerships have been able to take advantage of the latest
developments in this area of the law, generally without adverse tax
effects, while S corporations remain saddled with the cumbersome and
inflexible corporate form of business.
An S corporation and its shareholders could benefit from a one-time
window of time within which to convert to an LLC or some other entity
taxed as a partnership, but without incurring the tax cost of
liquidation. The general outlines of such a proposal would be as
follows:
The proposal is limited to S corporations because those
already having elected S status are most likely to utilize and benefit
from a change to the LLC form.
Because state laws vary, the mechanics of a conversion
should not be determinative. Thus a conversion could be accomplished
through liquidation of the S corporation and contribution to the LLC or
(where allowed by local law) by merger or consolidation with the LLC
(or other new entity).
A limited period of time should be available to make the
conversion.
Consistency rules should be adopted to govern basis of
both the assets and the owners' interests in the company, as well as
holding periods of the assets and interests.
The S corporation and its shareholders should be required
to file an election with the timely-filed tax return for the period in
which the conversion takes place.
To limit the use of the technique for other tax planning
purposes, the proposal suggests requiring (a) that all, or
substantially all, of the assets of the S corporation be transferred to
the new entity, and (b) the shareholders of the S corporation own at
least 80 percent of the new entity (or an analogous continuity of
ownership rule).
Anti-abuse rules should be included to prevent use of the
conversion solely to avoid the tax effects of an anticipated corporate
liquidation. Such rules could require, for example, the continued
operation of the trade or business in the LLC form for a certain period
of time. The failure to meet this requirement would result in the
imposition on the shareholders of a recapture tax equivalent to the tax
due had the corporation been liquidated.
Closing
The Internal Revenue Code itself reflects a policy of respecting
economic reality over form in the conduct of a trade or business. For
example, section 1031, which existed even in the 1939 code, allows
nonrecognition of gain or loss in the exchange of property used in a
trade or business, or for investment, on the theory that the taxpayer
has not cashed out his investment. Code Sections 351 and 721 allow
nonrecognition on the contribution of property to a corporation or a
partnership, on the rationale that the taxpayer is only changing the
form of his investment.
The S election itself was a giant stride in removing tax
considerations in choice of entity. More recently, the Internal Revenue
Service has done much to remove tax considerations from the choice of
business form through the check the box regulations. The Service should
be commended for taking this step.
The next step in the process is allowing those S corporations that
can more efficiently function as an LLC the one-time chance to make the
conversion, without tax cost being the controlling factor. Until these
conversions can be accomplished, the task of reducing the role of taxes
in choosing a business form or in adapting to changing economic
conditions will remain unfinished.
The NCBA is grateful to the Subcommittee for the opportunity to
share our views on this important issue.
Chairman MCCRERY. Thank you, Mr. True.
Mr. Alexander, Subchapter S, as you pointed out, was first
enacted back in the fifties and has since been modernized, so
to speak, a couple of times, the most recent being in 1996. Can
you give us some idea of how the business environment has
evolved over time which would call for further modernization of
Subchapter S rules?
Mr. ALEXANDER. I will try to, Mr. Chairman. Yes, it was
effective January 1, 1958. That was one of my better years. At
first, it seemingly worked pretty well, but then people
discovered, after they elected Subchapter S, two things. Number
one, they were locked in; and number two, because of changes in
their businesses or additional needs of their businesses or
growth of their businesses, some of the restrictions placed in
Subchapter S by those who drafted it--and they were trying hard
to put together a simple pass-through system--made it very
difficult to grow their businesses under Subchapter S
restrictions.
One of those restrictions, of course, was the number of
stockholders, which grew from 10 in 1958 to 75 today--and
clearly ought to grow further, with the suggestions that have
been made in the bills that you are reviewing today. Another
one was mezzanine capital, the need for it, and the fact that
Subchapter S makes it extremely difficult to provide the
capital necessary for the growth of a business that might not
have been anticipated when the business first elected.
The last witness mentioned the possibility of moving from
Subchapter S to a limited liability form or other form--which
weren't permissible back in those antediluvian years when I was
working for the IRS--and, by making use of some very liberal
Department of the Treasury regulations, check the box to decide
on the business entity. That is great, to be able to move out,
but right now under current law you are locked in. You are
locked in to the election that you made years ago. You have to
go through the devices that I mentioned in order to do
something essential to the continuation and the growth of the
business. Those restrictions, as Ms. Olson stated when she was
in the private bar, should be lifted, because lifting them
simplifies, not complicates, the law.
Chairman MCCRERY. So, should I infer from your comments--
you have said a couple of times now that somebody from the
Department of the Treasury, before they were in the Department
of the Treasury, said something different from what they are
saying now. So, should I infer that you think the Department of
the Treasury has got blinders on, and they are just thinking
about revenue loss and not really thinking about what is best
for business structure and business decisions?
Mr. ALEXANDER. No, I think in good faith--and they are fine
people--they are more concerned about somehow preserving an
apparently simple system for simple people to do simple things
under. Business doesn't work that way.
I would hope that, even though I know that when you go into
government, you do tend to have a different attitude--maybe the
attitude you had before--that nevertheless we ought to try to
do something useful for the 2.5 million or so small businesses
that right now are caught unless some manner of escape is
written. Now we don't have one.
Chairman MCCRERY. Thank you. Mr. Zarzar, can you describe
for us some of the traps that are out there for the unwary that
have Subchapter S and can catch small businesses?
Mr. ZARZAR. Mr. Chairman, certainly I would say first as a
threshold matter that the S corporation regime is not as
complex as some others. So, that is fortunate. Nevertheless, as
you ask, there are some of those both with respect to the
eligibility of use of Subchapter S and as to the issues of
basis limitation and the like.
What I would like to do, after noting that indeed the
legislation does seem to take care of all these, I guess I
would ask my colleague, Ms. MacDonough, to speak to some of
those more esoteric technical details, if you would.
Chairman MCCRERY. Sure.
Ms. MACDONOUGH. I think that the bill goes a long way in
eliminating many of the traps for the unwary. In particular,
the changes to the ESBT rules are very favorable; I think that
that is a major hurdle. The rules relating to bank-to-bank
loans is probably one of the most significant traps. It is
probably the most litigated area in Subchapter S. I think that,
for whatever reason, the courts and the IRS have taken a very
harsh view on the ability of closely held businesses to
restructure their finances in order to create basis. So, that
is a very, very important provision.
The step transaction doctrine and the application of that
upon electing QSub status is really a trap for the unwary,
especially small businesses that would restructure related
entities and not have the advantage of tax advisors who are
going to warn them that they may be triggering tax as a result
of that. The sale of a partial interest in a QSub would also be
a trap for somebody who is not being properly advised.
Interestingly, the regulations with respect to QSubs
specifically point out a planning technique to get around that
particular trap, but unless you are advised by a tax advisor
who is familiar with those regulations, that would be something
very easy to miss.
Overall, we think that Subchapter S is simple, that that is
one of the major advantages of it, and that the provisions--and
this legislation goes really, really a long way in eliminating
many of the traps. So, we are very much in favor of these
provisions.
Chairman MCCRERY. Thank you very much. I have some more
questions, but I am going to pause now and give my colleague,
Ms. Tubbs Jones, an opportunity to inquire of witnesses. Ms.
Tubbs Jones.
Ms. TUBBS JONES. Thank you, Mr. Chairman. Mr. Alexander,
you took the Ohio bar in 1954. Were you living in Ohio at the
time, or had business, or what?
Mr. ALEXANDER. Yes, ma'am. I was living in Cincinnati,
which is a great city in a great State.
Ms. TUBBS JONES. Well, thank you. I am from Cleveland.
Mr. ALEXANDER. Right. I knew you were.
Ms. TUBBS JONES. Okay. Let me ask you, when I first came to
Congress, I was serving on the Committee on Financial Services.
We were debating financial modernization--H.R. 10, financial
modernization. One of the questions I ask is--really, what we
are about to do is to allow people to do legally what they have
been doing by way of legal fiction already.
In essence, are you suggesting in your commentary about
having--I made a note of this--``rigidity that does not promote
simplicity''--that really people have been able to use legal
fictions to address some of the issues; that we ought to be
able to straight-out allow them to do what they need to do to
make their businesses successful?
That was a long question. I apologize for that. In essence,
what I am trying to find out from you is, do you think that
these changes need to be made in order for small or S
corporations to be able to do better business?
Mr. ALEXANDER. Absolutely. Do better business if they
didn't have to try to get around these rigid rules. As both the
AICPA witness and I have testified, if you have to look in the
regulations to find a way to get around the rules, that means
you have to hire lawyers, and that means you have to spend
money on lawyers rather than on the business.
Ms. TUBBS JONES. Are there any other suggestions that are
not included in this legislation that you think would help S
corporations?
Mr. ALEXANDER. We have talked about two types of
legislation today: One, the fixing-it-up type, as exemplified
by the Mr. Shaw and Mr. McInnis bill; and two, the ``Hey, let
them out without making it impossible for them to get out,''
bill which is Mr. Houghton's bill. Those might go hand-in-hand,
but if you didn't do the first one, there is going to be a huge
need to do the second. The problem with that is that some
people, some businesses cannot conduct themselves in this
partnership mode--tax nirvana, as it is called. Banks on the
reserve method can't; some construction companies and other
companies can't. I guess a cattle ranch in Wyoming could. It
would be great to do that.
They have a problem. Even if they were let out without a
punitive inside-outside tax, which is the rule now, you
couldn't get out because you couldn't conduct your business
because of other laws, State laws, and other rules.
Ms. TUBBS JONES. Thank you. Either of the CPAs----
Mr. ZARZAR. We will figure that one out.
Ms. TUBBS JONES. Okay. We have gone through--again, from my
experience on the Committee on Financial Services, the Enrons,
the Global Crossings, and on and on and on and on and on, and a
whole discussion about responsibilities of CPAs and auditors
and accountants and so forth. In the S corporation world, are
there issues that people should be paying attention to with
regard to accounting that should come to our attention? I am
not trying to be an investigative reporter, I am just curious
as I sit here and am responsible for making policy.
Ms. MACDONOUGH. I think in our written testimony we did
address some areas of concern with the legislation, where we
felt that there would be opportunities for manipulation, and we
would be happy to discuss those with you at greater length.
There are also some areas that we did not have the opportunity
to address in our written testimony that we would like to
supplement, because we are aware of not a lot----
Ms. TUBBS JONES. Give me an example, because I haven't had
a chance to read all that material.
Ms. MACDONOUGH. I will give you an example of something
that is not in the written testimony that is being used as a
planning idea, and it relates to the deductibility of State
income taxes. There is a position that if an S corporation
makes composite payments of taxes on behalf of its
shareholders, that under a special rule under 164, that allows
a corporation to claim a deduction for taxes that are paid as a
result of a shareholder owning stock, that the corporation
claims that deduction. So, some people are encouraging S
corporations to make composite payments, have the S corporation
claim the deduction, and by doing that you are taking that as a
trade or business deduction and not subject to the limitations
on itemized deductions, and not a preference for the
alternative minimum tax.
There are technical problems with that position, but
nevertheless there are firms that are advocating that. So, that
would be an example of something we would like to recommend
that you clarify as you move forward.
Chairman MCCRERY. Thank you, Ms. Tubbs Jones. I am going to
ask a few more questions and then I would invite you to further
inquire if you so desire. Mr. Zarzar, this question has to do
with the tax bill that the President just signed.
Mr. ZARZAR. Yes.
Chairman MCCRERY. It concerns the passive income
limitations in section 1375. Those provisions only affect C
corporations that have converted to S corporations. Is that
right?
Mr. ZARZAR. That is correct, Mr. Chairman.
Chairman MCCRERY. It is my understanding that the policy
behind the passive income limitations in section 1375 is to
mirror the personal holding company rules in Subchapter C. Thus
a C corporation could not avoid the personal holding company
rules merely by converting to Subchapter S status.
Mr. ZARZAR. Also correct, sir.
Chairman MCCRERY. Now, in the tax bill the President just
signed, we reduced the rates on dividends distributed by C
corporations to 15 percent. The new law also lowers the rates
on personal holding companies from 35 percent to 15 percent.
Did we lower the rates under section 1375?
Mr. ZARZAR. The rate under section 1375 was not lowered,
Mr. Chairman.
Chairman MCCRERY. If we intended the passive income
limitations in section 1375 to mirror the personal holding
company rules, shouldn't the rate in section 1375 be lowered?
Mr. ZARZAR. I would argue absolutely it should be, Mr.
Chairman, yes.
Chairman MCCRERY. Thank you. Now, Mr. Cloutier, prior to
1997, banks were not allowed to be S corporations, is that
right?
Mr. CLOUTIER. That is correct, Mr. Chairman.
Chairman MCCRERY. As C corporations, it was common for
stock in a bank to be held in an IRA. Is that correct?
Mr. CLOUTIER. That is correct, yes, Mr. Chairman.
Chairman MCCRERY. Can IRAs own S corporation stock?
Mr. CLOUTIER. Not at this time.
Chairman MCCRERY. So, many banks that would prefer to
become S corporations couldn't do so because of that
restriction. Is that right?
Mr. CLOUTIER. My bank is an example of that.
Chairman MCCRERY. In your opinion, would more banks
consider switching to S corporation status if this restriction
were removed?
Mr. CLOUTIER. I can tell you that I have done a number of
State conventions--I just came from Ohio not long ago--and that
is the number one question asked by community bankers: Can we
get it expanded? Can we get IRAs in it? A lot of opportunity
have their stock in IRAs in banks, and they didn't know the law
was going to change in 1996. That is what we are proposing, is
that we go back and grandfather those people to allow them to
switch.
We think it is also the same thing, when we look at the
directors' shares that I mentioned. We are the most highly
regulated industry in America. We think on all of these
things--passive income, director shares--that we certainly
should follow the rules as set out by the OCC and the Federal
Deposit Insurance Corp. (FDIC). I found it kind of interesting
that the Department of the Treasury, which the OCC is a part
of, says no, you can't do this with Subchapter S, but yet the
OCC says no, you can't do away with them either.
I really appreciate it, Mr. Chairman, you asking them to
get together to try to work this out, because we are just a
highly regulated industry. We wouldn't want one regulator
telling us we can't do something, and it would affect our
shareholder value. So, we appreciate that a great deal. Thank
you, sir.
Chairman MCCRERY. You are quite welcome. Let us hope we get
some results. Also concerning regulations, isn't it so that
regulators require banks to have invested assets to maintain
adequate liquidity for safety and soundness purposes?
Mr. CLOUTIER. Absolutely, yes, sir.
Chairman MCCRERY. Depending on a bank's loan demand, they
may invest funds in government securities which generate
passive income?
Mr. CLOUTIER. That is absolutely correct, Chairman. Once
again, a lot of those rules are set up, as I know you all are
well aware of, by the regulatory agencies, the FDIC, the OCC,
and so forth. We think, personally, sometimes it is a little
unfair for them to say, well, you can do this, but the
regulators tell us you must do this. So, we would like to have
that rule clarified, if we could. We think it is only fair.
Chairman MCCRERY. Mr. True, I take it the gist of your
testimony--tell me if I am wrong--but it seems to me the gist
of your testimony is that you are being punished merely because
of the timing of your selection of organization for your
business. You chose that organization before the LLC was in
existence. So, you were already an S corporation. Now all of a
sudden there is this new form that is out there available to
new businesses, but you can't opt for that new form because you
are stuck in a Subchapter S. Is that the gist of what you are
telling us.
Mr. TRUE. Yes, Mr. Chairman. Our family businesses were
started back in the late forties by my mother and father. Since
that time, my two brothers and I have assumed the
responsibility of running those businesses. Each operation that
we have--and that was the point of trying to mention them in my
testimony--each operation that we have is set up by its own
entity. Some of those entities go back to literally the early
fifties, and S corporation elections were chosen early in the
operations of those entities. As you indicated a minute ago,
those early-on elections and the S corporation laws have helped
our family through the years. With the new development of other
law in this choice of entity arena, we feel that we need the
flexibility to choose not only new entity forms, but also to
choose entity forms for ongoing operations.
Chairman MCCRERY. Fine. Well, thank you very much. Ms.
Tubbs Jones, would you like to follow up?
Ms. TUBBS JONES. Thank you, Mr. Chairman. To Mr. Cloutier.
Mr. CLOUTIER. Yes, ma'am.
Ms. TUBBS JONES. Okay. The FDIC recently adopted a final
rule granting deposit insurance to a State bank chartered as a
LLC. If the remaining restrictions on the establishment of bank
LLCs are removed, would the number of banks that would be
organized as LLCs likely dwarf the number of Subchapter S
banks, or the other way around? Or neither?
Mr. CLOUTIER. That would be hard to tell, Ms. Jones,
because--the reason being is that each regulatory agency--as
you said, the FDIC has just released the rules. You have to
remember we also have to deal with the Federal Reserve and, in
my case, the OCC. I am a national bank. So, I think we would
have to look at it and study it and make determinations as to
which one would be more effective for us.
Many of the small community banks are looking for a way to
do that, and LLCs might end up being better if we are allowed
to do them, but once again, we have to read through all the
regulations--having served on the House Committee on Financial
Services, I know you know how much that can be--and certainly
visit with our accountants and our attorneys. I think a lot of
banks would look at it very hard--I would be honest with you--
because they want an avenue that would help them continue to
serve their communities. A Subchapter C, Subchapter S, and LLC
are giving them a better opportunity to do that.
Ms. TUBBS JONES. Let's go to the accountants. What would
the motivation be to someone taking a look at whether the LLC
would be a better vehicle, or stay in Subchapter S with that
change?
