[Congressional Record Volume 147, Number 101 (Thursday, July 19, 2001)]
[Senate]
[Pages S7959-S7963]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]

      By Mr. HATCH. (for himself, Mr. Breaux, Mrs. Lincoln, Mr. Allard, 
        Mr. Thompson, and Mr. Graham):
  S. 1201. A bill to amend the Internal Revenue Code of 1986 to provide 
for S corporation reform, and for other purposes; to the Committee on 
Finance.
  Mr. HATCH. Mr. President, I rise today to introduce the Subchapter S 
Modernization Act of 2001. I am very pleased to be joined in this 
effort by Senators Breaux, Lincoln, Thompson, Allard, and Gramm.
  The bill we are introducing today is a continuation of a bipartisan 
effort that began in the Senate nearly a decade ago when former 
Senators Pryor and Danforth, along with myself and six other senators, 
introduced the S Corporation Reform Act of 1993. We recognized then, as 
the sponsors of today's bill do now, that S corporations are a vital 
and growing part of our economy and that our tax law should reflect the 
importance of these entities and provide tax rules that allow them to 
grow and compete with a minimum of complexity and a maximum of 
flexibility.
  According to the Joint Committee on Taxation, there were nearly 2.6 
million S corporations in the United States in 1998, up from about 
500,000 in 1980. In fact, S corporations now outnumber both C 
corporations and partnerships. These are predominantly small businesses 
in the retail and service sectors. Over 92 percent of all S 
corporations in 1998 reported less than $1 million in assets. Many of 
these businesses, however, are growing rapidly. These are the kinds of 
businesses that make up ``Main Street USA.'' In my home state of Utah, 
over half the corporations have elected Subchapter S treatment.
  Subchapter S of the Internal Revenue Code was enacted in 1958 to help 
remove tax considerations from small business owners' decisions to 
incorporate. This elective tax treatment has been helpful to millions 
of small businesses over the years, particularly to those just starting 
out. Subchapter S provides entrepreneurs the advantage of corporate 
protection from liability along with the single level of tax enjoyed by 
partnerships and limited liability companies.
  However, Subchapter S as enacted and modified over the years contains 
a variety of limitations, restrictions, and pitfalls for the unwary. 
And, even though some very important improvements have been made over 
the years, including many first introduced in the 1993 S Corporation 
Reform Act I mentioned earlier, more needs to be done to bring the tax 
treatment of these important businesses into the 21st Century. This is 
what our bill today is all about.
  A May 2001 study by the Federal Reserve Bank of Kansas City 
highlights the importance of small businesses to our economy and points 
out why Congress should do everything possible to make it easier for 
these entities to get started and grow. The study points out that more 
than 75 percent of the net new jobs created from 1990 to 1995 occurred 
in small firms, defined as those with fewer than 500 employees. 
Moreover, seven of the ten fastest growing industries have been 
dominated by small businesses in recent years, including the high 
technology sector, where small firms employ 38 percent of that 
industry's workers.
  In the rural parts of America, the role of small enterprises is even 
more important. Small businesses account for 90 percent of all rural 
establishments. In 1998, small companies employed 60 percent of rural 
workers and provided half of rural payrolls.
  What do these small businesses, especially those in small-town 
America, most need to grow, to thrive, and even to survive? According 
to the White House Conference on Small Business, two of the most 
important issue areas for these enterprises is easier access to capital 
and an easing of the tax burden. The bill we are introducing today 
addresses both of these vital issues.
  Perhaps the biggest challenge facing all kinds of businesses, but 
especially smaller ones, is attracting adequate capital. Unfortunately, 
Subchapter S is currently a hindrance, rather than a help, for many 
corporations facing this challenge. For example, current law allows for 
only one class of stock for S corporations. Further, S corporations are 
not allowed currently to issue convertible debt. Nor are they allowed 
to have a non-resident alien as a shareholder. These restrictions all 
limit the ability of S corporations in attracting capital, which is 
very often the lifeblood of growing a business.
  Several of the provisions of the Subchapter S Modernization Act are 
designed to alleviate these restrictions on the ways S corporations can 
attract capital. This will help make them more competitive with other 
small enterprises doing business in other forms, such as partnerships 
or limited liability companies, that do not face such barriers.
  Even though electing Subchapter S currently offers much to a small 
corporation in the way of tax relief, principally because such an 
election eliminates the corporate level of taxation, S corporations 
still face some significant tax burdens in the way of potential 
pitfalls and tax traps for the unwary. Some of these impediments exist 
in the requirements of elective S corporation status, and others are in 
the rules governing the day-to-day operations of the

