[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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                      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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \1\ P.L. 108-27.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \3\ See H.R. Rep. No. 104-586 at 89 (1996)
---------------------------------------------------------------------------
    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:
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \3\ Public Law 104-188.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \4\ U.S. General Accounting Office, ``Banking Taxation, 
Implications of Proposed Revisions Governing S-Corporations on 
Community Banks,'' June 2000. (GAO/GGD-00-159).
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \5\ Grant Thornton LLP, Ninth Annual Survey of Community Bank 
Executives.
---------------------------------------------------------------------------
    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:
---------------------------------------------------------------------------
    \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:
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \8\ Internal Revenue Code Sec. 4975(c)(1)(A).
    \9\ Internal Revenue Code Sec. 408(e)(2)(A).
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \10\ Internal Revenue Code Sec. 408(e)(2).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \11\ (PTE 98-59) 63 FR 69326, 12/16/98 (25 BPR 2673, 11/16/98).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \12\ Internal Revenue Code Sec. 1361(b)(1)(D).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \13\ Internal Revenue Code Sec. 1361(b)(1)(D).
    \14\ 12 U.S.C. section 72.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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:
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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:
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
      Equity investments needed to conduct business (FHLB stock 
etc.); \25\
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
      Assets pledged to a 3rd party to secure deposits or 
business; \26\ and
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
      Investment assets needed for liquidity or loan 
demand.\27\
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \5\ Section 101, National Bank Directors.
    \6\ Section 110, Business Organization Flexibility for National 
Banks.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
       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.
---------------------------------------------------------------------------
    \4\ Reg. Sec. 1.1502-13(j)(6).
---------------------------------------------------------------------------
       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\
---------------------------------------------------------------------------
    \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.

                                 
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