Ms. MACDONOUGH. I think that it depends on whether you are
looking from an organization perspective or from a business
perspective or from a tax perspective. From a business
perspective, there really is not a tax issue with taking an
existing corporation and moving to LLC form. It would require
that you check the box to tax it as a corporation, but if, from
a business perspective, you want to operate it as an LLC,
current law accommodates that without a problem.
In terms of an existing business, you are generally going
to operate under Subchapter S, versus Subchapter K, if you
previously operated as a corporation because of the problem
that Mr. True pointed out, which is that you can't convert from
a corporation to a partnership without incurring corporate-
level taxes, while the shareholder-level taxes are resolved at
the liquidation.
From making the decision for a new entity, I would say that
a lot of people use LLCs because they are more flexible.
However, there are still advantages to Subchapter S, its
simplicity being one of the advantages, and then there are also
payroll tax advantages and advantages from a State tax
perspective.
Ms. TUBBS JONES. Mr. Cloutier, one last question for you.
What else would the community bankers like to see this
Committee address if there were other things we could address
in any of the bills that are being presented right now?
Mr. CLOUTIER. Well, as I mentioned, the real key points to
us is increasing the number to 150. I could not tell you,
Congresswoman, how many bankers have come to me and said if
this would be increased, I would really consider it.
Straightening out the directors' share issue. Once again,
this is a regulatory problem. It is not the banks wanting to do
this, it is the regulators telling us we must do it.
Then, of course, as I have talked about, we really want to
see IRAs grandfathered to where we can be able to do that.
Also, in a lot of our banks, the ESOPs own a lot of banks.
These are really community institutions.
So, we think those things would be important, and we think
these are excellent bills, and we support them very strongly.
Thank you all very much for having this hearing.
Ms. TUBBS JONES. Mr. True, I don't have a question, but I
would love to give you a couple of minutes to tell me whatever
you want to tell me. Within limits.
Mr. TRUE. Thank you very much, Congresswoman. I appreciate
the opportunity. We feel--our family has been in business for
over 50 years, as I indicated earlier.
Ms. TUBBS JONES. I do have a question. Are all of these
businesses that you are telling me about S corporations?
Mr. TRUE. No, we have--actually, we operate in different
forms in different operations for different reasons. As I
indicated, certainly some of them are tax-related. Others are
liability-limiting reasons. Part of them are regulatory
reasons. Up until 1997, we operated our community bank as a C
corporation because of regulatory demands. Once we had the
opportunity to move to an S corporation with our community
bank, we took that opportunity at that time.
So, we also have operations that are currently S
corporations, we have several operations that are currently all
C corporations, and we have a couple that are general
partnerships just within our own organization.
The point I wanted to demonstrate is we need the
flexibility, we would like the flexibility to be able to choose
the entity form that we feel is best for our ongoing operation
and our family and our 800 employees based on non-tax issues.
We want to be able to make those decisions in a tax-free
environment, if you will, and not allowing tax to be the driver
in deciding the type of entity that we have to select. Thank
you.
Ms. TUBBS JONES. Thank you, Mr. Chairman.
Chairman MCCRERY. I want to thank all the witnesses today
for coming and sharing with us your views on Subchapter S
reform, and also thank you for being patient as we worked
through our legislative schedule today.
With that, this hearing is adjourned.
[Whereupon, at 3:02 p.m., the hearing was adjourned.]
[Submissions for the record follow:]
Statement of Credit Union National Association, Inc.
The Credit Union National Association (CUNA) is pleased to provide
comments for the record in connection with the June 19, 2003 hearing of
the Select Revenue Measures Subcommittee of the House Committee on Ways
and Means on ``S Corporation Reforms'' and commends Chairman Jim
McCrery (R-LA) and Ranking Member Michael McNulty (D-NY) for their
insightful leadership in holding these hearings.
CUNA represents over 90 percent of the nation's approximately
10,400 state and federally chartered credit unions and their 83 million
members.
Subchapter S of the Internal Revenue Code was first enacted in 1958
to reduce the impact of federal taxation on small business
corporations' choice of business structure and to eliminate the
corporate level of tax for such entities. Banks were first allowed to
elect Subchapter S status in the Small Business Job Protection Act of
1996. Since that time approximately 1,900 banks have elected Subchapter
S status.
The proposed legislation, H.R. 714, the ``Small Business and
Financial Institutions Tax Relief Act of 2003,'' introduced by
Representative Scott McInnis (R-CO); H.R. 1498, the ``Small Business
Opportunity and Growth Act of 2003,'' introduced by Representative Jim
Ramstad; and H.R. 1896, the ``Subchapter S Modernization Act of 2003,''
introduced by Representative E. Clay Shaw, Jr., (R-FL), would
significantly expand and enhance Subchapter S benefits for the banking
industry. In this connection, we note the industry's longstanding
lobbying effort to enact such S Corporation legislation.\1\
Incongruously, while aggressively lobbying to increase the tax
advantages of Subchapter S for banks, the banking industry also
continues to actively lobby to impose additional taxes on credit
unions,\2\ arguing that credit unions' income tax status provides a
competitive advantage and that imposing additional taxes would ``level
the playing field.''
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\1\ Subchapter S bank legislation was first introduced in the 106th
Congress, The Small Business and Financial Institutions Tax Relief Act
of 1999, H.R. 1638, and 1994, by Representatives Scott McInnis (R-CO),
Jim McCrery (R-LA) and J.D. Hayworth (R-AZ), and S. 875, by Senator
Wayne Allard (R-CO).
\2\ Most recently State bank associations have initiated a
coordinated lobbying effort to impose additional taxes on state
chartered credit unions. See, e.g., California State Bills AB 1226 and
SB 901; Iowa State Bills HF 388, SF 242 and HSB 293; New Mexico State
Bill HM 29; Oregon State Bill HB 3491; and Utah State Bill 162.
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In introducing the Senate version of the ``Small Business and
Financial Institutions Tax Relief Act of 2003'', S. 850, Senator Wayne
Allard (R-CO) said he would rather level the playing field by reducing
taxes and regulation on other financial institutions. To that end, he
reintroduced legislation that would raise the maximum allowable number
of S corporation shareholders and thus make it easier for banks to
switch to tax-advantaged S corporation status. He observed that his
bill would ``reduce the tax burden on community banks by permitting the
smaller institutions to more easily convert to small-business
corporations known as Subchapter S corporations.'' He also said ``Some
voices are calling for the taxation of credit unions. I oppose it.
Credit unions are not-for-profit businesses and should not be taxed.''
\3\
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\3\ Credit unions are not-for-profit financial cooperatives,
serving members who share something in common: employment, association
membership, or residence in a particular geographic area. Members elect
credit union boards of directors; each member has an equal vote,
regardless of how much he or she has on deposit. Only members may serve
as directors, and the vast majority of directors serve without
remuneration. Presently, more than 129,000 Americans volunteer for
their credit unions. More than 82 million U.S. consumers are member-
owners of, and receive all or part of their financial services from the
nation's 10,120 credit unions. Of these, 17% rely on credit unions for
all of their financial services; 36%, while also using other financial
institutions, primarily use credit unions; and 47% are credit union
members who primarily use other financial institutions. (Source:
Federal Reserve Survey of Consumer Finances, 1998).
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CUNA has no objection to financial institutions reducing their tax
burden and believes any savings should be passed along to customers.
However, we feel compelled to point out the duplicity of the banking
industry position. Recent attempts in at least six states to impose
additional taxes on credit unions focus on budget deficits and the
revenue cost of the credit union income tax exemption. By contrast,
CUNA estimates that the direct cost to the U.S. Treasury of the
elimination of double taxation under bank Subchapter S election
amounted to a record $593 million in foregone taxes in 2001 and $2.1
billion over the past five years. These figures are adjusted for the
fact that Subchapter S bank shareholders receive higher dividends (and
consequently pay more taxes) than they would if their institutions had
not opted for formation under Subchapter S.
If recent growth rates continue, the total foregone tax revenue due
to Subchapter S election by banks will amount to approximately $13.5
billion over the next 10 years. By 2006, the annual foregone tax
revenue from Sub S banks will exceed the foregone revenue from the
credit union tax treatment.
Further, a detailed examination of Subchapter S bank financial
results for 2001 shows that these banks charged depositor fees that
were a bit higher than the fees charged by other small (and some large)
banks. At the same time they recorded earnings (ROA) that ranged as
much as two times higher than peer commercial banks. For example, the
Subchapter S bank average ROA was 1.69% for the year while non-
Subchapter S banks with less than $100 million in assets earned 0.79%
and non-subchapter S banks with less than $1 billion in assets earned
1.05%. Subchapter S bank cash dividends as a percent of assets averaged
as much as 2.5 times higher than those at peer banks.
Recent statements by banking industry lobbyists made in connection
with the President's dividend proposal suggest that the primary
motivation for industry efforts in expanding Subchapter S is maximizing
the amount of dividends to be paid to shareholders (and not to generate
more competitive rates and lower fees for customers).\4\ These comments
tend to belie the earlier claims that the bankers are disadvantaged in
providing quality lower cost services to their customers. We believe
any such savings should be passed along to customers in the form of
more competitive rates and fees. So, while the bankers complain that
credit union tax status deprives them of a level playing field, the
evidence suggests that a major reason for their competitive issues lies
with their failure to pass their tax savings along to their customers
in the form of more competitive pricing.
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\4\ In this connection, several bankers and the American Bankers
Association's Senior Tax Counsel and Director of the group's center for
community bank tax indicated banks would be less inclined to pursue S-
Corporation status and that banks and thrifts that currently have it
might convert back to a typical corporate structure if the President's
original dividend proposal had become law. ``The primary motivation for
electing Subchapter S is to avoid taxation at the corporate level, but
this gets rid of it at the individual level. I think if this passes
bankers will be saying--Why deal with the ridiculousness of the
subchapter S laws?'' American Banker, p.1, January 14, 2003.
Interestingly, in a later Letter to the Editor, a tax attorney-
commentator observed the article ``left the impression that banks
should reconsider whether S status is preferable to C status.'' The
attorney pointed out that even if the President's dividend tax proposal
were enacted ``The well-informed thoughtful decision will be to remain
an S corporation or make an S election as soon as possible. The
benefits of being taxed as an S corporation far outweigh the
disadvantages.'' He then enumerated eight such benefits. American
Banker, January 17, 2003.
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Finally, we note that the banking industry is aggressively pursuing
additional tax advantages. H.R.1375, the ``Financial Services
Regulatory Relief Act of 2003'' contains provisions that would permit
the Comptroller of the Currency to issue regulations or orders
permitting individual directors of national banks that are S
corporations to hold subordinated debt of the bank in the amount of
$1,000 or more in lieu of stock in the corporation.\5\ The bill also
would authorize the Comptroller of the Currency to prescribe
regulations that would allow national banks to organize as limited
liability companies (LLCs).\6\ In this connection, the Federal Deposit
Insurance Corporation (FDIC) has recently adopted a final rule granting
deposit insurance to a State bank chartered as a limited liability
company (LLC). The Internal Revenue Service has not yet authorized bank
LLCs. However, if the remaining restrictions on the establishment of
Bank-LLCs are removed, the number of banks that would be organized as
LLCs could dwarf the number of Subchapter S banks--and banks would reap
even greater tax benefits that the substantial ones already afforded
under current law.
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\5\ Section 101, National Bank Directors.
\6\ Section 110, Business Organization Flexibility for National
Banks.
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We commend your efforts to reduce taxation of financial
institutions and to promote increased savings. We recommend that
Congress monitor these tax-advantaged banks to determine the amount of
advantage passed along to customers in the form of more competitive
rates and fees. Thank you for considering our views.
Statement of Employee-Owned S Corporations of America
Background
Employee-Owned S Corporations of America (ESCA) is the only
organization that speaks exclusively for America's private, employee-
owned businesses on the issue of pension and retirement savings.
Thousands of non-public companies across America are employee-owned.
These companies, the vast majority of which are small- and medium-sized
and/or family businesses, are a hallmark of American entrepreneurship.
Today, ESCA companies operate in virtually every state in the
nation, in industries ranging from groceries to general contracting,
pizza parlors to printing, health care supplies to heavy manufacturing.
Through their ESOP-owned structures, ESCA businesses around the nation
provide their employee-owners with substantial retirement benefits
through ownership of the businesses where they work. Millions of
employees have amassed substantial retirement savings and retired early
as a result of owning shares of their company. Employees want to own
company stock in their retirement plans knowing that their hard work
results in easily measurable cash benefits to them.
Current law makes it difficult for S corporation ESOPs to repay debt
in- curred to purchase employer stock and limits the retirement
savings of employee-owners
ESOPs are a wonderful way to help employees build a retirement nest
egg, but current law restricts the ability of ESOPs sponsored by S
corporations to repay debt incurred to purchase employer stock. In this
regard, current law is at odds with the economic interests of the
employees who participate in S corporation ESOPs.
As this Committee is aware, the Internal Revenue Code generally
prohibits loans or guarantees between a tax-qualified plan and a
corporation that sponsors the plan (a ``prohibited transaction''). IRC
Sec. 4975(d)(3), however, provides an exemption for loans that fund the
purchase of employer stock if the loan is primarily for the benefit of
plan participants and their beneficiaries and the ESOP provides no
collateral for the loan other than employer securities (``exempt
loans'').
The Internal Revenue Service has taken the position in private
letter rulings that Treasury Regulations under IRC Sec. 4975(d)(3) do
not allow an ESOP to repay an exempt loan with distributions on shares
of S corporation stock that have been allocated to the accounts of plan
participants and do not serve as collateral for the loan. IRC Sec.
404(k)(5)(B) allows an ESOP to use ``dividends'' received with respect
to shares of employer stock to make payments on an exempt loan,
regardless of whether such shares have been allocated to the accounts
of participants and are no longer pledged as collateral to secure the
loan. This provision, however, does not apply to distributions by S
corporations because they technically are not ``dividends'' for federal
income tax purposes. Thus, S corporation ESOPs are precluded from
repaying exempt loans with distributions on S corporation stock that
has been allocated to the accounts of participants, even though a
comparable distribution from a C corporation could be so used.
Current law hurts S corporation ESOPs and their employee participants
In current economic conditions, so many of America's S corporations
find themselves hard-pressed to survive and prosper. Moreover, with S
corporation businesses so heavily concentrated in manufacturing--a
sector that has been particularly hard-hit by the national economic
downturn--this situation is all the more severe. ESCA applauds the
Subcommittee's desire to identify what steps can be taken to enhance S
corporations' access to capital markets and their economic well-being.
It should come as no surprise to Committee members that today's
economy leaves S corporation ESOPs with limited options for servicing
debt. Restrictions such as the one described here--which stand in stark
contrast to the policy underpinnings of IRC Sec. 404(k)(5)(B) to
facilitate the payment of ESOP loans and promote employee ownership--
make the current situation worse. By limiting the debt repayment
options of S corporation ESOPs, these restrictions limit the ability of
ESOP-owned S corporations to reinvest earnings in the business and
bolster the value of the retirement savings of their employee-owners.
Beneficial legislation has previously been introduced
In the 107th Congress, legislation was introduced in the House and
Senate--H.R. 1896 and S. 1201--to modernize the rules governing S
corporation businesses. Included in both those measures was a provision
that would treat distributions received by an ESOP with respect to S
corporation stock as a dividend for purposes of IRC Sec. 404(k)(5)(B).
This legislation would address the challenge that leveraged S
corporation ESOPs currently face by allowing distributions with respect
to both allocated and unallocated shares of S corporation stock to be
used to repay exempt loans, thereby providing equal treatment for S
corporation ESOPs and C corporation ESOPs.
ESCA's members urge the Subcommittee and its leadership to seek out
opportunities to advance a similar measure in this Congress,
particularly to the extent that Subchapter S reforms may be included in
broader tax legislation this year.
Conclusion
ESCA looks forward to continuing to work with the Subcommittee to
promote the advancement of a provision that would enhance the ability
of S corporation ESOPs to repay debt incurred to purchase employer
stock. During such challenging economic times, such a measure is
particularly critical.
On behalf of the employee-owners of all our ESCA companies, we
thank the Subcommittee for its time and its effort to identify
opportunities like this one to improve the current rules governing--and
in this case, limiting--the ability of ESOP-owned S corporations to
thrive, grow and generate retirement benefits for their employees.
Thank you.
Statement of J. Michael Keeling, ESOP Association
On behalf of The ESOP Association and its nearly 1300 members
representing all 50 states, I thank you for the opportunity to have our
statement on H.R 1896, the Subchapter S Modernization Act, included in
the official record of the Subcommittee on Select Revenue Measures for
the House Committee on Ways and Means' hearing record from the June 19,
2003 hearing, ``S Corporation Reform.'' Of these 1300 companies,
approximately 900 are S Corporations sponsoring ESOPs.
The ESOP Association is a 501(c)(6) advocacy and educational entity
that has interacted with the Committee on Ways and Means since the
Association's beginnings in 1978 on various tax issues pertaining to
this nation's policies related to stock ownership by employees in the
companies where they work. These policies are dominated by the
ownership and retirement savings structure known as the employee stock
ownership plan, or ESOP.
This statement will address The ESOP Association's support for H.R.
1896, the Subchapter S Modernization Act, and, more specifically, the
Association's firm endorsement of Section 604, ``Distribution to an
Employee Stock Ownership Plan.''