[[Page S7960]]

entities. In either case, these provisions stifle growth and impede job 
creation.
  Most of the sections of the bill we introduce today are dedicated to 
eliminating many of these barriers and making it easier for companies 
to elect Subchapter S and to operate in this status once the election 
is made.
  The Small Business Job Protection Act of 1996 made many important 
changes to Subchapter S. One of the most significant was the ability 
for small banks to elect to be S corporations for the first time. This 
opened the door for many small community banks to become more 
competitive with other financial institutions operating in their towns 
and neighborhoods. So far, more than 1,400 banks in the U.S. have made 
the election, which represents about 18 percent of the more than 8,000 
community banks in the United States.

  According to a survey taken earlier this year by the accounting firm 
Grant Thornton, 3 percent of the remaining community banks plan to 
elect Subchapter S status in 2001, and another 14 percent are 
considering the election after this year.
  The availability of Subchapter S has been a positive development in 
increasing profitability and competitiveness of many community banks. 
However, two problems currently exist. The first is that current law 
includes several significant hurdles to many small banks in converting 
to S corporation status. These include restrictions on the types and 
number of shareholders allowed. The second problem is that some of the 
operating rules under Subchapter S are unduly inflexible, complex, and 
harsh.
  The bill we introduce today attempts to address many of these 
challenges by easing the restrictions on the kinds of shareholders who 
can own S corporation stock and the number of shareholders allowed, as 
well as relaxing some of the operational rules. These changes are 
designed to make it significantly easier for community banks to take 
advantage of the benefits of Subchapter S.
  Small businesses are key to the continued growth of our economy and 
to future job creation. The way I see it, it is the job of government 
to see that unnecessary restrictions and barriers to the success of 
these businesses are removed so that these small enterprises can 
attract capital and function with the maximum of efficiency.
  Some would argue that S corporations are a relic of the past and that 
newer, more flexible forms of doing business, such as limited liability 
companies, are the business entities of the future. Such a view is a 
great distortion of reality. S corporations are a large and growing 
part of our economy. They have served a vital function in our 
communities for the past 43 years and will continue to do so. Our tax 
laws should be overhauled to streamline these rules and make them as 
flexible and easy to work in as possible.
  The S Corporation Modernization Act enjoys the support of a broad 
range of associations and trade groups, many of which have worked with 
us in crafting the bill. I want to especially acknowledge the 
assistance of the American Institute of Certified Public Accountants, 
the Taxation Section of the American Bar Association, the Independent 
Bankers Association of America, and the Utah Bankers Association. These 
organizations contributed time and talent in making recommendations for 
many of the improvements in this bill.
  I urge my colleagues to take a close look at this bill, and to 
support it. Thousands of small and growing businesses in every State 
will benefit from the improvements included therein. Its enactment will 
lead to an increased ability of these enterprises to attract capital, 
expand, and create new jobs.
  I ask unanimous consent that a section-by-section description of the 
bill and a letter of support from a group of organizations that endorse 
it be printed in the Record.
  There being no objection, the additional material was ordered to be 
printed in the Record, as follows:

