[Congressional Record Volume 152, Number 106 (Thursday, August 3, 2006)]
[Senate]
[Pages S8850-S8856]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]

      By Mr. HATCH (for himself and Mrs. Lincoln):
  S. 3838. 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, on behalf of myself and my friend and 
colleague, Senator Lincoln, I rise today to introduce the S Corporation 
Reform Act of 2006.
  The bill we are introducing today is a continuation of a bipartisan 
effort that began in the Senate over a decade ago when former Senators 
Pryor and Danforth, me and six other Senators, introduced the S 
Corporation Reform Act of 1993. We recognized then, as we do today, 
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 S corporations to grow and compete with a 
minimum of complexity and a maximum of flexibility.
  According to the latest figures available from the Small Business 
Administration, there were approximately 3.1 million S corporations in 
the United States in 2002 with a total of $3.9 trillion in revenue. 
There were about a half million S corporations in 1980, so the growth 
of these entities has been striking. Surprisingly, the growth of S 
corporations has continued even after the advent of the Limited 
Liability Company, LLC, which offers many of the same benefits, but 
more flexibility, as S corporations. In fact, S corporations now 
outnumber both C corporations and partnerships. These are predominantly 
small businesses in the retail and service sectors. 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 in its current state contains a variety of 
limitations, restrictions, and pitfalls for the unwary. 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. The two biggest 
constraints that small businesses face are difficulties in getting 
access to capital and the tax burden. The bill we are

[[Page S8852]]

introducing today addresses both of these vital issues.
  Small businesses create two-thirds of all new jobs in the economy and 
account for roughly half of the overall employment in the country. 
Throughout the 1990s small businesses accounted for sixty to eighty 
percent of all new jobs. They are especially important in industries 
where technological innovation is important. According to the 
Congressional Research Service, small firms account for nearly forty 
percent of all scientists, engineers, and computer specialists working 
in the private sector.
  During the most recent downturn of 2001-2002, when the state of Utah 
lost jobs, small businesses actually created jobs and helped soften the 
blow for many Utahns. Today, as our economy is booming, small 
businesses continue to generate the bulk of new jobs.
  In rural 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.
  Perhaps the biggest challenge facing many American 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 currently allowed to issue convertible debt, nor are they allowed 
to have a nonresident alien as a shareholder.
  Several of the provisions of the S Corporation Reform Act of 2006 are 
designed to alleviate these restrictions on S corporations and help 
them attract capital. With these changes, S corporations will be more 
competitive with other small enterprises doing business as partnerships 
or limited liability companies that do not face such barriers.
  Even though electing subchapter S currently offers significant tax 
relief to a small corporation by eliminating the corporate level of 
taxation, S corporations still face some significant tax burdens and a 
myriad 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 entities. In either case, these provisions can stifle growth and 
impede job creation.
  Most of the provisions in our bill aim to eliminate these barriers 
and make 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 to allow, for 
the first time, small banks to elect to be S corporations. This opened 
the door for many small community banks to become more competitive with 
other financial institutions operating in towns and neighborhoods 
throughout the country. The availability of Subchapter S has been a 
positive development in increasing the profitability and 
competitiveness of many community banks. Some 2,300 banks have chosen 
to be S corporations, representing 25 percent of all banks. However, 
some of the operating rules under subchapter S remain unduly 
inflexible, complex, and harsh on banks.
  The bill we introduce today attempts to address many of these 
challenges by clarifying and relaxing some of the operational rules 
that apply to S corporations. These changes are designed to make it 
significantly easier for community banks to take advantage of the 
benefits of subchapter S. In my opinion, businesses should be allowed 
to focus on meeting their customers' needs and maximizing their 
shareholders' profits, and not preoccupied with conforming to Byzantine 
government rules.
  While the corporate structure of an S corporation would not generally 
make sense for larger companies, the tax structure applied to S 
corporations is quite sensible and can serve as a model for other 
companies. Economists hail the single level of taxation of profits in 
the S corporation law as a much more efficient approach, and something 
that would be desirable for all enterprises.