Since 1997, when Congress first enacted laws permitting S
Corporations to sponsor ESOPs, the employee ownership community has
been diligent in its fight to preserve and maintain laws and
regulations that help create and maintain broad-based employee stock
ownership among S Corporations. The Association has also worked
aggressively to advocate for more fair treatment in S corporations in
certain instances, because as is typical in drafting new law,
overlooked aspects of how the law will emerge after initial
Congressional action and impact the real world.
Passage of H.R. 1896 would permit S Corporation ESOP companies to
operate within a network of fewer constraints and less complications.
Similarly, inclusion of Section 604, ``Distributions by an S
Corporation to an Employee Stock Ownership Plan,'' would greatly expand
the appeal for an S Corporation to sponsor an ESOP by removing some of
the unintended restrictions on creation and operation of S corporation
ESOPs, particularly when the ESOP holds less than 50% of the stock,
that often deter ESOP companies from converting to S status, or S
Corporations from implementing ESOPs. These restrictions generally
provide benefits to S Corporations by putting S Corporation
shareholders on a level playing field with C Corporation shareholders.
Again, we thank the Subcommittee for permitting our written
statement to be included in the official record of the hearing
entitled, ``S Corporation Reform.''
Statement of the Honorable Scott McInnis, a Representative in Congress
from the State of Colorado
I would like to begin by thanking Chairman McCrery, Ranking Member
McNulty and the Select Revenue Measures Subcommittee for holding this
hearing today on subchapter S corporation reforms. The hearing is
timely, and I welcome the chance to discuss these issues as a strong
proponent of reforming and simplifying the many complexities inherent
in subchapter S.
For the last three Congresses, including the 108th Congress, I have
introduced legislation designed to simplify and reform subchapter S
corporation tax laws. My legislation includes both broadly applicable
reform proposals and several proposals focused on enhancing the ability
of community banks to convert to and operate as a subchapter S
corporation.
My legislation, the Small Business and Financial Institutions Tax
Relief Act of 2003 (H.R. 714), is designed to help ease the tax burden
on thousands of small businesses and community banks. This bill targets
the businesses that drive growth in the communities they serve, and
assists small businesses and community banks which have already chosen
to operate as subchapter S corporations. These provisions would spur
economic growth by enabling small businesses organized as subchapter S
corporations to add shareholders, simplifying complex tax rules for
these small businesses, and reducing barriers to enable community banks
to convert and operate as subchapter S corporations.
My bill expands subchapter S eligibility, enabling small businesses
to raise capital--which is immediately invested into the business and
the community. It also addresses impediments to community banks that
seek better tax treatment. When Congress passed the Small Business Job
Protection Act of 1996, it made community banks eligible to elect
subchapter S corporation status for the first time in tax year 1997.
Unfortunately, because of the complicated interplay between banking and
tax laws, many community banks encounter significant barriers to
qualifying under the current rules and cannot benefit from Congress'
intended tax relief. My bill would correct many obstacles that often
prevent community banks from converting to subchapter S.
Key features of the Small Business and Financial Institutions Tax
Relief Act of 2003 include increasing the number of subchapter S
corporation eligible shareholders to 150 from 75; permitting S
corporation shares to be held in Individual Retirement Accounts;
clarifying that interest on bank investment held for liquidity and
safety and soundness purposes will not be included as restricted
passive income; and clarifying the treatment of directors shares, which
banks are required to issue under certain banking laws and rules.
The measures in H.R. 714, designed to provide tax relief and an
economic boost to small businesses organized as subchapter S
corporations, have additional significance because small businesses
produce two-thirds to three-quarters of all the net new jobs, and
community banks are a primary source of the capital that enables those
small businesses to grow. Moreover, providing subchapter S corporation
relief builds upon recent legislation to reduce the impact of the
double taxation of dividends, while focusing on small businesses, and
offers a genuine opportunity for these small businesses to grow and
create jobs.
There is strong support for reforming and simplifying subchapter S
corporation rules. I have been joined on my legislation by seven other
Members of the Ways and Means Committee, as well as an additional
twenty-four other cosponsors. Moreover, subchapter S relief enjoys
broad support from Members of this Committee based on support for bills
introduced this year or last by Representatives Shaw and Ramstad.
I look forward to working with the Subcommittee, the full Committee
on Ways and Means, and other interested parties to move these
subchapter S corporation reforms forward. Again, I would like to thank
the Select Revenue Measures Subcommittee for holding this hearing, and
thank you for the opportunity to raise these important small business
issues with you.
Statement of the Section of Taxation of the American Bar Association
EXECUTIVE SUMMARY
The views expressed herein represent the position of the Section of
Taxation and have not been approved by the House of Delegates or the
Board of Governors of the ABA. Accordingly, these views should not be
construed as representing the position of the ABA.
Congress enacted Subchapter S of the Internal Revenue Code as a
part of the Technical Amendments Act of 1958. Pub. L. No. 85-866, 72
Stat. 1606 (1958), reprinted in 1958-3 C.B. 254, 298-305. The stated
purpose of Subchapter S was to permit small businesses to select the
form of business organization desired by the owners without the
necessity of taking into account major differences in tax consequences.
S. Rep. No. 1983, 85th Cong., 2d Sess. 87, reprinted in 1958-3 C.B.
922, 1008.
In 1982, Congress substantially revised Subchapter S by enacting
the Subchapter S Revision Act of 1982. Pub. L. No. 97-354, 96 Stat.
1669 (1982). The 1982 revisions were designed to expand the eligibility
for Subchapter S status and simplify the operation of S corporations.
In 1996, Congress enacted the Small Business Job Protection Act of 1996
(the ``1996 Act''). Pub. L. No. 104-188, 110 Stat. 1755 (1996). The
1996 Act included a number of provisions expanding the utility and
availability of S corporations, including the elimination of the
prohibition of an S corporation being the member of an affiliated
group, therefore permitting an S corporation to own subsidiaries. A
wholly-owned subsidiary was permitted by the 1996 Act to make a
qualified Subchapter S subsidiary election (a ``QSub election'')
resulting in disregarding entity treatment for the wholly-owned
subsidiary, with the result that an S corporation is able to combine
the results of its operations and its wholly-owned subsidiary
corporations in a single tax return. The 1996 Act increased the
numerical limitation on S corporation shareholders from 35 to 75 and
permitted complex trusts to hold S corporation stock as electing small
business trusts or ``ESBTs.''
Several bills have been introduced in the 108th Congress to address
many of the problems S corporations and their shareholders encounter as
a result of onerous and unnecessary statutory restrictions. These bills
include: H.R. 714, the ``Small Business and Financial Institutions Tax
Relief Act of 2003,'' introduced by Rep. Scott McInnis (R-CO); H.R.
1498, the ``Small Business Opportunity and Growth Act of 2003,''
introduced by Rep. Jim Ramstad (R-MN); and H.R. 1896, the ``Subchapter
S Modernization Act of 2003,'' introduced by Rep. E. Clay Shaw, Jr.,
(R-FL). Several of these bills include common proposals for revisions
to the limitations on S corporations. The Shaw bill, which is the
subject of these comments, is the current version of legislation
previously introduced as H.R. 2576 and S. 1201 in the 107th Congress by
Rep. Shaw in the House and by Senator Hatch (for himself and on behalf
of Senators Breaux, Lincoln, Allard, Thompson, and Gramm) in the
Senate. The following comments have been developed during the pendency
of the 2001 proposals and have been updated to refer to the current
version of the bill.
H.R. 1896 includes a number of Subchapter S modernization
provisions, including the following:
The members of a family (within 6 generations of a common
ancestor) are treated as one shareholder.
Nonresident aliens are allowed to be S corporation
shareholders.
The numerical shareholder limitation is increased from 75
to 150.
The issuance of preferred stock by an S corporation would
be permitted.
Convertible debt would be eligible for the straight debt
safe harbor.
Excess passive income would no longer be a termination
event.
The sting tax would be imposed when passive investment
income of an S corporation having accumulated earnings and profits
exceeds 60 percent of gross receipts (rather than 25%); capital gains
from the sale of stock or securities would no longer be included in
gross receipts for this purpose.
Shareholders would be allowed a full deduction for
charitable contributions of appreciated property by an S corporation,
by increasing shareholder basis to the extent the deduction exceeded
the basis of the property contributed.
Losses recognized by S corporation shareholders upon
liquidation of an S corporation will be treated as an ordinary loss to
the extent of basis increases attributable to ordinary income.
The carryover of suspended passive activity losses from C
to S years would be permitted.
Suspended losses would be transferred to the transferee
upon the transfer of S corporation stock incident to divorce.
The disposition of S corporation stock by a QSST would
trigger the recognition of suspended losses at the beneficiary level.
The statutory restrictions on electing small business
trusts (``ESBTs'') would be relaxed to provide that:
Interest expense on debt incurred to acquire S
corporation stock would be deductible by the S portion of an ESBT.
Unexercised powers of appointment would be disregarded
in determining the potential current beneficiaries of an ESBT.
Distributions from an ESBT sourced to the S portion
would be treated separately from a distribution sourced to the non-S
portion.
Amounts contributed to charity by an ESBT pursuant to
the terms of the governing instrument would be allowable as a deduction
to the ESBT and taken into account as UBTI by the charity.
S corporation shareholders would be permitted to increase
basis for amounts loaned to the S corporation, even through the funds
were obtained by the shareholder from a ``back to back'' loan from a
related party.
A bank S corporation would not include in the definition
of ``passive investment income'' interest income from any source and
dividend income from investments required to conduct a banking
business.
Shares of a bank S corporation held by a director
(``qualifying director-shares'') would not be treated as outstanding
shares for purposes of the single class of stock requirement and
allocations of income or loss.
A bank S corporation would be permitted to recognize the
section 481(a) adjustment resulting from the change from the reserve
method of accounting for bad debts to the charge-off method in one year
rather than over four years.
The IRS would be granted authority to grant relief for
inadvertent invalid or inadvertently terminated QSub elections.
Q-Subs would be treated as separate entities for purpose
of certain informational returns required under sections 6031 through
6060.
The sale of an interest in a QSub, resulting in the
termination of the QSub election, would be treated as the sale of an
undivided interest in the subsidiary's assets followed by a deemed
contribution by the S corporation transferor and the transferee to a
new corporation in a section 351 transaction.
A QSub election would be treated as a tax-free
liquidation under section 332, without regard to the application of the
step transaction doctrine (for example, in the case of a restructuring
of an S corporation and its subsidiaries).
Earnings and profits attributed to pre-1983 S years would
be eliminated, without regard to whether the S election was in Gain or
loss from deferred intercompany transactions would not be triggered on
the conversion of a consolidated group to S corporation or QSub status,
but would be treated as recognized built-in gain or loss when the asset
is disposed of in a taxable transaction.
Charitable contribution carryforwards and foreign tax
credit carryfowards arising from a C year would be allowed as a
deduction against net recognized built-in gain under section 1374.
Distributions by an S corporation to an ESOP would be
treated as a dividend for tax purposes under section 404(k)(2)(A),
permitting the use of the distribution to make principal payments on an
ESOP loan without violating the prohibited transaction rules and
permitting the pass through of dividends to ESOP beneficiaries without
the premature distribution penalties otherwise applicable to early
distributions from qualified retirement plans.
COMMENTS ON ACT PROVISIONS
The views expressed herein represent the position of the Section of
Taxation and have not been approved by the House of Delegates or the
Board of Governors of the ABA. Accordingly, these views should not be
construed as representing the position of the ABA.
The Section of Taxation believes that the Subchapter S
Modernization Act of 2003 (the ``Act'') represents a significant
improvement to current law and we support its enactment. The Act would
enhance the utility of the S corporation election to small businesses,
promote fairness by mitigating certain traps under current law, and
foster simplification by reducing transactional complexity now facing S
corporations. We do, however, have comments regarding certain
provisions and have suggestions regarding how the drafting of
particular provisions of the Act could be improved from a technical
perspective. The following discussion sets forth our comments on the
provisions currently included in the Act.
Section 101--Members of Family Treated as 1 Shareholder
General Explanation. The Act provides that, solely for purposes
of counting the number of shareholders of an S corporation to determine
if there are no more than 75 shareholders (increased to 150 under
Section 104 of the Act) (the ``shareholder limit''), all ``members of
the family'' with respect to which an election is in effect are treated
as one shareholder. The members of the family would be comprised of a
person known as the ``common ancestor,'' the lineal descendants of the
common ancestor, and the spouses (or former spouses) of the lineal
descendants or common ancestor. The lineal descendants included in the
family under this provision are those up to six generations removed
from the common ancestor, as of the later of the effective date of the
provision (taxable years beginning after December 31, 2003) or the time
an S corporation election is made. The election requires the consent of
shareholders (including family members) holding in the aggregate more
than one-half of the shares of stock in the corporation on the day the
election is made. The provision also clarifies that the trustee of an
electing small business trust and the beneficiary of a qualified
subchapter S trust are to make the election. In conjunction with
providing for the election to treat family members as one shareholder,
the Act provides for relief when the election is inadvertently invalid
or inadvertently terminated.
Comments. This provision would allow businesses owned by large
families to obtain or retain S corporation status, without precluding
employees or others from having an equity stake. This provision would
be particularly helpful to a business owned in large part by a
multigenerational family. Some multi-generational family-owned
businesses currently are denied the benefit of S corporation status
solely because there are too many family members to satisfy the
numerical shareholder limitation. Increasing the number of shareholders
an S corporation can have alone will not necessarily address the
concerns of businesses owned by multigenerational families, since these
families can consist of more than 150 members in some cases.
Recommendation. We support the enactment of this provision.
Section 102--Nonresident Aliens Allowed to Be Shareholders.
General Explanation. The Act would amend section 1361(b) to
permit nonresident aliens to be S corporation shareholders. In concert
with this amendment, section 1446 would be amended to require the S
corporation to withhold and pay a withholding tax on effectively
connected income allocable to its nonresident alien shareholders.
Comments. This provision would enhance the ability of an S
corporation--which, by definition, must be a domestic corporation--to
expand into international markets by providing it with the ability to
offer an equity interest to an individual recruited to enhance its
overseas business. In addition, the provision would increase the S
corporation's access to foreign capital markets and would obviate the
need to raise such capital through a partnership of which the S
corporation is a partner. Eliminating the need to utilize a partnership
structure would be a significant step towards simplification. Moreover,
the bill would prevent significant revenue loss by subjecting
nonresident alien shareholders to U.S. withholding tax on S corporation
income. We also recognize the possibility that the current version of
Subchapter S may be a violation of U.S. international tax treaties that
preclude discrimination against nonresident aliens.
Under the Act, any withheld amount would be treated as
distributed to the foreign shareholder by the S corporation on the
earlier of--(i) the date the withholding tax is paid by the S
corporation, or (ii) the last day of the S corporation's taxable year
for which the tax is paid. This provision potentially raises an issue
under the one-class-of-stock rules of Section 1361(b)(1)(D) by giving
the foreign shareholder a different right to distributions than other
shareholders. The Treasury regulations address a similar issue in the
context of state law requirements for payment and withholding of income
tax. In this connection, Treas. Reg. Sec. 1.1361-1(1)(2)(ii) provides
that state laws regarding withholding of state income taxes are
disregarded in determining whether all shares of stock confer the same
rights to distribution and liquidation proceeds, provided that, when
the constructive distributions resulting from the payment or
withholding are taken into account, the outstanding shares confer
identical rights to distribution and liquidation proceeds. By analogy,
as long as the remaining shareholders have the right to distributions
that take the withholding tax distributions to the nonresident alien
shareholders into account, the withholding provisions of section 1446
should not be deemed to create dissimilar rights to distributions for
purposes of the one-class-of-stock rule.
Recommendation. We support the enactment of this provision as
drafted. By analogy to the existing regulations under section 1361, it
should be clear that the proposed statutory language does not create
different rights to distribution and liquidation proceeds for purposes
of the one-class-of-stock requirement. We recommend that this be
confirmed by the appropriate committee reports or other legislative
history accompanying the enactment of this provision.
Section 103--Expansion of Bank S Corporation Eligible Shareholders to
Include IRAs.
General Explanation. The Act would amend section 1361(c)(2) to
provide that a trust which is an individual retirement account (IRA)
could be a permitted shareholder of an S corporation, but only in the
case of a corporation that is a bank, and only to the extent of the
stock held by the trust on the date of enactment of the provision. If
an IRA is a shareholder in an S corporation, its allocable share of the
income from the corporation will be subject to the tax imposed by
section 511 on the unrelated business taxable income of certain exempt
organizations. In addition, the Act would exempt from the prohibited
transaction rules of section 4975 a sale of stock by an IRA in
existence on the date of enactment to the individual for whose benefit
the trust was established.
Comment. We generally support the expansion of the availability
of the S corporation form by permitting IRAs to be shareholders of S
corporations. We believe, however, that it would be helpful for any
legislation allowing an IRA to be a shareholder to make clear to what
extent the rules regarding unrelated business income tax (``UBIT'')
apply to the S corporation income that ``flows through'' to the IRA
shareholder. Various other kinds of tax-exempt organizations and
qualified retirement plans currently can hold S corporation stock;
however, only employee stock ownership plans (ESOPS) are not subject to
current tax on S corporation flow through income, and Congress has
enacted ``anti-abuse'' legislation to address concerns with particular
ESOP arrangements. Imposition of UBIT could raise administrative
concerns in the context of IRAs.
We also could support a proposal similar to that proposed by
Chairman Baucus in the markup document for the Small Business and Farm
Recovery Act of 2002. Although the Senate Finance Committee postponed
indefinitely the markup of that bill, the proposal would have allowed
an IRA to transfer stock of a corporation to its beneficiary without
triggering a ``prohibited transaction'' problem in order to allow the
corporation to make an S corporation election. We would recommend that
such a proposal apply to all corporations that are making S corporation
elections, rather than being limited to a particular industry.