               Supporters of S Corporation Modernization

       Dear Senators Hatch, Breaux, Lincoln, and Allard: The 
     undersigned organizations, speaking on behalf of many of 
     America's small businesses, want to commend and thank you for 
     sponsoring the S Corporation Modernization Act of 2001. This 
     important legislation will improve capital formation 
     opportunities for small businesses, preserve family-owned 
     businesses, and eliminate unnecessary and unwarranted traps 
     for taxpayers. We want to express our unqualified and 
     enthusiastic support for the entire bill.
       In 1958, Congress created S corporations to create an 
     effective alternative business structure for private 
     entrepreneurs. Under Subchapter S, if certain requirements 
     and restrictions are met, a business can choose to operate in 
     corporate form without being penalized with a second level of 
     tax. Today, about 2.6 million S corporations operate in 
     virtually every sector and in every State across America. 
     These S corporations employ many Americans and hold over 
     $1.45 trillion in business assets.
       Though many of these businesses have been successful 
     ventures, the qualifications and restrictions contained in 
     the original Subchapter S rules were very limiting and 
     complex. Over time, Congress has removed some of these 
     restrictions and has made incremental changes to update and 
     improve the Subchapter S rules. Congress last acted in 1996 
     to pass reforms to make S Corporation rules more compatible 
     with modern-day business demands.
       Unfortunately today, many of these companies are still 
     burdened by obsolete rules, which stunt expansion, inhibit 
     venture capital attraction, and otherwise impede these 
     businesses from meeting the demands of the challenging global 
     economy. As the domestic economy faces increasing challenges, 
     such restrictions are particularly troubling. For S 
     corporations, which have been a key element in America's 
     economic growth, we can no longer afford to keep such 
     antiquated restrictions in place.
       Indeed, the need for any of these restrictions is highly 
     doubtful. Over the last decade, all States (with supporting 
     rulings from the IRS) have now enacted statutes creating 
     limited liability companies (LLCs). LLCs operate like S 
     corporations (with limited liability and subject to a single 
     level of tax), but face none of the burdensome and 
     unnecessary restrictions. As a result, new business 
     enterprises are being formed at an accelerating rate under 
     the LLC regime. The Subchapter S Modernization Act of 2001 
     will go a long way toward lifting these needless burdens on S 
     corporations.
       For these reasons, we agree with you that it is again time 
     to revisit Subchapter S reform, and we look forward to 
     working with you to enact the S Corporation Modernization Act 
     of 2001. Thank you again for your championship of this 
     important initiative.
           Sincerely,
         U.S. Chamber of Commerce; Employee-Owned S Corporations 
           of America; S Corporation Association; National 
           Cattleman's Beef Association; Associated General 
           Contractors of America; National Association of 
           Realtors; National Multi Housing Council; National 
           Apartment Association; Small Business Survival 
           Committee; Independent Insurance Agents of America; 
           National Association of Manufacturers; Independent 
           Community Bankers of America; American Bankers 
           Association; Utah Bankers Association; Independent 
           Bankers Association of Texas; Independent Bankers of 
           Colorado; Maine Association of Community Banks; 
           Independent Community Bankers of Minnesota; Community 
           Bankers of Wisconsin; Community Bankers Association of 
           Indiana; Community Bankers Association of Kansas; 
           Bluegrass Bankers Association; The Community Bankers 
           Association of Alabama; Independent Community Bankers 
           of New Mexico; Iowa Independent Bankers; California 
           Independent Bankers; Community Bankers Association of 
           Illinois; Montana Independent Bankers; Missouri 
           Independent Bankers Association; Nebraska Independent 
           Community Bankers; Arkansas Community Bankers; 
           Community Bankers Association of Georgia; Michigan 
           Association of Community Bankers; Community Bankers of 
           Louisiana; Independent Bankers Association of New York; 
           Pennsylvania Association of Community Bankers; 
           Independent Community Bankers of South Dakota; 
           Independent Community Bankers of North Dakota; West 
           Virginia Association of Community Bankers; Virginia 
           Association of Community Banks; Community Bankers 
           Association of Oklahoma; Community Bankers Association 
           of New Hampshire.
                                  ____


 Subchapter S Modernization Act of 2001--Section-by-Section Description

       The Subchapter S Modernization Act of 2001 includes the 
     following provisions to help improve capital formation 
     opportunities for small business, preserve family-owned 
     businesses, and eliminate unnecessary and unwarranted traps 
     for taxpayers.


           Title I--Eligible Shareholders of An S Corporation

     Section 101. Members of family treated as 1 shareholders
       The Act provides for an election to count family members 
     that are not more than six generations removed from a common 
     ancestor as one shareholder for purposes of the number of 
     shareholder limitation (currently 75 shareholders). The 
     election requires the consent of a majority of all 
     shareholders. The provision helps family-owned S corporations 
     plan for the future without fear of termination of their S 
     corporation elections.