  The S Corporation Reform Act of 2006 enjoys the support of a broad 
range of associations and trade groups, many of which have worked with 
us in crafting the 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 in the bill. Its enactment 
will lead to an increased ability of these enterprises to attract 
capital and create new jobs.
  I ask unanimous consent that the text of the bill and section-by-
section explanation of the bill be printed in the Record.

                                S. 3838

  There being no objection, the text was ordered to be printed in the 
Record, as follows:
       Be it enacted by the Senate and House of Representatives of 
     the United States of America in Congress assembled,

     SECTION 1. SHORT TITLE; REFERENCE; TABLE OF CONTENTS.

       (a) Short Title.--This Act may be cited as the ``S 
     Corporation Reform Act of 2006''.
       (b) Amendment of 1986 Code.--Except as otherwise expressly 
     provided, whenever in this Act an amendment or repeal is 
     expressed in terms of an amendment to, or repeal of, a 
     section or other provision, the reference shall be considered 
     to be made to a section or other provision of the Internal 
     Revenue Code of 1986.
       (c) Table of Contents.--The table of contents for this Act 
     is as follows:

Sec. 1. Short title; reference; table of contents.

           TITLE I--ELIGIBLE SHAREHOLDERS OF AN S CORPORATION

Sec. 101. Nonresident aliens allowed to be shareholders.
Sec. 102. Expansion of S corporation eligible shareholders to include 
              IRAS.

 TITLE II--QUALIFICATION AND ELIGIBILITY REQUIREMENTS OF S CORPORATIONS

Sec. 201. Issuance of preferred stock permitted.
Sec. 202. Safe harbor expanded to include convertible debt.
Sec. 203. Repeal of excessive passive investment income as a 
              termination event.
Sec. 204. Modifications to passive income rules.
Sec. 205. Adjustment to basis of s corporation stock for certain 
              charitable contributions.

           TITLE III--TREATMENT OF S CORPORATION SHAREHOLDERS

Sec. 301. Treatment of losses to shareholders.
Sec. 302. Deductibility of interest expense incurred by an electing 
              small business trust to acquire S corporation stock.
Sec. 303. Back to back loans as indebtedness.

       TITLE IV--EXPANSION OF S CORPORATION ELIGIBILITY FOR BANKS

Sec. 401. Treatment of qualifying director shares.
Sec. 402. Recapture of bad debt reserves.

              TITLE V--QUALIFIED SUBCHAPTER S SUBSIDIARIES

Sec. 501. Treatment of the sale of interest in a qualified subchapter S 
              subsidiary.

                    TITLE VI--ADDITIONAL PROVISIONS

Sec. 601. Elimination of all earnings and profits attributable to pre-
              1983 years.
Sec. 602. Repeal of LIFO recapture tax.
Sec. 603. Expansion of post-termination transition period.
Sec. 604. Reduction in tax rate on excess net passive income.
Sec. 605. Increase in cap on qualified small issue bonds.
Sec. 606. Special rules of application.

           TITLE I--ELIGIBLE SHAREHOLDERS OF AN S CORPORATION

     SEC. 101. NONRESIDENT ALIENS ALLOWED TO BE SHAREHOLDERS.

       (a) Nonresident Aliens Allowed to Be Shareholders.--
       (1) In general.--Paragraph (1) of section 1361(b) (defining 
     small business corporation) is amended--
       (A) by adding ``and'' at the end of subparagraph (B),
       (B) by striking subparagraph (C), and
       (C) by redesignating subparagraph (D) as subparagraph (C).
       (2) Conforming amendments.--
       (A) Paragraph (4) and (5)(A) of section 1361(c) (relating 
     to special rules for applying subsection (b)) are each 
     amended by striking ``subsection (b)(1)(D)'' and inserting 
     ``subsection (b)(1)(C)''.
       (B) Clause (i) of section 280G(b)(5)(A) (relating to 
     general rule for exemption for small business corporations, 
     etc.) is amended by striking ``but without regard to 
     paragraph (1)(C) thereof''.
       (b) Nonresident Alien Shareholder Treated as Engaged in 
     Trade or Business Within United States.--
       (1) In general.--Section 875 is amended--
       (A) by striking ``and'' at the end of paragraph (1),
       (B) by striking the period at the end of paragraph (2) and 
     inserting ``, and'', and