We take no position regarding whether Section 103 of the Act,
which is targeted to banks and to IRAs that hold stock at a particular
time, should be adopted.
Section 104--Increase in Number of Eligible Shareholders to 150.
General Explanation. The Act provides for an increase in the
numerical limitation on the shareholders of an S corporation from 75 to
150.
Comments. This provision, consistent with other provisions in
the Act, would make S corporation status accessible to more businesses
operated in the corporate form without adding levels of administrative
complexity.
Recommendation. We support the enactment of this provision. In
the absence of a complete elimination of the shareholder limit, which
would simplify the eligibility rules considerably, an increase in the
number of shareholders that an S corporation may have, in conjunction
with the new provision allowing members of a family to be treated as
one shareholder for purposes of the shareholder limit, will be a
welcome change facilitating the S election for more closely held
businesses. Administrative issues relating to the increased number of
shareholders of a corporate pass-through entity would be no more
burdensome than the administrative issues that arise in connection with
partnerships and limited liability companies taxable as partnerships,
which are not subject to fixed numerical limitations on the number of
partners or members.
Section 201--Issuance of Preferred Stock Permitted.
General Explanation. The Act would amend section 1361(f) to
allow an S corporation to issue qualified preferred stock (``QPS'').
QPS generally would be stock that (i) is not entitled to vote, (ii) is
limited and preferred as to dividends and does not participate in
corporate growth to any significant extent, and (iii) has redemption
and liquidation rights which do not exceed the issue price of such
stock (except for a reasonable redemption or liquidation premium).
Stock would not fail to be treated as QPS merely because it is
convertible into other stock. Further, QPS would not be treated as a
second class of stock and a person holding QPS would not be treated as
a shareholder of the S corporation. A distribution (not in payment for
the QPS) would 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.''
Comments. One objective of this provision is to provide
flexibility to S corporations in raising capital by allowing the S
corporation to issue preferred stock. Generally, this senior equity
must be ``plain vanilla'' preferred, except that a convertibility
feature would not, in itself, cause the preferred stock not to qualify
as QPS. Nevertheless, as a practical matter, preferred stock with a
convertibility feature would seldom meet the definition of QPS. That is
because most commonly used convertibility features, e.g., a fixed
conversion rate such as one share common for one share preferred, would
allow the preferred stock to participate in corporate growth to a
significant extent. This would cause the stock to violate the
requirement of section 1504(a)(4)(B) (``limited and preferred as to
dividends and does not participate in corporate growth to any
significant extent''). In fact, unless the conversion feature required
the conversion to be based on a fair market valuation of the common
stock at the date of conversion, it appears unlikely that convertible
preferred stock could satisfy the requirements of Section
1504(a)(4)(B). Thus, while the ability to have preferred stock is
certainly welcome, the utility of the provision as a source of capital
is circumscribed. For example, because venture capital investors
typically require that preferred stock contain a convertibility feature
that allows the investor to participate in corporate growth to a
significant extent, QPS probably would not be attractive to such
investors.
The Act would facilitate family succession by permitting the
older generation of shareholders to relinquish control of the S
corporation while still maintaining an equity interest. It also would
reduce transactional complexity by eliminating the need for the S
corporation to enter into a joint venture with an investor who demands
a preferential return (i.e., through use of a partnership structure).
Therefore, we support this provision, subject to the comments herein.
The current language of the proposed amendment to section
1361(f) does not prescribe the specific treatment of the income to the
holder and the deduction to the corporation. Instead, it merely
describes the income as ordinary and the deduction as an expense.
Recommendation. If QPS is to fulfill an objective of opening
another avenue of capital attraction to S corporations, it would be
helpful for the convertibility feature to be broadened by amending the
last sentence of section 1361(f)(2) to provide as follows:
Stock shall not fail to be treated as qualified preferred stock
merely because it is convertible into other stock and such
convertibility feature allows a significant participation in corporate
growth.
To provide certainty to S corporations and their shareholders,
and to minimize the possibility of different interpretations by
taxpayers and the Government, we recommend that the language of this
provision be modified to provide that distributions with respect to QPS
be treated as interest expense to the corporation, and interest income
to the holder, respectively.
A potential issue also arises with respect to the timing of the
income inclusion to the holder and the deduction of the S corporation.
Under the current language, the income is includible as income of the
holder, and deductible in computing taxable income under Code section
1363(b), in the year such distribution is received. However, as
indicated in the example below, this language can be ambiguous.
Example--A owns QPS in corporation X, an S corporation. A's
taxable year ends November 30 and X's taxable year ends December 31. On
December 31, 2001, X distributes to A $100,000 with respect to A's QPS.
Is the distribution includible as income by A in its taxable year
ending November 30, 2002 and deductible as expense by X in its taxable
year ending December 31, 2002?
We recommend that section 1361(f) be rewritten as follows to
eliminate the possible ambiguity with respect to this issue.
``(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 income of the holder
and shall be treated as deductible expense to the corporation for
purposes of computing its taxable income under 1363(b). The income of
the holder shall be includible, and any deduction of expense to the
corporation under this chapter shall be allowable, as of the taxable
year of the holder and the corporation, respectively, in which occurs
the date that the distribution is received by the holder. Solely for
purposes of section 265(a), qualified preferred stock shall be treated
as indebtedness of the corporation issuing the qualified preferred
stock.
Section 202--Safe Harbor Expanded to Include Convertible Debt.
General Explanation. Under current law, debt of an S corporation
can qualify as safe-harbor debt only if (among other requirements) the
creditor is an individual (other than a nonresident alien), an estate
or a trust that is permitted to be an S corporation shareholder, or a
person that is actively and regularly engaged in the business of
lending money. Further, convertible debt cannot qualify as safe-harbor
debt. Act section 202 would expand the safe-harbor debt provision to
permit nonresident alien individuals, section 501(c)(3) organizations
and certain trusts forming part of a qualified stock bonus, pension or
profit-sharing plan as creditors. In addition, a convertibility feature
would not automatically disqualify debt as safe-harbor debt provided
the terms of the promise to repay, taken as a whole, are substantially
the same as the terms which could have been obtained on the effective
date of such promise from a person which is not a related person to the
S corporation or its shareholders.
Comments. We believe that this provision would assist S
corporations in obtaining capital and we support its enactment.
Expanding the list of ``permissible safe harbor'' creditors to include
nonresident alien individuals would be consistent with allowing such
individuals to be S corporation shareholders directly. (See discussion
above.) Similarly, allowing section 501(c)(3) organizations and certain
trusts forming part of a qualified stock bonus, pension or profit-
sharing plan to be ``permissible safe-harbor'' creditors is consistent
with existing law which allows such persons to be shareholders of an S
corporation. Finally, expanding the safe-harbor to include certain
convertible debt would allow an S corporation an alternative source of
financing without risking its S status due to the one-class-of-stock
requirement.
Section 203--Repeal of Excess Passive Investment Income as a
Termination Event.
General Explanation. Under current law, a corporation's status
as an S corporation will terminate if (1) it has accumulated earnings
and profits at the close of each of three consecutive taxable years,
and (2) has gross receipts for each of such taxable years more than 25
percent of which are ``passive investment income.'' Section 1362(d)(3).
In addition, an S corporation with accumulated earnings and profits is
subject to a corporate-level ``sting'' tax during each year in which it
has ``excess'' passive investment income under section 1375. This
``sting'' tax is intended to be a surrogate for the personal holding
company tax that is imposed on C corporations with significant income
from ``passive'' sources (such as certain rents, royalties and
interest). Section 203 of the Act would repeal the rule that S
corporation status terminates if a corporation with earnings and
profits has excess passive investment income for three consecutive
years, but would leave in place (subject to a modification in Act
section 204, discussed below) the corporate level ``sting'' tax.
Comments. We support the enactment of this provision as drafted.
The corporate-level ``sting'' tax alone is a sufficient deterrent to
preclude a corporation from converting to S corporation status in order
to avoid the personal holding company tax. Layering on the termination
of S corporation status in situations where a corporation with earnings
and profits has ``excess'' passive investment income for several years
appears harsh. For example, consider the case where an S corporation
discovers that it has had a single dollar of earnings and profits from
a prior period as a C corporation that it has not yet distributed. It
also has had gross receipts for 3 years of which 27 percent are from
rent; clearly, losing its S corporation status is an exceptionally high
price to pay for ``foot-faulting'' into a passive investment income
situation. Although ``inadvertent termination'' relief may be available
through petitioning the IRS, the availability of relief is not certain,
and the taxpayer must bear the significant costs of preparing and
filing a private letter ruling request.
Section 204--Modification of Section 1375 Sting Tax, Including Repeal
of Passive Investment Income Capital Gain Category.
General Explanation. As indicated above, the ``sting'' tax of
section 1375 is imposed upon S corporations that have both ``excess''
passive investment income and C corporation earnings and profits. For
this purpose, passive investment income is defined in section
1362(d)(3)(C) as including ``gross receipts from royalties, rents,
dividends, interest, annuities, and sales or exchanges of stock or
securities (gross receipts from such sales or exchanges being taken
into account for purposes of this paragraph only to the extent of gains
therefrom).'' Section 204 of the Act would remove gross receipts from
sales or exchanges of stock or securities from the definition of
passive investment income for purposes of the section 1375 tax.
Because, as discussed above, the Act would repeal excess passive
investment income as a termination event, Act section 204 also would
insert the definition of passive investment income into the ``sting''
tax provisions of section 1375; currently, the definition is contained
in the termination provision in section 1362(d)(3) and is merely cross-
referenced in section 1375(b)(3). Act section 204 also would increase
the required level at which the ``sting'' tax would occur so that a
corporation would be subject to ``sting'' tax, only if more than 60
percent of its gross receipts constituted passive investment income,
rather than more than 25 percent under current law.
Comments. We support this provision. As indicated above, the
``sting'' tax is intended to be a surrogate for the personal holding
company tax imposed on C corporations under section 541. However, the
definition of ``personal holding company income'' for purposes of
section 541 does not include gross receipts from sales or exchanges of
stock or securities; instead, it generally is limited to certain
dividends, interest, royalties, and rents. See section 543. Further,
there is no independent policy reason for including gross receipts from
sales or exchanges of stock or securities in the definition of passive
investment income for purposes of the 1375 corporate level tax. Thus,
to achieve consistency with section 541, we recommend that this item be
dropped from the definition of passive investment income. However,
while gains from the sale or exchange of stock or securities are
appropriately excluded as passive investment income, we recommend
retention of a gross receipts modification by inserting paragraph
(b)(4) as follows:
(4) Gross receipts from sales of capital assets. For purposes of
paragraph (3), in the case of dispositions of capital assets, gross
receipts from such dispositions shall be taken into account only to the
extent of the capital gain net income therefrom.
In this respect, to the extent that Congress believes that a
``sting'' tax is appropriate, the suggested retention of a modification
of the definition of gross receipts is necessary to avoid vitiating the
``sting'' tax provision.
Example--X is an S corporation with accumulated earnings and
profits. X's only asset is a money market account of $10,000,000, which
produces annual interest income in the amount of $500,000. On December
10, X purchases $500,000 of GE stock and on December 20, sells the GE
stock for $500,000. Without the modification, no portion of the
interest income would be subject to Code section 1375 sting tax,
because X's passive investment income (interest of $500,000) would not
be more than 60 percent of X's gross receipts ($1,000,000 gross
receipts consisting of $500,000 interest income and $500,000 gross
proceeds from the sale of GE stock).
Section 205--Allowance of Deduction for Charitable Contributions of
Appreciated Property.
General Explanation. As indicated in the example below, the
current Subchapter S rules discourage making charitable gifts of
appreciated property through S corporations. Section 1366(d)(1) limits
the amount of losses and deductions that flow through to a shareholder
to the shareholder's basis in his or her stock and debt; however, there
currently is no mechanism for increasing the shareholder's stock basis
to reflect appreciation in property that is contributed to a charity.
As a result, when an S corporation contributes appreciated property to
a charity, the full amount of the deduction for the contribution may
not be available to the shareholders at that time, notwithstanding
Congressional intent to encourage charitable contributions through
providing a fair market value deduction. The Act would remedy this
problem by amending section 1367 to provide for an increase in the
shareholders' basis to the extent of the excess of the deductions for
charitable contributions over the basis of the property contributed.
Example--Bob contributes property with a basis of $500 and a
value of $1,500 to his newly-formed S corporation in exchange for
stock. At some later time, the property appreciates further in value to
$2,000. The S corporation then contributes the property to a charity.
(Assume no other assets, income or activity.) Under section 1366, the
amount that flows through to Bob is limited to his $500 tax basis in
his stock (with the remainder ``suspended'' indefinitely, until Bob has
sufficient basis). Thus, Bob did not benefit from the fair market value
deduction at the time because his stock basis did not reflect the
property's appreciation. However, if Bob had never contributed the
property to his corporation, he could have benefited from a $2,000
deduction.
Comments. We support the enactment of this provision as drafted.
As indicated above, the current law rules undercut Congressional
efforts to encourage charitable giving through providing a fair market
value deduction. Further, charitable contributions through partnerships
currently are treated more favorably than charitable contributions
through S corporations because the statutory provisions for
partnerships are different than those for S corporations; this has
allowed the IRS the flexibility to reach the proper policy result in
the partnership situation. (See Rev. Rul. 96-11, 1996-1 C.B. 140 for
the treatment of charitable contributions by a partnership.) The Act
would modify the S corporation statutory rules to produce the proper
result for S corporations as well and to remove a potential trap for
the unwary who make charitable contributions of appreciated property
through S corporations.
Section 301(a)--Treatment of Losses to Shareholders/Liquidations.
K General Explanation. The Act would amend section 331 to provide
that the portion of any loss recognized by an S corporation shareholder
on amounts received by the shareholder in a distribution in complete
liquidation of the S corporation would be treated as an ordinary loss
to the extent of the shareholder's ``ordinary income basis'' in the S
corporation stock. The ``ordinary income basis'' of the shareholder
would be an amount equal to the portion of such shareholder's basis in
such stock equal to the aggregate increases in such basis under section
1367(a)(1) resulting from the shareholder's ``pro-rata share of
ordinary income of such S corporation attributable to the complete
liquidation.''
Comments. We believe that this provision is necessary in order
to prevent character mismatches on the liquidation of S corporations
and support the provision, with the following comment. We also believe,
however, that the definition of ``ordinary income basis'' is drafted
too narrowly since it can be interpreted to encompass only ordinary
income recognized upon a distribution of property in complete
liquidation of the corporation. Ordinary income basis should also
include ordinary income recognized in connection with sales or
exchanges of S corporation property that arise pursuant to certain
dispositions that are made before, but in contemplation of,
liquidation.
In certain circumstances, the language of proposed section
331(c) also may provide unintended benefits. For example, consider the
situation below:
X, an S corporation, has 3 assets:
Adj. Basis FMV
Land $2,000,000 $1,000,000
Inventory (1) 1,000,000 2,000,000
Inventory (2) 2,000,000 1,000,000
TOTAL $5,000,000 $4,000,000
A, X's sole shareholder, has $6,000,000 basis in his S
corporation stock.
On liquidation of X--
Land ($1,000,000) capital loss
Inventory (1) 1,000,000 ordinary income
Inventory (2) ( 1,000,000) ordinary loss
TOTAL ($1,000,000)
A's stock basis: $6,000,000 - 1,000,000 + 1,000,000 - 1,000,000 =
$5,000,000.
Loss on liquidation: $4,000,000 - $5,000,000 = (1,000,000)
Proposed section 331(c) arguably would treat this loss as
ordinary loss (because of the $1,000,000 ordinary income), even though
there is no need for recharacterization in this situation. In this
respect, the gain on the sale of Inventory (1) and the loss on sale of
Inventory (2) arguably are not netted under section 1366(a)(1)(B) and
are separately stated under section 1366(a)(1)(A) because the separate
treatment of those items could affect the liability for tax of any
shareholder.
Recommendation. We recommend that the definition of ordinary
income basis be modified to reflect a concept similar to that contained
in section 453(h)(1), i.e., include ordinary income recognized upon a
sale or exchange of property by the corporation during the 12-month
period beginning on the date a plan of complete liquidation is adopted,
provided that all of the assets of the corporation are distributed in
complete liquidation within such 12-month period. To prevent unintended
benefits, we further recommend that the character of the stock loss be
recharacterized only to the extent of net ordinary income resulting
from such sale or exchange.
Section 301(b)--Suspended Passive Activity Losses.
General Explanation. The Act would amend section 1371(b) to
permit the carryover of suspended passive activity losses from a year
in which a corporation was a C corporation to a year in which the
corporation is an S corporation.
Comments. This provision would codify the result in St. Charles
Investment Co. v. Commissioner, 232 F. 3d 773 (10th Cir. 2001). In St.
Charles, the Tenth Circuit reversed a Tax Court decision that had held
that suspended passive activity losses may not be carried forward when
a corporation converts from a C corporation to an S corporation. The
Tenth Circuit resolved a tension between sections 1371(b)(1) and
469(b). Section 1371(b)(1) provides that ``[n]o carryforward, and no
carryback, arising for a taxable year for which a corporation is a C
corporation may be carried to a taxable year for which such corporation
is an S corporation.'' Section 469(b) provides that ``[e]xcept as
otherwise provided in this section (emphasis added), any loss . . .
from an activity which is disallowed under subsection (a) shall be
treated as a deduction . . . allocable to such activity in the next
taxable year.'' The Tenth Circuit concluded that the plain language of
section 469 precludes application of section 1371 to the suspended
passive activity losses of a corporation in the first year of its S
election. Suspended passive activity losses from C years were made
available as a deduction against both passive activity gains and other
ordinary income upon the disposition of the passive activity.