[[Page S7961]]

     Section 102. Nonresident aliens allowed to be shareholders
       The Act would permit nonresident aliens to be S corporation 
     shareholders. To assure collection of the appropriate amount 
     of tax, the Act requires the S corporation to withhold and 
     pay a tax on effectively connected income allocable to its 
     nonresident alien shareholders. The provision enhances an S 
     corporation's ability to expand into international markets 
     and expands an S corporation's access to capital.
     Section 103. Expansion of bank S corporation eligible 
         shareholders to include IRAs
       The Act permits Individual Retirement Accounts (IRAs) to 
     hold stock in a bank that is a S corporation. Additionally, 
     the Act would exempt the sale of bank S corporation stock in 
     an IRA from the prohibited transaction rules. Currently, IRAs 
     own community bank stock, which results in a significant 
     obstacle to banks that want to make an S election. The 
     provision allows an IRA to own bank S stock, and thus, avoids 
     transactions to buy back stock, which drains the bank's 
     resources.
     Section 104. Increase in number of eligible shareholders to 
         150
       Currently a corporation is not eligible to be an S 
     corporation if it has more than 75 shareholders. The Act 
     increases the number of permitted shareholders to 150. The 
     provision will enable S corporation to raise more capital and 
     plan for the future without endangering their S corporation 
     status.


 Title II--Qualification and Eligibility Requirements of S Corporations

     Section 201. Issuance of preferred stock permitted
       The Act would permit S corporations 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. This provision 
     increases access to capital from investors who insist on 
     having a preferential return and facilitates family 
     succession by permitting the older generation of shareholders 
     to relinquish control of the corporation but maintain an 
     equity interest.
     Section 202. Safe harbor expanded to include convertible debt
       The Act permits S corporations to issue debt that may be 
     converted into stock of the corporation provided that the 
     terms of the debt are substantially the same as the terms 
     that could have been obtained from an unrelated party. The 
     Act also expands the current law safe-harbor debt provision 
     to permit nonresident alien individuals as creditors. The 
     provision facilitates the raising of investment capital.
     Section 203. Repeal of excessive passive investment income as 
         a termination event
       The Act would repeal the rule that an S corporation would 
     lose its S corporation status if it has excess passive income 
     for three consecutive years. A corporate-level ``sting'' (or 
     double) tax would still apply, as modified in Section 204 
     below, to excess passive income.
     Section 204. Modifications to passive income rules
       The Act would increase the threshold for taxing excess 
     passive income from 25 percent to 60 percent (consistent with 
     a Joint Tax Committee recommendation on simplification 
     measures). In addition, the Act removes gains from the sales 
     or exchanges of stock or securities from the definition of 
     passive investment income for purposes of the sting tax.
     Section 205. Stock basis adjustment for certain charitable 
         contributions
       Current rules discourage charitable gifts of appreciated 
     property by S corporations. The Act would remedy this problem 
     by providing for an increase in the basis of shareholders' 
     stock in an amount equal to excess of the value of the 
     contributed property over the basis of the property 
     contributed. This provision conforms the S corporation rules 
     to those applicable to charitable contributions by 
     partnerships.