[[Page S8853]]

       (C) by adding at the end the following new paragraph:
       ``(3) a nonresident alien individual shall be considered as 
     being engaged in a trade or business within the United States 
     if the S corporation of which such individual is a 
     shareholder is so engaged.''.
       (2) Pro rata share of s corporation income.--The last 
     sentence of section 1441(b) (relating to income items) is 
     amended to read as follows: ``In the case of a nonresident 
     alien individual who is a member of a domestic partnership or 
     a shareholder of an S corporation, the items of income 
     referred to in subsection (a) shall be treated as referring 
     to items specified in this subsection included in his 
     distributive share of the income of such partnership or in 
     his pro rata share of the income of such S corporation.''.
       (3) Application of withholding tax on nonresident alien 
     shareholders.--Section 1446 (relating to withholding tax on 
     foreign partners' share of effectively connected income) is 
     amended by redesignating subsection (f) as subsection (g) and 
     by inserting after subsection (e) the following new 
     subsection:
       ``(f) S Corporation Treated as Partnership, etc.--For 
     purposes of this section--
       ``(1) an S corporation shall be treated as a partnership,
       ``(2) the shareholders of such corporation shall be treated 
     as partners of such partnership,
       ``(3) any reference to section 704 shall be treated as a 
     reference to section 1366, and
       ``(4) no withholding tax under subsection (a) shall be 
     required in the case of any income realized by such 
     corporation and allocable to a shareholder which is an 
     electing small business trust (as defined in section 
     1361(e)).''.
       (4) Conforming amendments.--
       (A) The heading of section 875 is amended to read as 
     follows:

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

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

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

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

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

``Sec. 1446 Withholding tax on foreign partners' and S corporation 
              shareholders' share of effectively connected income.''.
       (C) Permanent establishment of partners and s corporation 
     shareholders.--Section 894 (relating to income affected by 
     treaty) is amended by redesignating subsection (c) as 
     subsection (d) and by inserting after subsection (b) the 
     following new subsection:
       ``(c) Permanent Establishment of Partners and S Corporation 
     Shareholders.--If a partnership or S corporation has a 
     permanent establishment in the United States (within the 
     meaning of a treaty to which the United States is a party) at 
     any time during a taxable year of such entity, a nonresident 
     alien individual or foreign corporation which is a partner in 
     such partnership, or a nonresident alien individual who is a 
     shareholder in such S corporation, shall be treated as having 
     a permanent establishment in the United States for purposes 
     of such treaty.''.
       (c) Application of Other Withholding Tax Rules on 
     Nonresident Alien Shareholders.--
       (1) Section 1441.--Section 1441 (relating to withholding of 
     tax on nonresident aliens) is amended by redesignating 
     subsection (g) as subsection (h) and by inserting after 
     subsection (f) the following new subsection:
       ``(g) S Corporation Treated as Partnership, etc.--For 
     purposes of this section--
       ``(1) an S corporation shall be treated as a partnership,
       ``(2) the shareholders of such corporation shall be treated 
     as partners of such partnership, and
       ``(3) no deduction or withholding under subsection (a) 
     shall be required in the case of any item of income realized 
     by such corporation and allocable to a shareholder which is 
     an electing small business trust (as defined in section 
     1361(e)).''.
       (2) Section 1445.--Section 1445(e) (relating to special 
     rules relating to distributions, etc., by corporations, 
     partnerships, trusts, or estates) is amended by redesignating 
     paragraph (6) as paragraph (7) and by inserting after 
     paragraph (5) the following new paragraph:
       ``(6) S corporation treated as partnership, etc.--For 
     purposes of this section--
       ``(A) an S corporation shall be treated as a partnership, 
     and
       ``(B) the shareholders of such corporation shall be treated 
     as partners of such partnership, and
       ``(C) no deduction or withholding under subsection (a) 
     shall be required in the case of any gain realized by such 
     corporation and allocable to a shareholder which is an 
     electing small business trust (as defined in section 
     1361(e)).''.
       (d) Additional Conforming Amendments.--
       (1) Section 1361(c)(2)(A)(i) is amended by striking ``who 
     is a citizen or resident of the United States''.
       (2) Section 1361(d)(3)(B) is amended by striking ``who is a 
     citizen or resident of the United States''.
       (3) Section 1361(e)(2) is amended by inserting ``(including 
     a nonresident alien)'' after ``person'' the first place it 
     appears.
       (e) Effective Date.--The amendments made by this section 
     shall apply to taxable years beginning after December 31, 
     2006.