Recommendation. We support the enactment of this provision as
drafted. This provision represents a helpful clarification of the
relationship between sections 1371(b)(1) and 469. Suspended passive
activity losses from C years would be treated as deductions against
passive activity gains in subsequent S years, and (as in St. Charles)
would become available as a deduction against both passive activity
gains and other ordinary income upon the disposition of the passive
activity in a subsequent S year.
Section 302--Transfer of Suspended Losses Incident to Divorce.
General Explanation. Under current section 1366(d), because
losses disallowed due to a shareholder having insufficient basis in
stock and debt of an S corporation (``suspended losses'') are carried
over to a subsequent year only ``with respect to that shareholder,''
once a shareholder transfers all of his/her shares to another person
the suspended losses vanish and are not available to be used by anyone.
The Act would provide an exception for transfers incident to a decree
of divorce.
Comment. Because of the frequency of stock transfers in divorce
situations, an exception for divorce situations from the general rule
in section 1366(d) that losses are not available to transferees would
be very meaningful and helpful. Thus, we believe this provision is
necessary and add the following comment. As drafted, by referring to
``any loss or deduction . . . attributable to such stock'' the
provision appears to suggest that if a shareholder transfers only some
of his/her stock incident to a decree of divorce, only a portion of the
suspended losses of the shareholder will become available to the
transferee and the remaining amount will remain with the transferor
shareholder. This approach is equitable and clearly preferable to
making all of the suspended losses of a transferor shareholder
available to the transferee. However, the provision is not completely
clear. Thus, it may be helpful to explain, perhaps in legislative
history, that a proration concept is contemplated when suspended losses
become available upon the transfer of a portion of stock to a
transferee incident to a decree of divorce.
Recommendation. We support the enactment of this provision. We
recommend clarification that if a shareholder transfers only some of
his/her stock incident to a decree of divorce, only the pro rata amount
of losses attributable to the transferred shares be included in the
transfer of the stock.
Section 303--Use of Passive Activity Loss and At-Risk Amounts by
Qualified Subchapter S Trust Income Beneficiaries.
General Explanation. The Act would amend section 1361(d)(1) to
clarify that the disposition of S corporation stock by a trust electing
QSST status shall be treated as a disposition of the stock by the QSST
beneficiary for purposes of applying the passive activity loss and the
at-risk limitations of sections 465 and 469(g).
Comments. The QSST beneficiary is taxed on all of the items of
income, loss, deduction and credit attributable to the ownership of S
stock by the QSST. However, gain or loss realized upon the sale of S
corporation stock by a QSST is taxable to the QSST rather than the QSST
beneficiary under Treas. Reg. Sec. 1.1361-1(j)(8).
It appears that Act Section 303 is intended to trigger the
recognition of loss by the S Corporation shareholder upon the
disposition of S corporation stock, otherwise suspended under the
passive loss and at-risk limitation of sections 465 and 469(g). Since
the current regulations treat the disposition of S corporation stock by
a QSST as the termination of the QSST election and provide for the
recognition of gain or loss on the sale as gain or loss to the trust,
the Act clarifies that such disposition also triggers the recognition
of suspended losses at the beneficiary level.
Recommendation. While we support the enactment of this
provision, we recommend that the committee reports accompanying the
bill clarify that the disposition of S corporation stock by a QSST
should be treated as a disposition of such stock by the taxpayer
otherwise required to recognize income attributable to such disposition
under applicable law and regulations (i.e. the QSST) and that the
amendment is intended to clarify that suspended losses attributed to
such stock are recognized by the beneficiaries upon such disposition.
Sections 304, 305, 306 and 307--Clarification of Electing Small
Business Trust Provisions.
Background. The 1996 Act permitted multiple beneficiary trusts
to own S corporation stock provided the trust meets the requirements of
an ``electing small business trust'' or ``ESBT'' set forth in code
section 1361(e)(1), including the following:
a. the beneficiaries must be individuals, estates or certain
nonprofit organizations;
b. no interest in the trust may have been acquired by purchase;
c. the trust makes a proper election to be treated as an ESBT;
d. the trust does not also make a QSST election with respect to
the stock of the same S corporation; and
e. the trust is not exempt from tax.
All of the potential current beneficiaries of an ESBT, as
defined in Code section 1361(e)(2), are counted for the purposes of the
75-shareholder limitation (150 under the Act) and must be permitted S
corporation shareholders in their own right.
An ESBT is taxed on the income attributable to the ownership of
the stock in the S corporation at the highest marginal rate, without
the benefit of the personal exemption, in accordance with code section
641(d). For purposes of Subchapter J, the portion of the ESBT that owns
stock in an S corporation is treated as a separate trust under section
641(d)(1)(A). The taxation of this separate trust is determined under
ESBT rules, while the non-ESBT portion of the trust is taxed under the
normal Subchapter J rules. Section 641(d)(1), (2), and (3). The S
corporation's income items are not included in the calculation of the
distributable net income (DNI) of the trust. No deduction is allowed
for the distribution of Subchapter S pass-through income to the ESBT
beneficiaries.
The Internal Revenue Service issued final regulations on May 14,
2002, providing detailed guidance on the qualification and taxation of
ESBTs. The final regulations provide that an ESBT will be treated as
having an ``S portion'' and a ``non-S portion.'' A grantor trust may
make an ESBT election, provided that the ``grantor portion'' is taxed
to the grantor under the grantor trust rules. Distribution to
beneficiaries are first considered to be distributed from the non-S
portion of the trust, carrying out DNI to the beneficiary receiving the
distribution, without regard to the source of the distribution.
General Explanation. Section 304 of the Act amends section
641(c)(2)(C) to provide that any interest expense incurred to acquire
stock in an S corporation is deductible by the S portion in determining
taxable income of an ESBT. Section 305 of the Act amends section
1361(e)(2) to clarify that unexercised powers of appointment are
disregarded in determining the potential current beneficiaries of an
ESBT and providing for a one-year correction period during which an
ESBT could dispose of stock after an ineligible shareholder becomes a
potential current beneficiary. Section 306 of the Act amends section
641(c)(1) by adding a new subparagraph (b) providing that any
distribution attributable to the portion of an ESBT treated as a
separate trust (the ``S portion'') shall be treated separately from any
distribution attributable to the non-S portion. Finally, Section 307 of
the Act amends section 641(c)(2)(C) to provide that an ESBT may deduct
amounts contributed to charity as described in section 642(c)(1),
provided that amounts received by the charity from an ESBT shall be
taken into account as unrelated business taxable income of the charity,
to the extent that such amount is deducted by the ESBT.
Comments. Sections 304, 305, 306 and 307 of the Act modify
certain provisions of the regulations finalized by the Internal Revenue
Service on May 14, 2002 (see T.D. 8994 (May 14, 2002)).
Section 304. The final regulations provide that interest
expenses paid by a trust electing ESBT status on indebtedness incurred
in connection with S corporation stock must be allocated to the S
portion of the ESBT, and such interest expenses are not deductible by
the S portion because they are not administrative expenses as limited
by the current statutory language. Treas. Reg. Sec. 1.641(c)-
1(d)(4)(ii). The final regulations provide that interest expenses
incurred to purchase S corporation stock do not increase the basis of
the stock held by the S portion. Section 304 of the Act amends Section
641(c)(2)(C) to correct this anomaly and provide that interest expense
incurred to acquire stock in an S corporation is deductible by the S
portion of the ESBT.
Section 305. The final regulations further provide that a person
entitled to receive a distribution from an ESBT only after a specified
time or upon the occurrence of a specified event is not a potential
current beneficiary until such time or the occurrence of the event. For
example, the holder of a testamentary power of appointment and the
permitted appointees under the power of appointment would not be
considered potential current beneficiaries until the death of the power
holder, when the testamentary directions will take effect. On the other
hand, the final regulations provide that the existence of a currently
exercisable power of appointment, such as a general lifetime power of
appointment that would permit distributions to be made from the trust
to an unlimited number of appointees, would cause the S corporation
election to terminate since the number of potential current
beneficiaries will exceed the numerical shareholder limit (75 under
current law and 150 under the Act). Section 305 of the Act amends
Section 1361(e)(2) to clarify that unexercised powers of appointment
are disregarded in determining the potential current beneficiaries of
an ESBT. In addition, Section 305 increases the period during which an
ESBT can dispose of S corporation stock after an ineligible shareholder
becomes a potential current beneficiary from 60 days under current law
to 1 year. Accordingly, an ESBT will have one year from the occurrence
of an event that entitles an ineligible shareholder to receive a
distribution from the trust to dispose of the S corporation stock
without resulting in the termination of the S election.
Section 306. The final regulations continue the approach
originally announced by the Service in Notice 97-49, 1997-1 C.B. 385
and the proposed regulations issued on December 29, 2000 with respect
to the treatment of distributions from an ESBT to beneficiaries. Under
the regulations, distributions to beneficiaries from the S portion or
from the non-S portion are first considered to be distributed from the
non-S portion of the trust, taxable under Subchapter J to the extent of
the distributable net income of the trust (the DNI). As a result,
distributions that may be clearly sourced from the S portion, even made
on the same day received from the S corporation, are treated as
distributions from the non-S portion. Section 306 of the Act changes
the results set forth in the final regulations by providing that any
distribution attributable to the S portion shall be treated separately
from any distribution attributable to the non-S portion.
Section 307. The final regulations provide that a charitable
contribution is deductible in determining the taxable income of the S
portion only if it is attributable to a charitable contribution by the
S corporation. The regulations provide that such a contribution will be
deemed to be paid by the S portion of the ESBT pursuant to the terms
for the trust's governing instrument within the meaning of Section
642(c)(1) so that the charitable deduction is allowable in determining
the taxable income of the S portion. Treas. Reg. Sec. 1.641(c)-
1(d)(2)(ii). Section 307 of the Act expands the charitable deductions
allowable in determining the taxable income of an ESBT to include
amounts contributed directly by the ESBT to the charity pursuant to the
terms of the governing instrument. The Act provides that such amounts
received by a charity directly from an ESBT shall be taken into account
as unrelated business taxable income of the charity, to the extent such
amount is deducted by the ESBT.
Recommendation. We support the proposed amendments clarifying
the electing small business trust provisions as set forth in Sections
304, 305, 306 and 307 of the Act. With respect to Section 306 of the
Act, providing for separate treatment or ``tracing'' of distributions
attributable to the S portion from distributions attributable to the
non-S portion, we suggest that the appropriate Committee reports or
legislative history accompanying the Act clarify that the trustee of an
ESBT may allocate distributions to the S portion or non-S portion using
any reasonable method. Insofar as Sections 305 and 306 of the Act
modify certain provisions of the final regulations issued by the
Internal Revenue Service on May 14, 2002, we recommend that the
effective dates of these provisions be changed to the earliest date
that the final regulations would have otherwise become effective. (As
drafted, Section 305 is effective for taxable years beginning after
December 31, 2003 and Section 306 is effective for taxable years
beginning after December 31, 1996). We recommend that Section 304 and
307, at the election of the taxpayer, be applied to taxable years
beginning after December 31, 1996.
However, we further agree with the simplification recommendation
of the Joint Committee on Taxation, ``Study of the Overall State of the
Federal Tax System and Recommendations for Simplification,'' April 26,
2001, that an ESBT be subject to taxation under the normal rules of
Subchapter J. We do not believe that the ownership of S corporation
stock by a complex trust presents difficult tax policy or tax
administration problems. Other pass-through entities, including
partnerships, limited liability companies classified as partnerships
for income tax purposes, and REITs, may be held by complex trusts with
multiple beneficiaries under existing law. In light of the compression
of the individual tax rates, the limitations on the use of multiple
trusts, and the ``kiddie tax'' provisions (subjecting the income of
children under age 14 to tax at the highest marginal rate of the
parents), there is little opportunity for tax avoidance or tax
minimization by trusts through allocations of income among
beneficiaries. Given the income tax limitations on trusts under
Subchapter J and the compression of income tax rates, any concerns that
income would be distributed only to persons who have large losses to
offset the income, that income would be distributed to unrelated
persons, or that distributions would be made from year to year in order
to minimize income taxes, are not well-founded.
Section 308--Shareholder Basis Not Increased By Income Derived From
Cancellation of S Corporation Debt.
General Explanation. Act section 308 would reverse the result in
Gitlitz v. Commissioner, 531 U.S. 206 (2000) by amending section
1366(a)(1) to exclude cancellation of indebtedness income excludable
under Section 108 as an item of income that flows through to an S
corporation shareholder. This would prevent any increase in the
shareholder's basis in S corporation stock.
Comment. Pub. Law 105-206, Sec. 6004(f)(1) has effectively
addressed the basis increase allowed under Gitlitz by amending section
108(d)(7)(A) to provide that any COD income excluded at the corporate
level under Section 108(a) is not taken into account under section
1366(a). That provision generally is effective for discharges of
indebtedness after October 11, 2001, in tax years ending after October
11, 2001.
Section 309--Back-to-Back Loans as Indebtedness.
General Explanation. Section 1366(d)(1)(B) currently allows an S
corporation shareholder to deduct losses allocable to the shareholder
under section 1366(a) to the extent of the shareholder's adjusted basis
in the shareholder's stock and the shareholder's adjusted basis in any
indebtedness of the S corporation to the shareholder. The Act amends
Code section 1366(d) to clarify that a back-to-back loan (a loan made
to an S corporation shareholder who in turn loans those funds to his S
corporation) constitutes ``indebtedness of the S corporation to the
shareholder'' within the meaning of section 1366(b)(1)(D) so as to
increase such shareholder's basis in the S corporation. This provision
would allow an S corporation shareholder to increase his basis in the S
corporation by the amount he loans to the S corporation, even though
the amounts loaned by the shareholder to his S corporation are obtained
by the shareholder by means of a loan from another person even if the
person loaning the funds to the shareholder is related to the
shareholder.
Background. Under section 1366(d), the aggregate amount of an S
corporation's losses and deductions taken into account by a shareholder
for any taxable year cannot exceed the sum of the adjusted basis of the
shareholder's stock in the S corporation plus the shareholder's
adjusted basis of any indebtedness of the S corporation to the
shareholder. Any loss or deduction that is disallowed for any taxable
year by this provision will be treated as incurred by the corporation
in the succeeding taxable year with respect to that taxpayer.
The IRS has held (and the courts have agreed) that to increase
the basis in the indebtedness of an S corporation, there must be an
economic outlay on the part of the shareholder. The required economic
outlay must leave the taxpayer ``poorer in a material sense.'' Perry v.
Commissioner, 54 T.C. 1293, 1296 (1970).
The economic outlay requirement has caused a great deal of
confusion for S corporation shareholders in situations in which the
funds loaned to the S corporation are borrowed from a related lender.
We believe that most practitioners, in advising clients about
structuring alternatives for financing S corporation activities, take
the position that back-to-back loan transactions among the lender
(including lenders related to the shareholder and/or the S
corporation), the shareholder, and the S corporation result, or should
result, in the shareholder obtaining basis in indebtedness of the S
corporation to the shareholder.
Recommendation. We support the enactment of this provision. The
amendment of section 1366(d)(1)(B) clarifying this result will help
many shareholders avoid inequitable pitfalls encountered where a loan
to an S corporation is not properly structured, even though the
shareholder has clearly made an economic outlay with respect to his
investment in the S corporation for which a basis increase is
appropriate, and alleviate the significant amount of litigation arising
out of back to back loan transaction where the shareholder obtains
funds lent to an S corporation from a related person. We recommend that
the legislation state that the revisions to section 1366(d)(1)(B)
should not be interpreted to infer the status of the law prior to the
amendments.
Section 401--Exclusion of Investment Securities Income from Passive
Income Test for Bank S Corporations.
General Explanation. The Act would provide for additional
exclusions from the definition of ``passive investment income'' for
purposes of section 1375(b)(3) (as amended by Act section 204(b)(1))
(relating to the tax on excess net passive investment income). In the
case of a bank, bank holding company, or qualified subchapter S
subsidiary that is a bank, the defined term would exclude both interest
income from any source and dividend income from certain investments
required to conduct a banking business.
Comments. Notice 97-5, 1997-1 C.B. 352, was issued shortly after
the enactment of the 1996 Act, which first allowed banks to be S
corporations and qualified subchapter S subsidiaries. In this Notice,
the Service excluded interest income on investments necessary to meet
``reasonable liquidity needs (including funds needed to meet
anticipated loan demands)'', but did not provide the unqualified
exclusion that the proposed legislation would provide.
Recommendation. We support the enactment of this provision.
Section 402--Treatment of Qualifying Director Shares.
General Explanation. The Act would amend section 1361 to provide
that ``qualifying director shares'' would not be treated as a second
class of stock, and that no person shall be treated as a shareholder of
the corporation by reason of holding qualifying director shares. Such
shares would be defined as shares of stock in a bank or bank holding
company which are held by an individual solely by reason of status as a
director and which are subject to an agreement pursuant to which the
holder is required to dispose of the shares of stock upon termination
of the holder's status as a director at the same price as the
individual acquired such shares of stock. In a manner similar to the
treatment of restricted stock under section 83, any dividend
distributions with respect to qualifying director shares will be
treated as ordinary income to the holder and deductible to the
corporation. Because these shares would not be treated as outstanding,
no allocations would be made with respect to such stock under section
1366(a).