           TITLE III--TREATMENT OF S CORPORATION SHAREHOLDERS

     Section 301. Treatment of losses to shareholders
       In the case of a liquidation of an S corporation, current 
     law can result in double taxation because of a mismatch of 
     ordinary income (realized at the corporate level and passed 
     through to the shareholder) and a capital loss (recognized at 
     the shareholder level on the liquidating distribution). 
     Although careful tax planning can avoid this result, many S 
     corporations do not have the benefit of sophisticated tax 
     advice. The Act eliminates this potential trap by providing 
     that any 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.
     Section 302. Transfer of suspended losses incident to divorce
       The Act 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. Under current IRS 
     regulations, any suspended losses or deductions are personal 
     to the shareholder and cannot, in any manner, be transferred 
     to another person. Accordingly, if 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 are permanently 
     disallowed. This result is inequitable and unduly harsh, and 
     needlessly complicates property settlement negotiations.
     Section 303. Use of passive activity loss and at-risk amount 
         by qualified subchapter S trust income beneficiaries
       The Act clarifies that, if a QSST transfers its entire 
     interest in S corporation stock to an unrelated party in a 
     fully taxable transaction, the income beneficiary's suspended 
     losses from S corporation activity under the passive activity 
     loss rules would be freed up for use by the income 
     beneficiary. The Act further provides that the income 
     beneficiary's at-risk amount with respect to S activity would 
     be increased by the amount of gain recognized by the QSST on 
     a disposition of S stock. These provisions clarify a 
     troublesome area under current law, and so, eliminate traps 
     for the unwary taxpayer.
     Section 304. Deductibility of interest expense incurred by an 
         electing small business trust to acquire S corporation 
         stock
       The Act provides that interest expense incurred by an ESBT 
     to acquire S corporation stock is deductible by the S portion 
     of the trust. Recently issued proposed regulations would 
     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. This result is contrary to 
     the treatment of other taxpayers, who are entitled to deduct 
     interest incurred to acquire an interest in a pass through 
     entity. Further, Congress never intended to place ESBTs at a 
     disadvantage relative to other taxpayers.
     Section 305. Disregard of unexercised powers of appointments 
         in determining potential current beneficiaries of ESBT
       The Act revises the definition of a ``potential current 
     beneficiary'' in the context of the ESBT eligibility rules by 
     providing that powers of appointment should only be evaluated 
     when the power is actually exercised. Current law provides 
     that postponed or non-exercisable powers will not interfere 
     with the making of an ESBT election. However, proposed 
     regulations provide that, once such powers become 
     exercisable, the S election will automatically terminate if 
     the power could potentially be exercised in favor of an 
     ineligible individual--whether it was actually exercised in 
     favor of the ineligible individual or not. The application of 
     this rule would prevent many family trusts from qualifying as 
     ESBTs.
       The Act expands the existing method to cure a potential 
     current beneficiary problem. Under the Act, an ESBT will have 
     a period of up to one year (currently 60 days) to either 
     dispose of all of its S stock or otherwise cause the 
     ineligible potential current beneficiary's position in the 
     trust to be eliminated without causing the ESBT election or 
     the corporation's S election to fail.
     Section 306. Clarification of electing small business trust 
         distribution rules
       The Act clarifies that, with regard to ESBT distributions, 
     separate share treatment applies to the S and non-S portions 
     under section 641(c).
     Section 307. Allowance of charitable contributions deduction 
         for electing small business trusts
       The Act permits a deduction for charitable contributions 
     made by an ESBT, while taxing the charity on its share of the 
     S corporation's income as unrelated business taxable income. 
     Current law discourages charitable contributions by S 
     corporation shareholders by preventing an ESBT from claiming 
     a charitable contribution deduction. The Act encourages 
     philanthropy by permitting a charitable deduction while at 
     the same time effectively taxing the S corporation's income 
     in the hands of the recipient charity to the extent of the 
     deduction.
     Section 308. Shareholder basis not increased by income 
         derived from cancellation of S corporation's debt
       The Act provides that cancellation of indebtedness (COD) 
     income excluded from the gross income of an S corporation, 
     i.e., due to the S corporation's insolvency, does not 
     increase shareholder's basis in S corporation stock. The Act 
     changes the result reached in the recent U.S. Supreme Court 
     decision in Gitlitz v. Comm'r (2000).
     Section 309. Back-to-back loans as indebtedness.
       The Act clarifies 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'' so as to increase such 
     shareholder's basis in the S corporation. The provision would 
     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.