     SEC. 102. EXPANSION OF S CORPORATION ELIGIBLE SHAREHOLDERS TO 
                   INCLUDE IRAS.

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

 TITLE II--QUALIFICATION AND ELIGIBILITY REQUIREMENTS OF S CORPORATIONS

     SEC. 201. ISSUANCE OF PREFERRED STOCK PERMITTED.

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

       ``(I) In general.--Clause (i) shall not apply in the case 
     of a recapitalization under section 368(a)(I)(E) of a family-
     owned corporation or S corporation.''.

       (4) Subsection (a) of section 1373 is amended by striking 
     ``and'' at the end of paragraph (1), by striking the period 
     at the end of paragraph (2) and inserting ``, and'', and by 
     adding at the end the following new paragraph:
       ``(3) no amount of an expense deductible under this 
     subchapter by reason of section 1361(f)(3) shall be 
     apportioned or allocated to such income.''.
       (c) Effective Date.--The amendments made by this section 
     shall apply to taxable years beginning after December 31, 
     2006.

     SEC. 202. SAFE HARBOR EXPANDED TO INCLUDE CONVERTIBLE DEBT.

       (a) In General.--Subparagraph (B) of section 1361(c)(5) 
     (defining straight debt) is amended by striking clauses (ii) 
     and (iii) and inserting the following new clauses:
       ``(ii) in any case in which the terms of such promise 
     include a provision under which the obligation to pay may be 
     converted (directly or indirectly) into stock of the 
     corporation, such terms, taken as a whole, are substantially 
     the same as the terms which could have been obtained on the 
     effective date of the promise from a person which is not a 
     related person (within the meaning of section

[[Page S8854]]

     465(b)(3)(C)) to the S corporation or its shareholders, and
       ``(iii) the creditor is--

       ``(I) an individual,
       ``(II) an estate,
       ``(III) a trust described in paragraph (2),
       ``(IV) an exempt organization described in paragraph (6), 
     or
       ``(V) a person which is actively and regularly engaged in 
     the business of lending money.''.

       (b) Effective Date.--The amendment made by this section 
     shall apply to taxable years beginning after December 31, 
     2006.

     SEC. 203. REPEAL OF EXCESSIVE PASSIVE INVESTMENT INCOME AS A 
                   TERMINATION EVENT.

       (a) In General.--Section 1362(d) (relating to termination) 
     is amended by striking paragraph (3).
       (b) Conforming Amendments.--
       (1) Section 1362(f)(1) is amended by striking ``or (3)''.
       (2) Clause (i) of section 1042(c)(4)(A) is amended by 
     striking ``section 1362(d)(3)(C)'' and inserting ``section 
     1375(b)(3)''.
       (c) Effective Date.--The amendments made by this section 
     shall apply to taxable years beginning after December 31, 
     2006.

     SEC. 204. MODIFICATIONS TO PASSIVE INCOME RULES.