Comments. It is not clear whether current law is inadequate to
deal with the circumstance of an individual who is required to hold
nominal title to shares of stock in a bank or bank holding company in
order to serve as a director of that organization. Present law would
apparently apply traditional benefits-and-burdens test to determine
whether a director is the Federal tax owner of stock subject to the
type of agreement described in the proposed legislation. In a case
where the issuing bank or bank holding company, rather than the
individual director, is the Federal tax owner of the stock, presumably
the stock would not be treated as outstanding, and thus could not
violate the single-class-of-stock requirement applicable to S
corporations.
Recommendations. We recommend that the committee reports
accompanying the bill specify whether the proposal is intended to be a
safe-harbor provision or the exclusive means of avoiding a second-
class-of-stock issue in this context.
Proposed section 1361(g)(1) would provide that the operative
rules described above apply ``[f]or purposes of this subchapter'',
i.e., subchapter S. We recommend that further consideration of the
scope of the operative rules should be undertaken. For example, it
might be appropriate to cause these rules to be applicable for purposes
of chapter 1 of the Code rather than solely subchapter S, so that
qualifying director shares are not treated as stock for purposes of
subchapter C.
Proposed section 1361(g)(2)(i) (which should be designated as
section 1361(g)(2)(A)) would define ``qualifying director shares'' as
shares of stock held by an individual ``solely by reason of status as a
director'' of the bank, bank holding company, or its controlled
subsidiary. We recommend that the definition be clarified so that it
achieves its apparent purpose, e.g., shares ``which are required to be
held by an individual under applicable Federal or state law in order to
permit such individual to serve as a director of such bank or company
or its controlled subsidiary''.
We also recommend that, in appropriate committee reports or
other legislative history, it would be clarified that ``qualifying
director shares'' will not be treated as outstanding for purposes of
determining whether an S corporation holds 100 percent of the stock of
a qualified subchapter S subsidiary. This conclusion may already be
apparent from Treas. Reg. Sec. 1.1361-2(b), but further clarification
would be appropriate and helpful.
Section 403--Recapture of Bad Debt Reserves.
General Explanation. The Act would establish an ``off Code''
provision that would permit an S corporation bank to recognize the
section 481(a) adjustment resulting from the required change from the
reserve method of accounting for bad debts to the charge-off method in
one year (either the taxable year ending with or beginning with the
election), rather than ratably over four years under current method-
change procedures.
Comments. A financial institution that uses the reserve method
of accounting for bad debts is not permitted to be an S corporation.
However, if a financial institution desires to make an S corporation
election, or to have a qualified subchapter S subsidiary election made
for it by its parent S corporation, it may change from the reserve
method to the specific charge-off method, effective not later than the
beginning of the taxable year for which the S corporation or qualified
subchapter S subsidiary election becomes effective. Rev. Proc. 97-18,
1997-1 C.B. 642, first set forth the procedures for a reserve-method
bank to make an automatic method change to the specific charge-off
method in connection with an S corporation or qualified subchapter S
subsidiary election. These automatic procedures are currently set forth
in Rev. Proc. 99-49, 1999-2 C.B. 725. In general, if the automatic
method change is made, the positive section 481(a) adjustment, which is
generally equal to the amount of the bank's reserve for tax purposes as
of the beginning of the year of change, is required to be included in
income ratably over a four-year period. This section 481(a) adjustment
is treated as a built-in gain, for purposes of section 1374, in each of
the years in which the adjustment is included in income. As the bank
begins to apply the specific charge-off method, however, its deductions
for bad debts with respect to loans held by the bank on the date of
conversion from C corporation to S corporation status are treated as
built-in losses for section 1374 purposes only to the extent that the
deductions are taken within the first taxable year of the S corporation
status. Treas. Reg. Sec. 1.1374-4(f). Section 1374 does not permit S
corporations to carry forward unused recognized built-in losses to
subsequent years in the recognition period in order to offset
recognized built-in gains. Accordingly, an S corporation bank may incur
a tax liability under Code section 1374(a) solely because of the
combined effects of the four-year section 481(a) adjustment period and
the one-year rule for the specific charge-off of bad debts.
Recommendations. We recommend several changes to improve the
scope and clarity of the proposal:
1. Statutory provisions affecting the Code that are not actually
enacted into the Code present traps for the unwary taxpayer and
practitioner. We recommend that this provision should be enacted as
part of section 481.
2. We recommend that the provision clarify that the treatment is
elective, by providing that ``such bank may elect to recognize'' the
section 481(a) adjustment over one year.
3. As currently drafted, the provision refers to the bank's
recognition of ``built-in gains'' from the method change. Because it
purports to modify the rules and procedures generally applicable to
section 481, we recommend that it provide that the election applies to
shorten the period for recognizing ``the adjustment required by section
481(a)''.
4. We recommend that the provision apply, in addition to an S
corporation election made by a bank, to a qualified subchapter S
subsidiary election made for a subsidiary of a bank holding company.
5. It is not clear what is intended by referring to the
taxpayer's choice to include the section 481(a) adjustment ``either in
the taxable year ending with or beginning with such an election.'' It
is plausible that the drafters intended the electing corporation to
take the section 481(a) adjustment into account in full in either its
last taxable year as a C corporation or its first taxable year as an S
corporation. Because an S corporation election becomes effective on the
first day of the taxable year of the corporation, there is no taxable
year that ``end[s] with . . . such an election.'' Therefore, we
recommend that the language relating to the year of recognition of the
section 481(a) adjustment be restated as ``either the taxable year
immediately preceding the taxable year for which the election is first
effective or the taxable year for which the election is first
effective.''
Section 501--Relief for Qualified Subchapter S Subsidiary Elections
That Are Inadvertently Invalid of Inadvertently Terminated.
General Explanation. The Act would amend section 1362(f) to
provide statutory authority for the Secretary to grant relief for
invalid QSub elections and terminations of QSub status if the Secretary
determines that the circumstances resulting in such ineffectiveness or
termination were inadvertent. This would allow the IRS to provide
relief in appropriate cases, just as it currently can in the case of
invalid or terminated S corporation elections.
Comments. We support the enactment of this provision. Section
1362(f) currently provides the IRS with authority to grant relief for S
corporation elections that are inadvertently invalid or inadvertently
terminated. Taxpayers typically seek such relief through the private
letter ruling process. Numerous petitions for relief are granted each
year, reflecting the fact that it is common for taxpayers to
inadvertently run afoul of the S corporation eligibility requirements.
It is inevitable that taxpayers similarly will inadvertently
fail to meet the eligibility requirements for Qualified Subchapter S
Subsidiary (``QSub'') status. For example, an inadvertently invalid
election could occur where an S corporation makes a QSub election for a
subsidiary that it in good faith believes it wholly owns, but later
discovers that an arrangement with a third party that was structured as
debt constitutes equity in the subsidiary for Federal tax purposes.
However, there currently is no mechanism for taxpayers to receive
relief from the IRS. The IRS had provided for inadvertent QSub
termination relief in the proposed QSub regulations, but removed this
provision from the final regulations because of concerns that it lacked
the authority to provide relief without an explicit statutory mandate
from Congress. (See the preamble to the final QSub regulations under
section 1361.)
Section 502--Information Returns for QSubs.
General Explanation. The Act would provide that, in the case of
information returns required under part III of subchapter A of chapter
61 (i.e., sections 6031 through 6060), a QSub would be treated as a
separate entity and would not be treated as, in effect, a division of
the parent S corporation.
Comments. Section 1361(b)(3)(A) currently provides the Secretary
with authority to provide exceptions to the general rule that, for
Federal tax purposes, a QSub is not treated as a separate corporation
but instead is treated as a division of the parent S corporation. The
Treasury and IRS have provided certain exceptions to this general rule
for banks and for employment tax purposes, and have authority to
provide additional exceptions. It is not clear why this change is
necessary or appropriate. We recommend that a QSub be treated as a
disregarded entity for purposes of information returns required under
Part III of subchapter A of section 61 (sections 6031 through 6060)
which would be required of the S corporation parent.
Recommendation. We do not perceive any justification for the
enactment of this provision. We recommend that the informational
returns otherwise required under current law be required to be filed by
the S corporation parent, since the existence of the QSub is
disregarded for federal tax purposes, except to the extent provided by
regulations.
Section 503--Sale of an Interest in a QSub.
General Explanation. Act Section 503 would clarify the tax
treatment of the termination of a corporation's status as a QSub where
the termination is a result of disposition of stock in the QSub. Under
section 1361(b)(3)(E), a termination by reason of disposition of stock
in the QSub would be treated as a sale of an undivided interest in the
subsidiary's assets based on the percentage of the stock transferred
followed by a deemed contribution by the S corporation transferor and
the transferee to a new corporation in a section 351 transaction.
Comments. Section 1361(b)(3)(C) provides that if any QSub ceases
to meet the QSub eligibility requirements, it will be treated as ``a
new corporation acquiring all its assets (and assuming all of its
liabilities) immediately before such cessation from the S corporation
in exchange for its stock.'' The legislative history to the 1996 Act is
silent as to how this deemed contribution of assets, subject to
liabilities, should be treated for Federal tax purposes.
The final regulations on QSubs apply the step transaction
doctrine to the deemed transfer of assets to the ``Newco'' in exchange
for Newco stock. As indicated below, the examples in the final
regulations illustrate how the application of this doctrine can lead to
recognition of 100 percent of the gain in a QSub's assets where as
little as 21 percent of the subsidiary's stock is sold. The examples
also illustrate how this inappropriate result can be avoided through a
merger or through structuring the sales transaction differently.
Example 1 of Treas. Reg. Sec. 1.1361-5(b)(3) sets forth a
situation where an S corporation sells 21 percent of the stock of a
QSub to an unrelated purchaser for cash, thereby terminating the QSub
election. The example notes that the S corporation may have to
recognize gain on the assets deemed transferred to the subsidiary
because the deemed transfer would not qualify for nonrecognition
treatment under section 351 (i.e., because the S corporation is not
``in control'' of the subsidiary immediately after the transfer, as a
result of the sale of the stock). As a result, the transfer is treated
as fully taxable.
Example 2 of Treas. Reg. Sec. 1.1361-5(b)(3) is the same as
above, except that immediately prior to the sale of the interest in the
subsidiary, the subsidiary is merged into a single member limited
liability company (LLC) owned by the S corporation. In this case, the
sale of the 21-percent interest in the entity results in the formation
of a partnership for Federal tax purposes. Under Rev. Rul. 99-5, 1999-1
C.B. 434 that sale is treated as the sale of 21 percent of the entity's
assets, followed by a contribution of all of the entity's assets to a
partnership. Under this scenario, the S corporation recognizes gain on
only 21 percent of the subsidiary's assets.
Example 3 of Treas. Reg. Sec. 1.1361-5(b)(3) is the same as
Example 1, except that the unrelated party contributes an asset to the
subsidiary in exchange for 21 percent of the subsidiary's stock,
instead of purchasing 21 percent of the subsidiary's stock from the S
corporation. In this situation, the transaction would qualify for
treatment under section 351 because the S corporation and the unrelated
party would be viewed as co-transferors that are in control of the
subsidiary immediately after the transaction.
We believe that Congress did not intend when it enacted
legislation that was intended to facilitate S corporation-QSub
structures for an S corporation to recognize 100 percent of the gain on
the deemed sale of a QSub's assets when it sells less than 100 percent
of the QSub's stock. Moreover, although the regulations provide
examples of how this result can be avoided through structuring
alternatives, it is inefficient to make taxpayers engage in otherwise
meaningless activity solely to be taxed on the proper amount of gain or
to penalize taxpayers who are unaware of the need to employ such
structuring alternatives.
Recommendation. We support the enactment of this provision, with
the following technical suggestions. First, we recommend that the
provision be modified to apply to ``transfers'' of QSub stock and use
consistent language throughout; as currently drafted, the provision
characterizes all dispositions as sales. This will create confusion in
the case of dispositions as sales. In this same connection, we
recommend that the statutory provision and the accompanying legislative
history make clear how the provision applies in the case of transfers
of QSub stock in the context of nonrecognition transactions. For
example, when a QSub is merged with and into another corporation (the
``acquiring corporation''), we recommend that the provision specify
that the acquiring corporation is treated as having acquired the QSub's
assets, and having assumed its liabilities, from the S corporation, in
exchange for the acquiror's stock. As another example, we recommend
that the legislative history make clear that, if an S corporation
transfers, say, 30 percent of the stock of a QSub to a partnership in
exchange for a partnership interest in what otherwise qualifies as a
section 721 exchange, the tax consequences of the transfer should be
determined as if the S corporation had transferred an undivided
interest in 30 percent of the QSub's assets to the partnership in a
section 721 exchange and then the S corporation and the partnership had
contributed their respective interests in the assets to a new
corporation in exchange for stock.
Second, we recommend that the provision be modified to make
clear that the tax consequences of the sale of all of the stock of a
QSub shall be determined as if the S corporation first transferred all
of the subsidiary's assets to the transferee in an asset sale, followed
by a contribution of such assets by the transferee to a new
corporation. In such case, there is no joint contribution by the S
corporation and the transferee, but a contribution by the transferee to
a new corporation controlled by the transferee.
Third, we do not believe it is necessary to state that the
deemed contribution that follows the deemed transfer of an undivided
interest in the assets is a section 351 transaction; instead, the tax
consequences of the deemed contribution should be based on general
principles of tax law. We recommend that the legislative history make
clear, however, that the deemed contribution will qualify as a section
351 transaction if the requirements of Code section 351 otherwise are
satisfied. Further, we recommend that the statute or the legislative
history make clear that the deemed contribution is made to a new
corporation in exchange for stock of such corporation.
Finally, we recommend that the provision apply retroactively
only by election, given that taxpayers who understood current law
already have engaged in transactions based on the final QSub
regulations.
Section 504--Provide Exception to Application of ``Step Transaction
Doctrine'' for Restructuring in Connection with Making QSub
Elections.
General Explanation. The Act amends section 1361(b)(3) to
provide that a QSub election shall be treated as a deemed liquidation
to which Code section 332 applies, without regard to the application of
the step transaction doctrine.
Comments. The legislative history to the Small Business Job
Protection Act of 1996, P.L. 104-188 (the ``1996 Act'' or the
``SBJPA''), provided that ``if an election is made to treat an existing
corporation (whether or not its stock was acquired from another person
or was previously held by the S corporation) as a QSub, the subsidiary
will be deemed to have liquidated under sections 332 and 337
immediately before the election is effective.'' H.R. Rept. 104-586 at
p. 89 and Joint Committee General Explanation of Tax Legislation
Enacted in 104th Cong., JCS-12-96 (``Blue Book'') at p. 121. The
legislative history to the technical corrections legislation enacted in
1997 clarified that Treasury has the authority to provide, in
appropriate cases, exceptions to the general rule that a QSub election
is treated as a deemed liquidation under section 332. It did not,
however, provide any examples as to what kinds of exceptions would be
appropriate. (H.R. Rept. 105-48 at p. 644.)
Final regulations regarding QSubs apply the ``step transaction
doctrine'' to determine the tax consequences of the deemed liquidation
resulting from the QSub election (subject to a limited transition rule
that already has expired). Under the regulations, the deemed
liquidation is collapsed together with the restructuring that was
necessary to make the QSub election in order to determine the Federal
tax consequences of the transactions. As explained below, the
application of the step transaction doctrine requires a knowledge of
the intricacies and vagaries of Subchapter C, and can lead to
surprising and uncertain results in certain cases.
We believe that, as a general rule, it is not appropriate to
apply the step transaction doctrine to the restructuring associated
with making a QSub election. As illustrated by the examples below,
applying the doctrine can lead to dramatically different Federal tax
consequences in some cases than if the deemed liquidation resulting
from the QSub election were treated as a separate liquidation (e.g.,
treatment as a stock acquisition, plus a separate liquidation).
Example 1: Assume that A, the sole shareholder of two solvent S
corporations, determines that she would like to operate the two
corporations in a parent/subsidiary structure. Indeed, the
legislative history of the QSub legislation indicated that the
QSub rules were intended to allow shareholders to arrange their
``separate corporate entities under parent/subsidiary
arrangements as well as brother-sister arrangements.'' House
Report at p. 89 and S. Rep. No. 281, 104th Cong., 2d. Sess. 54-
55 (1996) (``Senate Report''). Therefore, A contributes all of
her stock in one S corporation (Corpl) to the other S
corporation (Corp2). Corp2 elects to treat Corp1 as a QSub. At
the time of the transaction, the liabilities of Corp1 exceed
Corp1's basis in its assets. If the step transaction is not
applied, the transaction will be treated as a tax-free exchange
by A of the stock of Corp1 for stock of Corp2 under section 351
(or a tax-free reorganization under section 368(a)(1)(B)),
followed by a tax-free liquidation of Corp1 under Code sections
332 and 337 pursuant to the QSub election. However, if the step
transaction doctrine is applied, the transaction will be
treated as a ``D'' reorganization (i.e., a reorganization under
section 368(a)(1)(D)). See Rev. Rul. 67-274, 1967-2 C.B. 141
and Rev. Rul. 78-130, 1978-1 C.B. 114. Under this analysis, the
QSub election would trigger gain to Corp1 pursuant to Code
section 357(c) to the extent its liabilities exceeded its basis
in its assets.
Example 2: Assume that ABC Corporation, an S corporation,
acquires all of the stock of Target Corporation from its
shareholder, T, an unrelated individual, in exchange for $50
cash and $500 worth of ABC voting stock, representing 10
percent of ABC's outstanding stock. Target has no liabilities.