[[Page S7962]]

       title iv--expansion of s corporation eligibility for banks

     Section 401. Exclusion of investment securities income from 
         passive income test for bank S corporations
       The Act clarifies that interest and dividends on 
     investments maintained by a bank for liquidity and safety and 
     soundness purposes shall not be ``passive'' income. 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.
     Section 402. Treatment of qualifying director shares
       The Act clarifies that qualifying director shares of bank 
     are not to be treated as a second class of stock. Instead, 
     the qualifying director shares are treated as a liability of 
     the bank and no increase or loss from the S corporation will 
     be allocated to these qualifying director shares. The 
     provision clarifies the law and removes a significant 
     obstacle unique among banks contemplating a S corporation 
     election.
     Section 403. Bad debt charge offs in years after election 
         year treated as items of built-in loss
       The Act permits bank S corporations to recapture up to 100 
     percent of their bad debt reserves on their first S 
     corporation tax return and/or their last C corporation income 
     tax return prior to the effective date of the S election. 
     Banks that convert to S corporation status must change from 
     the reserve method of accounting to the specific charge off 
     method. The resulting recapture income is treated as built-in 
     gain subject to tax at both the shareholder and the corporate 
     level. The Act allows banks to accelerate the recapture of 
     bad debt reserve to their last C corporation tax year. The 
     corporate level tax would still be paid on the recapture 
     income, but the recapture would no longer trigger a tax for 
     the bank's shareholders.


              title v--qualified subchapter s subsidiaries

     Section 501. Relief from inadvertently invalid qualified 
         subchapter S subsidiary elections and terminations
       The Act provides 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 
     does in the case of invalid or terminated S corporation 
     elections.
     Section 502. Information returns for qualified subchapter S 
         subsidiaries
       The Act would help clarify that a Qualified Subchapter S 
     Subsidiary (QSSS) can provide information returns under their 
     own tax ID number to help avoid confusion by employers, 
     depositors, and other parties.
     Section 503. Treatment of the sale of interest in a qualified 
         subchapter S subsidiary
       The Act treats the disposition of QSub stock as a sale of 
     the undivided interest in the QSub's assets based on the 
     underlying percentage of stock transferred followed by a 
     deemed contribution by the S corporation and the acquiring 
     party in a nontaxable transaction. 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 as little as 21 
     percent of the QSub's stock. IRS regulations suggest 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 in the QSub). The Act achieves this 
     result without any unnecessary merger and thus removes a trap 
     for the unwary.
     Section 504. Exception to application of step transaction 
         doctrine for restructuring in connection with making 
         qualified subchapter S subsidiary elections
       The Act provides that the step transaction doctrine does 
     not apply to the deemed liquidation resulting from QSub 
     elections. Application of the step transaction doctrine, in 
     the context of making a QSub election, introduces complexity 
     and uncertainty in what should be a simple matter. The 
     doctrine requires knowledge of decades of jurisprudence and 
     administrative interpretations, and poses an unnecessary trap 
     for the unwary.


                    TITLE VI--ADDITIONAL PROVISIONS

     Section 601. Elimination of all earnings and profits 
         attributable to pre-1983 years
       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. The provision should apply to all 
     corporations  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 S corporation subsidiary
       The Act makes clear that any gain or income from an 
     intercompany transaction is not taxed at the time of the S 
     corporation or QSub elections.
     Section 603. Treatment of charitable contribution and foreign 
         tax credit carryforwards
       The Act provides that charitable contribution carryforwards 
     and other 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. This provision is 
     consistent with the legislative history of the 1986 Act.
     Section 604. Distribution by an S corporation to an employee 
         stock ownership plan
       An ESOP will usually borrow from the sponsoring corporation 
     to fund its acquisition of employer securities. In the case 
     of a C corporation, the tax code provides that an ESOP will 
     not be treated as engaging in a ``prohibited transaction'' if 
     it uses any ``dividend'' on employer securities purchased 
     with loan proceeds to make payments on the loan regardless of 
     whether such employer securities have been pledged as 
     collateral to secure the loan. The policy facilitates the 
     payment of ESOP loans and thereby promotes employee 
     ownership. Because S corporation distributions are 
     technically not ``dividends'', the Act provides that S 
     corporation distributions are treated as dividends. This 
     clarification is necessary to ensure that the policy of 
     facilitating the payment of ESOP loans applies equally to S 
     corporation and C corporation ESOPs.