       (a) Increased Limit.--
       (1) In general.--Subsection (a)(2) of section 1375 
     (relating to tax imposed when passive investment income of 
     corporation having accumulated earnings and profits exceeds 
     25 percent of gross receipts) is amended by striking ``25 
     percent'' and inserting ``60 percent''.
       (2) Conforming amendments.--
       (A) Subparagraph (J) of section 26(b)(2) is amended by 
     striking ``25 percent'' and inserting ``60 percent''.
       (B) Clause (i) of section 1375(b)(1)(A) is amended by 
     striking ``25 percent'' and inserting ``60 percent''.
       (C) The heading for section 1375 is amended by striking 
     ``25 PERCENT'' and inserting ``60 PERCENT''.
       (D) The table of sections for part III of subchapter S of 
     chapter 1 is amended by striking ``25 percent'' in the item 
     relating to section 1375 and inserting ``60 percent''.
       (b) Repeal of Passive Income Capital Gain Category.--
       (1) In general.--Subsection (b) of section 1375 (relating 
     to tax imposed when passive investment income of corporation 
     having accumulated earnings and profits exceeds 60 percent of 
     gross receipts), as amended by subsection (a), is amended by 
     striking paragraphs (3) and (4) and inserting the following 
     new paragraph:
       ``(3) Passive investment income defined.--
       ``(A) In general.--Except as otherwise provided in this 
     paragraph, the term `passive investment income' means gross 
     receipts derived from royalties, rents, dividends, interest, 
     and annuities.
       ``(B) Exception for interest on notes from sales of 
     inventory.--The term `passive investment income' shall not 
     include interest on any obligation acquired in the ordinary 
     course of the corporation's trade or business from its sale 
     of property described in section 1221(a)(1).
       ``(C) Treatment of certain lending or finance companies.--
     If the S corporation meets the requirements of section 
     542(c)(6) for the taxable year, the term `passive investment 
     income' shall not include gross receipts for the taxable year 
     which are derived directly from the active and regular 
     conduct of a lending or finance business (as defined in 
     section 542(d)(1)).
       ``(D) Treatment of certain dividends.--If an S corporation 
     holds stock in a C corporation meeting the requirements of 
     section 1504(a)(2), the term `passive investment income' 
     shall not include dividends from such C corporation to the 
     extent such dividends are attributable to the earnings and 
     profits of such C corporation derived from the active conduct 
     of a trade or business.
       ``(E) Coordination with section 1374.--The amount of 
     passive investment income shall be determined by not taking 
     into account any recognized built-in gain or loss of the S 
     corporation for any taxable year in the recognition period. 
     Terms used in the preceding sentence shall have the same 
     respective meaning as when used in section 1374.''.
       (2) Conforming amendments.--Section 1375(d) is amended by 
     striking ``subchapter C'' both places it appears and 
     inserting ``accumulated''.
       (c) Effective Date.--The amendments made by this section 
     shall apply to taxable years beginning after December 31, 
     2006.

     SEC. 205. ADJUSTMENT TO BASIS OF S CORPORATION STOCK FOR 
                   CERTAIN CHARITABLE CONTRIBUTIONS.

       (a) In General.--Paragraph (1) of section 1367(a) (relating 
     to adjustments to basis of stock of shareholders, etc.) is 
     amended by striking ``and'' at the end of subparagraph (B), 
     by striking the period at the end of subparagraph (C) and 
     inserting ``, and'', and by adding at the end the following 
     new subparagraph:
       ``(D) the excess of the amount of the shareholder's 
     proportionate share of any charitable contribution made by 
     the S corporation over the shareholder's proportionate share 
     of the adjusted basis of the property contributed.''.
       (b) Effective Date.--The amendments made by this section 
     shall apply to taxable years beginning after December 31, 
     2006.

           TITLE III--TREATMENT OF S CORPORATION SHAREHOLDERS

     SEC. 301. TREATMENT OF LOSSES TO SHAREHOLDERS.