After the acquisition, ABC makes a QSub election for Target. If
the step transaction does not apply to this acquisition, the
transaction would be treated as a taxable acquisition of the
stock of Target, followed by a tax-free liquidation under
sections 332 and 337. See Rev. Rul. 90-95, 1990-2 C.B. 67. The
acquisition of the stock of the Target cannot qualify as tax-
free because it does not meet the requirements to be a tax-free
reorganization under Code section 368(a)(1)(B) (there is boot
in the transaction) or the requirements to be a tax-free Code
section 351 transaction because T does not control ABC
immediately after the transaction). However, if the step
transaction doctrine is applied, the acquisition would qualify
as a tax-free reorganization under section 368(a)(1)(C) because
all of Target's assets are acquired in exchange for voting
stock of the acquiring corporation and no more than 20 percent
additional consideration (i.e., cash). Note that, in this
example, the Government benefits if the doctrine is not
applied.
As indicated by the above examples, applying the step
transaction doctrine introduces complexity and uncertainty into what
should be a simple matter of making the QSub election. The step
transaction doctrine is derived from numerous cases and rulings dealing
with various fact situations; as a result, it is subjective in nature
and does not always yield certain results. Further, applying the
doctrine requires knowledge of decades of jurisprudence and
administrative interpretations. However, many S corporations are small
businesses that do not have the benefit of sophisticated counsel who
are experts in the intricacies of Subchapter C. Similarly, because some
S corporations may view the act of making a QSub election as simple,
they may not seek out sophisticated tax advice. These taxpayers will
end up being surprised when audited to learn that the IRS views what
they thought was a simple matter--acquiring 100% ownership of a company
and making a QSub election--as having unanticipated tax consequences.
We also believe that a general rule that applies the step
transaction doctrine to the deemed liquidation from a QSub election is
inconsistent with Congressional intent in enacting the QSub provision,
as reflected in the legislative history of the 1996 Act. The QSub
provision was intended (among other things) to facilitate restructuring
into parent/subsidiary structures. However, as indicated above,
application of the doctrine can frustrate such restructuring by
producing surprising results for the unwary and requiring sometimes
costly analysis of the Subchapter C rules.
Moreover, as also illustrated in the examples above, applying
the step transaction doctrine does not always result in a pro-
Government result; conversely, not applying the doctrine does not
always produce a pro-taxpayer result. The argument for not applying the
doctrine is based on making the consequences of a QSub election simple
and certain for all taxpayers, especially those smaller businesses that
do not have the benefit of sophisticated tax advice.
Nonetheless, we recognize that there are certain limited
situations in which applying the step transaction doctrine makes more
sense as a matter of tax policy, produces more straightforward results,
and minimizes the creation of traps for the unwary. For example, assume
an S corporation forms a new subsidiary for which it makes an immediate
QSub election. Because the subsidiary is deemed to have liquidated a
moment after it was formed, it makes sense to treat the formation and
deemed liquidation as non-events for Federal tax purposes, rather than
to determine tax consequences based on a formation and a separate and
independent liquidation. As another example, assume an existing S
corporation is restructured so that it becomes a QSub of a newly-formed
S corporation holding company, the only asset of which is the QSub
stock. In such case, nothing of Federal tax significance has occurred
and it makes sense to treat the transaction as an ``F'' reorganization
of the S corporation (i.e., both at the beginning and end of the day,
there is just a single S corporation for Federal tax purposes).
Recommendation. We support the enactment of this provision, with
the following technical suggestion. In recognition of the fact that
there are limited situations in which applying the step transaction
doctrine is proper, we recommend that the Treasury be given regulatory
authority to provide appropriate exceptions to the general rule that a
QSub election is treated as a liquidation under section 332. We
recommend that the legislative history make clear that such regulatory
authority should be exercised only in limited situations, such as those
described immediately above, where an S corporation makes a QSub
election for a newly-formed subsidiary or where an S corporation
becomes a QSub of a new holding company.
Section 601--Elimination of All Earnings and Profits Attributable to
Pre-1983 S Election Years.
General Explanation. Under the current scheme of S corporation
taxation, accumulated earnings and profits of an S corporation may be
relevant for purposes of several provisions, including, treatment of
distributions under section 1368(c) and application of the section 1375
sting tax.
Act Section 601 clarifies a provision in the 1996 Act, Section
1311(a), which eliminated from an S corporation's accumulated earnings
and profits the portion of earnings and profits which was accumulated
in any taxable year beginning before January 1, 1983, for which the
corporation was an electing small business corporation under subchapter
S. Nevertheless, the elimination of accumulated earnings and profits
under the 1996 Act Section 1311(a) only applies if the corporation is
an S corporation for its first taxable year beginning after December
31, 1996. Act Section 601 amends the 1996 Act Section 1311(a) with
respect to any taxable year beginning after December 31, 1996 (the
general effective date of the 1996 Act S corporation provisions) to
eliminate the requirement that an S corporation must have had an S
election in effect for its first taxable year beginning after December
31, 1996.
Comments. We support the enactment of this provision. The 1996
Act Section 1311(a), was intended to eliminate a trap for the unwary
and complicated recordkeeping requirements for a corporation that might
have accumulated earnings and profits from a pre-1983 taxable year for
which an S election was in effect. Congress did not articulate, nor are
we aware of, a reason why the benefits of the provision should be
confined to a corporation that had an S election in effect for its
first taxable year beginning after December 31, 1996.
Section 602--Provide That Gain/Loss from Deferred Intercompany
Transactions Is Not Triggered on Conversion to S Corporation or
QSub Status, But Is Treated As Recognized Built-In Gain/Loss
When the Deferred Gain/Loss Is Taken into Account.
General Explanation. Act Section 602 is an off-Code provision
that directs that section 1502 (consolidated return regulations) not
cause gain or loss to be recognized in connection with an S election or
a QSub election.
Comments. As a result of changes made by the 1996 Act, the
common parent of a consolidated group can elect to be an S corporation
and to treat its consolidated subsidiaries as QSubs (assuming the S
corporation and QSub eligibility requirements are satisfied). However,
when these elections are made, there is uncertainty as to whether gain
or income from ``old intercompany transactions'' between members of the
consolidated group is required to be taken into income in the group's
last consolidated return. As explained below, the consolidated return
regulations, read together with the final QSub regulations, indicate
that such income is not taken into account in the final consolidated
return. However, it appears that some in the IRS may believe that such
income must be taken into account in the consolidated return, out of
concern that the income cannot be subject to the section 1374 ``built-
in gain'' tax in the future and, therefore, may escape corporate tax
entirely. Thus, as explained below, we recommend that section 1374 be
amended to treat such income or gain as recognized built-in gain when
it is taken into account by the S corporation (i.e., it would be
subject to corporate-level tax at that time), with the legislative
history clarifying that such income is not taxed at the time of the S
corporation and QSub elections. We further recommend that consideration
be given to providing similar treatment for ``new intercompany
transactions.''
Discussion. Because an S corporation is an ``ineligible
corporation'' within the meaning of section 1504(b) and cannot be
included in a consolidated group, a consolidated group's existence
terminates if the common parent elects to be treated as an S
corporation (whether or not it also elects to treat its subsidiaries as
QSubs). If the parent elects to be treated as an S corporation and also
elects to treat a wholly-owned solvent subsidiary as a QSub, both the
legislative history of the 1996 Act and the final QSub regulations
indicate that the QSub election will be treated as a deemed liquidation
of the subsidiary under section 332. In cases where the parent S
corporation makes simultaneous S election and QSub elections for all of
its subsidiaries, the regulations treat the deemed liquidations as
occurring at the close of the day before the QSub elections are
effective. Therefore, if the parent of a consolidated group makes an
election to be an S corporation and a QSub election for its subsidiary,
both of which are effective on the same day, the deemed liquidation
occurs prior to the termination of the consolidated group.
The consolidated return regulations provide two different sets
of rules governing the treatment of intercompany transactions that take
place within a consolidated group: the Old Intercompany Regulations,
that are applicable to ``old'' deferred intercompany transactions
occurring in tax years beginning before July 12, 1995; and the New
Intercompany Regulations, that are applicable to intercompany
transactions occurring in tax years beginning on or after that date.
Both sets of regulations provide that if the consolidated group
ceases to file consolidated returns, gains and income from intercompany
transactions must be taken into account in the final consolidated
return.\1\ However, the two sets of regulations have different
exceptions to the recognition of deferred gains and income when the
buying and selling members are liquidated into the common parent of the
consolidated group under section 332, prior to the deconsolidation of
the group.
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\1\ Former Reg. Sec. 1.1502-13(f)(1)(iii); Reg. Sec. Sec. 1.1502-
13(d)(1) and (d)(3) Example 1(f). Likewise, both sets of regulations
provide that losses and deductions from such transactions will remain
deferred under Code section 267. Former Reg. Sec. Sec. 1.267(f)-
2T(d)(1), 1.267(f)-IT(c)(5); and Reg. Sec. 1.267(f)-l(c)(1)(i).
---------------------------------------------------------------------------
Under section 1.1502-13(f)(2)(ii)(b) of the Old Intercompany
Regulations, the provision that causes deferred gain and/or income from
intercompany transactions to be taken into account when the group
ceases to file consolidated returns is made inapplicable if:
The group is terminated, and immediately after such termination
the corporation which was the common parent . . . owns the property
involved and is the selling member or is treated as the selling member
. . . Thus, for example, subparagraph (1)(iii) [regarding the
restoration of gain/income upon the termination of the group] does not
apply in a case where corporation P, the common parent of a group
consisting of P and corporations S and T, sells an asset to S in a
deferred intercompany transaction, and subsequently all of the assets
of S are distributed to P in complete liquidation of S. Moreover, if,
after the liquidation of S, P sold T, subparagraph (1)(iii) of this
paragraph would not apply even though P ceased to be a member of the
group.
Further, under the Old Intercompany Regulations, the common
parent is treated as the selling member with respect to a deferred
intercompany transaction if the selling member is liquidated into the
common parent in a tax-free liquidation under section 332.\2\
Therefore, gain/income from deferred intercompany transactions that
occurred in tax years beginning before July 12, 1995, would not be
taken into income under the applicable regulations provided that the
buying and selling corporations were liquidated tax-free into the
common parent under section 332 prior to the group ceasing to file
consolidated returns. In this case, the former common parent would
continue to defer the recognition of gain/income from such
transactions. Because the QSub regulations indicate that the
liquidation resulting from the QSub election occurs in the final
consolidated return, it appears that the gain/income from ``old''
deferred intercompany transactions should continue to be deferred. Such
gain/income should be taken into account by the former common parent
(i.e., the S corporation) when an event occurs that, under the Old
Intercompany Regulations, requires it to take such amounts into income
(e.g., the property is sold).
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\2\ Former Reg. Sec. 1.1502-13(c)(6).
---------------------------------------------------------------------------
Some Government officials, however, have suggested unofficially
that the Old Intercompany Regulations should be interpreted to provide
that, in these situations, the former common parent is required to take
the gain/income from deferred intercompany transactions into income
when the former common parent becomes an S corporation. Although there
does not appear to be anything in the Old Intercompany Regulations to
support this interpretation, this interpretation apparently is being
advanced out of concern that, unless gain/income from deferred
intercompany transactions is taken into account in the final
consolidated return, such gain/income will escape corporate tax
entirely. This concern appears to be based on the fact that section
1374 and the regulations promulgated thereunder may not subject
deferred gain/income to the section 1374 built-in gain tax, even if
such gain or income is taken into account within 10 years of conversion
to S corporation status.\3\ Although this concern may be well founded
given the current form of the section 1374 regulations, the better
solution is to make clear that the section 1374 tax applies in this
situation. Otherwise, the current confusion almost certainly will lead
to years of controversy and litigation.
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\3\ The section 1374 regulations provide that the built-in gain tax
will apply only to two kinds of gain/income: gain from the sale or
exchange of built-in gain property and income that would have been
properly taken into account prior to conversion to S corporation status
by an accrual basis taxpayer (``built-in income'' items). See Treas.
Reg. Sec. 1.1374-4(a) and (b). Gain/income from a deferred intercompany
transaction arguably does not fall within either category. Consider a
situation where there is a deferred gain from the sale of property
between members of the group and such property does not appreciate
after the sale. The property is not built-in gain property because its
tax basis (i.e., the buying member's purchase price) does not differ
from its value. Likewise, the deferred gain is not income that an
accrual basis taxpayer would have properly included prior to the
conversion to S corporation status.
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For later intercompany transactions, the New Intercompany
Regulations seem to provide that gain/income from such transactions
must be included in income when the common parent becomes an S
corporation. Although these regulations contain a similar exception to
the recognition of deferred gain/income when the consolidated group
terminates as a result of the tax-free liquidation of the members into
the common parent, such exception applies ``so long as [the common
parent] neither becomes a member of an affiliated group filing separate
returns nor becomes a corporation described in Section 1504(b).'' \4\
As described above, the 1996 Act added S corporations to the list of
non-includable corporations described in section 1504(b). As a result,
the exception in the New Intercompany Regulations to the recognition of
deferred gain/income on the termination of a consolidated group may be
inapplicable to situations where the group is terminated as a result of
the common parent electing to be an S corporation and filing QSub
elections for the other members of its group. It is unclear whether
this result was intended because these regulations were written prior
to the amendment to add S corporations to section 1504(b). While a
legislative change may not be necessary to avoid litigation and
confusion with regard to gain/income from ``new'' intercompany
transactions, we believe that consideration should be given to
subjecting gain/income from ``new'' intercompany transactions to the
same regime as old intercompany transactions--i.e., no gain triggered
upon conversion to S corporation status or election of QSub status, but
subject to the built-in gains tax when taken into account. This result
would protect against the avoidance of corporate tax without
introducing unnecessary tax burdens on taxpayers seeking to convert to
S corporation status.
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\4\ Reg. Sec. 1.1502-13(j)(6).
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Recommendation. We recommend that section 1374 be amended to
provide that, in the case of simultaneous S corporation and QSub
elections, gain or income from an intercompany transaction occurring in
tax years beginning before July 12, 1995 shall be treated as a
recognized built-in gain for the taxable year in which the S
corporation disposes of such property. For the sake of simplicity, we
recommend that consideration also be given to applying this provision
to all deferred intercompany transactions, without regard to whether
they occur on, before or after the July 12, 1995 date. In addition, we
recommend that the legislative history make clear that such gain or
income is not included in the final consolidated return of the group.
Section 603--Treatment of Subchapter C Attributes for Purposes of the
Built-In Gains Tax--Charitable Contribution and Foreign Tax
Credit Carryforwards.
General Explanation. The Act amends section 1374(b)(2) to
provide that charitable contribution carryforwards and foreign tax
credit carryforwards arising from a taxable year for which the
corporation was a C corporation shall be allowed as a deduction against
the net recognized built-in gain of the corporation for the taxable
year. The Act directs the Secretary to promulgate regulations providing
for similar treatment of other carryforwards attributable to taxable
years for which an S corporation was a C corporation.
Comments. Section 1374 provides for the imposition of a
corporate-level ``built-in gain'' tax on the recognition of gain by an
S corporation that formerly was a C corporation (or acquires an asset
whose basis is determined by reference to the basis of such asset in
the hands of a C corporation), but only to the extent such gain
reflects unrealized appreciation in the assets on the last day of the
corporation's final C year (or as of the date of acquisition from the C
corporation). This tax was intended to prevent C corporations from
circumventing the Tax Reform Act of 1986's repeal of the General
Utilities doctrine by electing to be treated as S corporations and then
disposing of their assets. (The 1986 Act, among other things, generally
required C corporations to recognize gain on liquidating distributions
of assets.)
Section 1374(b)(2) generally provides that a net operating loss
or capital loss carryforward arising in a taxable year for which the
corporation was a C corporation can be used to reduce ``net recognized
built-in gain'' (the tax base for the built-in gains tax). Treas. Reg.
Sec. 1.1374-5 provides that the only loss carryforwards allowed as a
deduction in computing the tax are those specified in section
1374(b)(2) and that ``any other loss carryforwards, such as charitable
contribution carryforwards under section 170(d)(2) are not allowed as
deductions'' in computing the tax.
Denying the corporation the ability to use these carryforwards
and losses can result in the benefit of these attributes being lost
forever and is not justified by any policy reason. Given that the
built-in gains tax is a surrogate for tax that would have been imposed
had the corporation remained a C corporation, an S corporation should
be able to reduce the tax by items that would have offset corporate tax
if the corporation had remained a C corporation. In fact, in describing
the enactment of the built-in gains tax, the Joint Committee on
Taxation's General Explanation of the Tax Reform Act of 1986, JCS-10-87
(May 4, 1987) provides that:
[t]he corporation may take into account all of its subchapter C
tax attributes in computing the amount of the tax on recognized built-
in gains. Thus, for example, it may use unexpired net operating losses,
capital loss carryovers, and similar items to offset the gain or the
resulting tax. [Emphasis added.]
The language used in current sections 1374(b)(2) and 1374(b)(3),
and the amended section 1374(b)(5) as proposed by the Act, refers to
carryforward attributes ``arising in a taxable year for which the
corporation was a C corporation.'' This language can be read as
limiting the benefits of such carryforwards solely to carryforwards
generated by an S corporation that has converted from C corporation
status. Nevertheless, such carryforwards also might be available to an
S corporation under section 381 as a result of a carryover in a
corporate acquisition. In this respect, assets acquired from a C
corporation in such a transaction would be subject to built-in gains
tax under section 1374(d)(8).