  Mr. BREAUX. Mr. President, I am pleased to introduce with my 
colleagues, Senators Hatch, Lincoln, and Thompson, the Subchapter S 
Modernization Act of 2001. This bill is very important to the 2.6 
million S Corporations in this country and to the thousands of S 
Corporations in my own State of Louisiana.
  The Small Business Administration estimates that small businesses 
account for seventy-five percent of the employment growth in the United 
Sates and are the major creators of new jobs. Small businesses employ 
52 percent of all private workers and provide 51 percent of the output 
in the private sector. They have been, in large part, the engine that 
fuels our economy.
  S Corporations make up a large number of the Nation's small 
businesses. In fact, the Joint Committee on Taxation estimates that 
over ninety-two percent of all S Corporations report less than $1 
million in assets. They operate in every sector of the economy, employ 
millions of Americans and hold over $1.45 trillion in business assets. 
As such, anything we can do the help S Corporations will help the 
economy. The Subchapter S Modernization Act does this by encouraging S 
Corporations to expand, allowing S Corporations to attract more 
capital, and removing tax traps for the unwary.
  The legislation expands the list of eligible shareholders to non-
resident aliens and some Individual Retirement Accounts held by banks. 
The bill also permits families to be treated as one shareholder, which 
not only expands the size of S corporations, but also helps keep family 
businesses together. In additional, the bill increases the number of 
permitted shareholders to 150 from the current law limit of 75.
  All of these important provisions also give S Corporations greater 
flexibility in attracting new sources of investment and capital. By 
permitting S Corporations to issue preferred stock, the Subchapter S 
Modernization Act increases access to capital from investors, such as 
venture capitalists, who insist on a preferential return. This 
provision also facilitates family ownership by allowing older 
generations to relinquish control of the corporation to later 
generations while maintaining an equity interest in the company.
  Lastly, the bill removes many complex tax traps and clarifies the law 
regarding many provisions enacted in 1996. Per the Joint Committee on 
Taxation's recommendation in its simplification report, our bill 
repeals the excessive passive investment income rule as a termination 
event for S corporations and increases the threshold for taxing excess 
passive investment income from 25 percent to 60 percent. Capital gains 
are excluded from the definition of passive income. The rules for 
taxing Electing Small Business Trusts and managing Qualified Subchapter 
S Subsidiaries are simplified in many ways, thus reducing the 
possibility that companies will inadvertently terminate their S 
corporation election.
  I urge my colleagues to support this bill.
  Mrs. LINCOLN. Mr. President, today my colleagues and I are 
introducing legislation which is critically important to millions of 
small and family-owned businesses across this Nation. The Subchapter S 
Modernization Act of

[[Page S7963]]

2001 is the culmination of months of hard work by Senators Hatch, 
Breaux and me. We have worked to bring new ideas together with known 
and necessary S corporation reforms into a comprehensive piece of 
legislation which will help improve capital formation opportunities for 
small businesses, will help preserve family-owned businesses, and will 
eliminate unnecessary and unwarranted traps for well-intentioned 
taxpayers.
  Small businesses are the backbone of commerce in my home State of 
Arkansas. There are between sixteen and seventeen thousand small 
businesses formed as S corporations in Arkansas and over 2.58 million 
nationwide. According to the Joint Committee on Taxation, over ninety-
two percent of these companies have assets totaling less than one 
million dollars and a majority are in the retail trade and service 
sectors. These are truly your mom and pop stores and businesses, and I 
am proud to be working on their behalf.
  This bill represents not just the hard work of the principal sponsors 
but also of several of my colleagues past and present. I would like, in 
the short time that I have, to acknowledge the past efforts of former 
Senators Pryor and Danforth, who represented small business S 
corporations so well and who helped develop many of the provisions we 
have included in the Subchapter S Modernization Act of 2001. I would 
also like to recognize Senator Allard, who has joined in sponsoring 
this legislation, and who has been a lead proponent of S corporation 
reforms which would allow small financial institutions to benefit from 
Subchapter S. And, of course, I would like to thank Senators Thompson, 
Gramm, and Thomas who have joined Senator Hatch, Breaux, and me as 
original sponsors of what I believe is very good legislation for hard 
working men and women across this Nation.
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