       (a) Liquidations.--Section 331 (relating to gain or loss to 
     shareholders in corporate liquidations) is amended by 
     redesignating subsection (c) as subsection (d) and by 
     inserting after subsection (b) the following new subsection:
       ``(c) Loss on Liquidations of S Corporation.--
       ``(1) In general.--The portion of any net loss recognized 
     by a shareholder of an S corporation (as defined in section 
     1361(a)(1))--
       ``(A) on amounts received by such shareholder in a 
     distribution in complete liquidation of such S corporation, 
     or
       ``(B) on an installment obligation received by such 
     shareholder with respect to a sale or exchange by the 
     corporation during the 12-month period beginning on the date 
     a plan of complete liquidation is adopted if the liquidation 
     is completed during such 12-month period, which does not 
     exceed the ordinary income basis of stock of such S 
     corporation in the hands of such shareholder shall not be 
     treated as a loss from the sale or exchange of a capital 
     asset but shall be treated as an ordinary loss.
       ``(2) Ordinary income basis.--For purposes of this 
     subsection, the ordinary income basis of stock of an S 
     corporation in the hands of a shareholder of such S 
     corporation shall be an amount equal to the portion of such 
     shareholder's basis in such stock which is equal to the 
     aggregate increases in such basis under section 1367(a)(1) 
     resulting from such shareholder's pro rata share of ordinary 
     income of such S corporation attributable to the complete 
     liquidation.''.
       (b) Suspended Passive Activity Losses.--Paragraph (3) of 
     section 1371(b) is amended to read as follows:
       ``(3) Treatment of s year as elapsed year; passive 
     losses.--Nothing in paragraphs (1) and (2) shall prevent 
     treating a taxable year for which a corporation is an S 
     corporation as a taxable year for purposes of determining the 
     number of taxable years to which an item may be carried back 
     or carried forward nor prevent the allowance of a passive 
     activity loss deduction to the extent provided by section 
     469(g).''.
       (c) Effective Date.--The amendments made by this section 
     shall apply to taxable years beginning after December 31, 
     2006.

     SEC. 302. DEDUCTIBILITY OF INTEREST EXPENSE INCURRED BY AN 
                   ELECTING SMALL BUSINESS TRUST TO ACQUIRE S 
                   CORPORATION STOCK.

       (a) In General.--Subparagraph (C) of section 641(c)(2) 
     (relating to modifications) is amended by inserting after 
     clause (iii) the following new clause:
       ``(iv) Any interest expense incurred to acquire stock in an 
     S corporation.''.
       (b) Effective Date.--The amendment made by this section 
     shall apply to taxable years beginning after December 31, 
     2006.

     SEC. 303. BACK TO BACK LOANS AS INDEBTEDNESS.

       (a) In General.--Section 1366(d) (relating to special rules 
     for losses and deductions) is amended by adding at the end 
     the following new paragraph:
       ``(4) Loans included in indebtedness of an s corporation.--
     For purposes of subsection (d), the indebtedness of an S 
     corporation to the shareholder shall include any loans made 
     or acquired (by purchase, gift, or distribution from another 
     person) by a shareholder to the S corporation, regardless of 
     whether the funds loaned by the shareholder to the S 
     corporation were obtained by the shareholder by means of a 
     recourse loan from another person (whether related or 
     unrelated to the shareholder).''.
       (b) Effective Date.--The amendment made by this section 
     shall apply to taxable years beginning after December 31, 
     2006.

       TITLE IV--EXPANSION OF S CORPORATION ELIGIBILITY FOR BANKS

     SEC. 401. TREATMENT OF QUALIFYING DIRECTOR SHARES.