Recommendation. We support the proposed amendment to section
1374 to allow Subchapter C attributes such as charitable contribution
carryforwards and foreign tax credit carryforwards to be taken into
account in computing the ``built-in gains'' tax. We recommend that the
language in sections 1374(b)(2) and 1374(b)(3) and section 1374(b)(5)
as proposed by the Act be clarified so that carryforward attributes of
a C corporation that carryover to an S corporation also are
carryforward attributes that are taken into account in computing built-
in gain and the amount of built-in gains tax.
The following language would accomplish this clarification:
Section 1374(b)(2) is amended by inserting ``(or the corporation
generating the net operating loss carryforward)'' after the words ``in
a taxable year for which the corporation'' in the first sentence of
section 1374(b)(2).
Section 1374(b)(2) is amended by inserting ``(or the corporation
generating the capital loss carryforward or charitable contribution
carryforward)'' after the words ``in a taxable year for which the
corporation'' in the second sentence of section 1374(b)(2) (as
currently proposed to be amended by Act Section 603(a)).
Section 1374(b)(3)(B) is amended by inserting ``(or the
corporation generating the business credit carryforward)'' after the
words ``arising in a taxable year for which the corporation'' in the
first sentence of section 1374(b)(3)(B).
Section 1374(b)(3)(B) is amended by inserting ``(or the
corporation generating the minimum tax credit or foreign tax credit
carryforward)'' after the words ``attributable to taxable years for
which the corporation'' in the second sentence of section 1374(b)(3)(B)
(as currently proposed to be amended by Act Section 603(b)).
Section 1374(b)(5) is amended by inserting ``(or the corporation
generating the attribute)'' after the words ``for which an S
corporation'' and before the words ``was a C corporation.''
Section 604--Distribution by an S Corporation to an Employee Stock
Ownership Plan.
General Explanation. The Act would enact a new section 1368(f)
to provide that a distribution by an S corporation to an employee stock
ownership plan (ESOP) is treated as a dividend under section
404(k)(2)(A). The Act would also amend section 404(a)(9)(C) to provide
that the deduction provided in section 404(a)(9) does not apply to an S
corporation.
Comments. ERISA section 406(a)(1)(B) and section 4975(c)(1)(B)
of the Code forbid any ``direct or indirect . . . lending of money or
other extension of credit between a plan and a party in interest.''
Absent an exception, this prohibition would disallow any debt financing
for the acquisition of employer stock by an Employee Stock Ownership
Plan (``ESOP''), where a party in interest extends credit through a
direct loan or loan guarantee. ERISA section 408(b)(3) and section
4975(d)(3) offer an exemption, however, from the prohibited transaction
rules provided the ESOP and the employer meet certain requirements. If
these provisions are met, the ESOP may borrow money using a direct loan
or a loan guarantee from a party in interest to accomplish its purchase
of employer stock.
One of the requirements for the exemption mandates that the
ESOP's liability for repayment of the loan be limited to the following:
(i) collateral given for the loan, (ii) contributions made to the ESOP
for loan repayment purposes (other than contributions of employer
stock), and (iii) earnings attributable to such collateral and the
investment of such contributions. Treas. Reg. Sec. 54.4975-7(b)(5)(i),
(ii), and (iii), DOL Regs. Sec. 2550.408b-3(c). Additionally, payments
made with respect to an exempt loan by the ESOP must not exceed an
amount equal to the sum of such contributions and earnings received
during or prior to the year less such payments in prior years. Treas.
Reg. Sec. 54.4975-7(b)(5). This language does not appear to allow
distributions made by an S corporation on ESOP-owned stock which has
been allocated to participant accounts to be used to make payments on
an applicable ESOP loan. Consequently, in the S corporation setting, no
method exists for repaying the principal of the ESOP loan from
distributions made on stock owned by an ESOP which has been allocated
to participant accounts pursuant to section 4975(d). In the C
corporation area, however, an ESOP may apply dividends received from
its sponsor in payment of the loan made on stock acquired with its
proceeds regardless of whether such stock has been allocated to
participants. Section 404(k)(2)(A)(iii).
Another requirement under Treas. Reg. Sec. 54.4975-11(f)(3)
states that income paid with respect to qualifying employer securities
acquired by an ESOP may be distributed any time after receipt by the
ESOP to participants on whose behalf such securities have been
allocated. This language, however, does not provide a vehicle for ESOPs
to distribute to participants earnings received by it from its S
corporation sponsor penalty free unless the distribution fails under
one of the exceptions outlined in section 72(t)(2)(A). Instead, these
pass-through payments constitute ``premature distributions''. Along
with premature distribution status comes the imposition of a ten
percent (10%) excise tax under section 72(t) on early distributions
from qualified retirement plans, distribution restrictions under
section 411(a)(11), and special withholding requirements under section
3405. In contrast, dividends paid with respect to stock of a
corporation which are described in section 404(k) are exempt from these
burdensome provisions.
Moreover, all of the regulatory interpretations of these
statutory provisions were promulgated long before S corporations were
permitted to have ESOP shareholders and thus do not reflect regulatory
considerations of S corporation issues arising in connection with
ESOPs.
Distributions on stock acquired by an S corporation sponsored
ESOP through an ESOP loan should be eligible to be applied in payment
of the loan regardless of whether the stock giving rise to the
distribution has been allocated to participant accounts in the same way
that the dividends of a C corporation can be applied to payment of such
loans.
Dividends received by an ESOP sponsored by a C corporation can
be passed through to its participants at the option of the ESOP under
section 404(k)(2)(A)(i) without being denominated as ``premature
distributions'' subject to the adverse ramifications attendant thereto.
The pass through to participants of earnings received from an S
corporation that sponsors an ESOP, however, does result in ``premature
distributions.'' As an owner of stock, the ESOP should have the option
to pass through S corporation earnings received by it as distributions
pro rata to its participants in the same manner as can C corporations.
The provisions of the tax law governing S corporation ESOPs should not
contain impediments discouraging such distributions.
Proposed new subsection (f) of section 1368 extends to ESOPs
sponsored by S corporations the same options presently available to C
corporation ESOPs with respect to earnings received, whether in the
form of dividends or distributions which are conceptually equivalent
(even though S corporation distributions will still not produce tax
deductions). Specifically, all such distributions will be able to be
applied in payment of a stock acquisition loan, and will also qualify
for pass through treatment to ESOP participants at the option of the
ESOP without penalties and onerous requirements that would otherwise
apply.
Recommendation. We support the enactment of these provisions of
the Act as drafted. These provisions will remove certain impediments to
the use of ESOPs sponsored by S corporations. The enactment of section
1368(f) would eliminate any uncertainty as to whether distributions
made by an S corporation to an ESOP with respect to allocated shares
could be used to make principal payments on the ESOP loan without
violating the prohibited transaction rules. The modification of section
404(a)(9)(C) would clarify that provisions of section 404(a)(9) other
than the deduction-allowance provision would continue to apply to S
corporations. The continued application of such other provisions to S
corporations is important, for example, because provisions elsewhere in
the Code incorporate some of the rules of section 404(a)(9) by
reference. The current version of section 404(a)(9)(C), which made all
of section 404(a)(9) inapplicable to an S corporation, created
uncertainty as to whether an S corporation could rely on any provision
of the that referred to section 404(a)(9).
Thompson & Knight, LLP
Dallas, Texas 75201
July 2, 2003
The Honorable Jim McCrery
Chairman, Subcommittee on Select Revenue Measures
Committee on Ways and Means
U.S. House of Representatives
2104 Rayburn House Office Building
Washington, D.C. 20515-1804
Re: S Corporation Reforms
Dear Representative McCrery:
This letter is being submitted in response to the Advisory from the
Committee on Ways and Means Subcommittee on Select Revenue Measures
dated June 19, 2003, regarding S corporation reforms.
As the Advisory recognized, several bills have been introduced this
Congress that address many of the problems S corporations and their
shareholders face, including H.R. 714, the ``Small Business and
Financial Institutions Tax Relief Act of 2003,'' introduced by Rep.
Scott McInnis (R-CO); H.R. 1498, the ``Small Business Opportunity and
Growth Act of 2003,'' introduced by Rep. Jim Ramstad (R-MN); and H.R.
1896, the ``Subchapter S Modernization Act of 2003,'' introduced by
Rep. E. Clay Shaw, Jr., (R-FL). The purpose of the hearing on S
corporation reforms held on June 19, 2003, was to give the Subcommittee
a better understanding of Subchapter S of the Internal Revenue Code of
1986, as amended (the ``Code''), and possible reforms to it.
The purpose of this letter is encourage the Subcommittee to
continue its efforts to simplify Subchapter S of the Code, to remove
the rules and restrictions on S corporations that unnecessarily inhibit
their growth, and to make corporate earnings subject to only one level
of tax. While this letter is being submitted on behalf of an interested
client that is an S corporation (``Client''), we believe that the
concerns of Client are shared by many S corporations.
Potential Current Beneficiary of Electing Small Business Trust
(ESBT). Client is wholly-owned by an electing small business trust (an
``ESBT''), of which an individual is the sole current beneficiary
(``Beneficiary''). Upon Beneficiary's death, the Trust will be divided
into multiple separate trusts for Beneficiary's heirs. Unless
disclaimed, each of Beneficiary's heirs will have lifetime and
testamentary powers of appointment over their respective trusts.
An S corporation may have only certain types of shareholders and
cannot have more than 75 qualifying shareholders. If an S corporation
has an ineligible shareholder or more than 75 qualifying shareholders,
its S election will terminate automatically. When an ESBT holds S
corporation stock, each ``potential current beneficiary'' of the ESBT
is considered a shareholder of the S corporation for purposes of
eligibility and the 75 shareholder limitation.
Section 1361(e)(2) of the Code defines a ``potential current
beneficiary'' as, ``with respect to any period, any person who at any
time during such period is entitled to, or at the discretion of any
person may receive, a distribution from the principal or income of the
trust.'' In enacting the ESBT rules, Congress intended for a trust that
provides for income to be distributed to, or accumulated for, a class
of individuals to be allowed to hold S corporation stock. Such a trust
is commonly known as a ``spray'' trust because it allows the trust to
``spray'' income among family members or others who are beneficiaries
of the trust.
The term ``potential current beneficiary'' is used to determine who
is treated as a shareholder of the S corporation. The term should not
include an unlimited class of persons to whom a current beneficiary
might conceivably, sometime in the future, transfer his interest and
his right to distributions. The term should include only the specific
class of persons to whom a person currently has discretion to
distribute principal or income. Thus, the term ``potential current
beneficiary'' should not include the persons in whose favor a power of
appointment may be exercised until the power of appointment is actually
exercised in such persons' favor.
This concern is addressed by section 305 of H.R. 1896, which would
amend section 1361(e)(2) of the Code to say the following (changes in
italics):
For purposes of this section, the term ``potential current
beneficiary'' means, with respect to any period, any person who at any
time during such period is entitled to, or at the discretion of any
person may receive, a distribution from the principal or income of the
trust (determined without regard to any unexercised (in whole or in
part) power of appointment during such period). If a trust disposes of
all of the stock which it holds in a S corporation, then, with respect
to such corporation, the term ``potential current beneficiary'' does
not include any person who first met the requirements of the preceding
sentence during the 1-year period ending on the date of such
disposition.
Consistent with the Subcommittee's goals, this provision would
remove a restriction that unnecessarily inhibits the use of S
corporations, particularly by families.
Passive Investment Income. Client converted from a C corporation to
an S corporation several years ago. Because Client has earnings and
profits from when it was a C corporation, Client must monitor its
passive investment income.
If Client has passive investment income in any one year that makes
up more than 25% of its gross receipts, Client may be subject to a
corporate-level tax. If Client's passive investment income exceeds 25%
of its gross receipts for three consecutive years, Client's S election
will terminate.
``Passive investment income'' means gross receipts derived from
royalties, rents, dividends, interest, annuities, and gains from the
sale or exchange of stock or securities. ``Gross receipts'' means the
total amount received or accrued under the method of accounting used by
Client in computing its taxable income without reduction for returns
and allowances, cost of goods sold, or deductions. Thus, to avoid the
corporate-level tax and the revocation of its S election, Client's
income from royalties, rents, dividends, interest, annuities, and the
sale of stock and securities must equal 25% or less of Client's total
gross receipts.
Section 203 of H.R. 1896 would no longer cause excessive passive
investment income to terminate a company's S election. Section 204 of
H.R. 1896 would cause the corporate-level tax on excess net passive
income to apply only if the gross receipts from passive investment
income exceeds 60% (rather than 25%) of total gross receipts. In
addition, section 204 would limit the items included in the definition
of ``passive investment income'' to ``royalties, rents, dividends,
interest, and annuities.'' Thus, gains from the sale or exchange of
stock or securities would no longer be treated as an item of passive
income.
The corporate-level passive investment income tax, sometimes called
the ``sting'' tax, is imposed so that C corporations cannot convert to
S corporations and thereby avoid the personal holding company tax that
applies to C corporations. The corporate-level tax is a sufficient
deterrent against a C corporation converting to S corporation status to
avoid the personal holding company tax. In addition, the removal of
capital gains from the definition of passive investment income makes
the tax base for the sting tax consistent with the tax base for the
personal holding company tax (see I.R.C. Sec. 543).
These provisions are consistent with the Subcommittee's goals
because they eliminate a trap for the unwary that can cause the loss of
a company's S election and make corporate earnings more likely to be
subject to only one level of tax.
Built-In Gains Tax. Because Client converted from a C corporation
to an S corporation, it must monitor the gain from the sale of its
assets for 10 years. As Client sells assets during the 10-year period
after its S election, it must pay a corporate-level tax at the highest
corporate rate on the built-in gain in those assets on the date of its
S election.
Section 2 of H.R. 1498 would not impose this corporate-level tax if
proceeds from the sale of built-in gain assets are used for certain
qualified expenditures, including investment in property used in the S
corporation's trade or business.
This provision is consistent with the Subcommittee's goals because
it relaxes a rule that unnecessarily inhibits the growth of S
corporations while at the same time providing an incentive for an S
corporation to reinvest in other business assets. In addition, this
provision makes corporate earnings more likely to be subject to only
one level of tax.
* * *
In summary, we applaud the Subcommittee's efforts to simplify
Subchapter S of the Code, to remove the rules and restrictions on S
corporations that unnecessarily inhibit their growth, and to make
corporate earnings subject to only one level of tax. By disregarding
unexercised powers of appointment when determining the potential
current beneficiaries of an S corporation, a restriction will be
removed that unnecessarily inhibits the use of S corporations,
particularly by families. If excessive passive investment income no
longer a terminates a company's S election, a trap for the unwary is
removed. The proposed changes to the passive investment income tax and
the built-in gains tax make corporate earnings more likely to be
subject to only one level of tax. They also decrease the likelihood of
S corporations becoming subject to these corporate-level taxes and thus
simplify tax compliance for many S corporations.
Please contact me if you have any questions or desire any
additional information.
Yours very truly,
Mary A. McNulty
Statement of Washington Council Ernst & Young
Washington Council Ernst & Young (WCEY) appreciates the opportunity
to submit testimony on behalf of its clients to the Subcommittee as
part of its hearing on Subchapter S reform. We applaud the committee
for giving serious consideration to the need to modernize Subchapter S
of the Internal Revenue Code and we recommend that you specifically
consider policies that will enable more employee-owned businesses to
operate under the Subchapter S rules.
Many older, established companies that began as sole
proprietorships and ultimately incorporated under Subchapter C did so
at a time when the tax code did not allow the current flexibility of
entity choice. As a result, some of these C corporations, especially
those that are entirely owned by a broad base of employees and
directors, find themselves at a competitive disadvantage relative to
newer companies that have been able to avail themselves of the more tax
efficient rules that govern limited partnerships, limited liability
companies and S corporations.
As you know, conversion from a C corporation to an entity subject
to a single level of tax is a taxable event under current law.
Moreover, due to restrictions imposed on S corporations, older
employee-owned businesses must remain as regular C corporations. Thus,
many long-established private, employee-owned companies remain locked
in Subchapter C where they are subject to a double layer of tax on
their earnings. Had President Bush's proposal to eliminate the double
taxation of corporate earnings been enacted into law, this disparity
would have been eliminated and all entities would have been subject to
only one level of tax.
In 1996 as part of the Small Business Job Protection Act the
Congress enabled certain tax-exempt entities, including Employee Stock
Ownership Plans (ESOPs) to be S corporation shareholders. In explaining
the reason for this change, the Congress stated:
``The Congress believed that the present-law prohibition of
certain tax-exempt organizations being S corporation shareholders may
have inhibited employee ownership of closely-held businesses,
frustrated estate planning, discouraged charitable giving, and
restricted sources of capital for closely-held businesses. The Congress
sought to lift these barriers by allowing certain tax-exempt
organizations to be shareholders in S corporations.'' \1\
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\1\ Joint Committee on Taxation, General Explanation of Tax
Legislation Enacted in the 104th Congress (JCS-12-6),
December 18, 1996, p. 130.
As Congress again looks to modernize Subchapter S, we believe that
you should consider changes to the current limitations with respect to
eligible shareholders that will further the goals of broad employee
ownership and access to capital for closely held businesses. In
particular, we suggest a change in the law to permit all active
employees and directors who own common stock in an employee-owned
regular C corporation to be considered as one shareholder.
Relaxing the limit on the number of shareholders in the case of
employee-owned S corporations will help align employees' interests with
that of the business, thus dramatically improving employee retention,
moral, loyalty, productivity and prosperity. We urge the members of the
subcommittee to consider the benefits of allowing employee-owned
companies greater access to Subchapter S and to include such a proposal
in appropriate legislation. We would be pleased to work with you and
your colleagues on these important issues.
Thank for your time and consideration.