       (a) In General.--Section 1361 (defining S corporation), as 
     amended by section 201(a), is amended by adding at the end 
     the following new subsection:
       ``(g) Treatment of Qualifying Director Shares.--
       ``(1) In general.--For purposes of this subchapter--
       ``(A) qualifying director shares shall not be treated as a 
     second class of stock, and
       ``(B) no person shall be treated as a shareholder of the 
     corporation by reason of holding qualifying director shares.
       ``(2) Qualifying director shares defined.--For purposes of 
     this subsection, the term `qualifying director shares' means 
     any shares of stock in a bank (as defined in section 581) or 
     in a bank holding company registered as such with the Federal 
     Reserve System--
       ``(A) which are held by an individual solely by reason of 
     status as a director of such bank or company or its 
     controlled subsidiary; and
       ``(B) 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.
       ``(3) Distributions.--A distribution (not in part or full 
     payment in exchange for stock) made by the corporation with 
     respect to qualifying director shares shall be includible as 
     ordinary income of the holder and deductible to the 
     corporation as an expense in computing taxable income under 
     section 1363(b) in the year such distribution is received.''.
       (b) Conforming Amendments.--

[[Page S8855]]

       (1) Section 1361(b)(1), as amended by section 201(b), is 
     amended by striking ``subsection (f)'' and inserting 
     ``subsections (f) and (g)''.
       (2) Section 1366(a), as amended by section 201(b), is 
     amended by adding at the end the following new paragraph:
       ``(4) Allocation with respect to qualifying director 
     shares.--The holders of qualifying director shares (as 
     defined in section 1361(g)) shall not, with respect to such 
     shares of stock, be allocated any of the items described in 
     paragraph (1).''.
       (3) Section 1373(a), as amended by section 201(b), is 
     amended by striking ``and'' at the end of paragraph (2), by 
     striking the period at the end of paragraph (3) and inserting 
     ``, and'', and adding at the end the following new paragraph:
       ``(4) no amount of an expense deductible under this 
     subchapter by reason of section 1361(g)(3) shall be 
     apportioned or allocated to such income.''.
       (c) Effective Date.--The amendments made by this section 
     shall apply to taxable years beginning after December 31, 
     1996.

     SEC. 402. RECAPTURE OF BAD DEBT RESERVES.

       Notwithstanding section 481 of the Internal Revenue Code of 
     1986, with respect to any S corporation election made by any 
     bank in taxable years beginning after December 31, 1996, such 
     bank may recognize built-in gains from changing its 
     accounting method for recognizing bad debts from the reserve 
     method under section 585 or 593 of such Code to the charge-
     off method under section 166 of such Code either in the 
     taxable year ending with or beginning with such an election.

              TITLE V--QUALIFIED SUBCHAPTER S SUBSIDIARIES

     SEC. 501. TREATMENT OF THE SALE OF INTEREST IN A QUALIFIED 
                   SUBCHAPTER S SUBSIDIARY.

       (a) In General.--Section 1361(b)(3) (relating to treatment 
     of certain wholly owned subsidiaries) is amended by adding at 
     the end the following new subparagraph:
       ``(F) Special rule on termination.--The tax treatment of 
     the disposition of the stock of the qualified subchapter S 
     subsidiary shall be determined as if such disposition were--
       ``(i) a sale of the undivided interest in the subsidiary's 
     assets based on the percentage of the stock transferred, and
       ``(ii) followed by a deemed contribution by the S 
     corporation and the transferee in a section 351 
     transaction.''.
       (b) Effective Date.--The amendment made by this section 
     shall apply to taxable years beginning after December 31, 
     1996.

                    TITLE VI--ADDITIONAL PROVISIONS

     SEC. 601. ELIMINATION OF ALL EARNINGS AND PROFITS 
                   ATTRIBUTABLE TO PRE-1983 YEARS.

       (a) In General.--Subsection (a) of section 1311 of the 
     Small Business Job Protection Act of 1996 is amended to read 
     as follows:
       ``(a) In General.--If a corporation was an electing small 
     business corporation under subchapter S of chapter 1 of the 
     Internal Revenue Code of 1986 for any taxable year beginning 
     before January 1, 1983, the amount of such corporation's 
     accumulated earnings and profits (as of the beginning of any 
     taxable year beginning after December 31, 1982) shall be 
     reduced by an amount equal to the portion (if any) of such 
     accumulated earnings and profits which were accumulated in 
     any taxable year beginning before January 1, 1983, for which 
     such corporation was an electing small business corporation 
     under such subchapter S.''.
       (b) Effective Date.--The amendment made by this section 
     shall apply to taxable years beginning after December 31, 
     1996.

     SEC. 602. REPEAL OF LIFO RECAPTURE TAX.

       (a) In General.--Section 1363 (relating to effect on 
     election on corporations) is amended by striking subsection 
     (d).
       (b) Effective Date.--The amendment made by this section 
     shall apply to elections made after the date of the enactment 
     of this Act.

     SEC. 603. EXPANSION OF POST-TERMINATION TRANSITION PERIOD.

       (a) In General.--Clause (ii) of section 1377(b)(1)(A) 
     (defining post-termination transition period) is amended to 
     read as follows:
       ``(ii) the date on which any refund or credit of any 
     overpayment of tax with respect to the return for such last 
     year as an S corporation is prevented by the operation of any 
     law or rule of law (including res judicata),''.
       (b) Effective Date.--The amendment made by this section 
     shall apply to periods beginning after the date of the 
     enactment of this Act.

     SEC. 604. REDUCTION IN TAX RATE ON EXCESS NET PASSIVE INCOME.

       (a) In General.--Section 1375(a) (relating to tax imposed 
     when passive investment income of corporation having 
     accumulated earnings and profits exceeds 25 percent of gross 
     receipts) is amended by striking ``computed by multiplying 
     the excess net passive income by the highest rate of tax 
     specified in section 11(b)'' and inserting ``15 percent of 
     the excess net passive income''.
       (b) Effective Date.--The amendment made by this section 
     shall apply to taxable years beginning after December 31, 
     2006.

     SEC. 605. INCREASE IN CAP ON QUALIFIED SMALL ISSUE BONDS.

       (a) In General.--Section 144(a)(4)(A)(i) (relating to 
     general rule for $10,000,000 limit in certain cases) is 
     amended by striking ``$10,000,000'' and inserting 
     ``$10,000,000($30,000,000 in the case of any bank (as defined 
     in section 581) or any depository institution holding company 
     (as defined in section 3(w)(1) of the Federal Deposit 
     Insurance Act (12 U.S.C. 1813(w)(1)) which is an S 
     corporation)''.
       (b) Adjustment of Cap for Inflation.--Section 144(a) 
     (relating to qualified small issue bond) is amended--
       (1) by redesignating paragraph (12) as paragraph (13); and
       (2) by inserting after paragraph (11) the following new 
     paragraph:
       ``(12) Inflation adjustment.--
       ``(A) In general.--In the case of any calendar year after 
     2006, the $30,000,000 amount contained in paragraph (4)(A)(i) 
     shall be increased by an amount equal to--
       ``(i) such dollar amount, multiplied by
       ``(ii) the cost-of-living adjustment determined under 
     section 1(f)(3) for such calendar year by substituting 
     `calendar year 2005' for `calendar year 1992' in subparagraph 
     (B) thereof.
       ``(B) Rounding.--Any increase under subparagraph (A) which 
     is not a multiple of $100,000 shall be rounded to the next 
     lowest multiple of $100,000.''.
       (c) Effective Date.--The amendments made by this section 
     shall apply to--
       (1) obligations issued after the date of the enactment of 
     this Act; and
       (2) capital expenditures made after such date with respect 
     to obligations issued on or before such date.

     SEC. 606. SPECIAL RULES OF APPLICATION.

       (a) Waiver of Limitations.--If refund or credit of any 
     overpayment of tax resulting from the application of any 
     amendment made by this Act is prevented at any time before 
     the close of the 1-year period beginning on the date of the 
     enactment of this Act by the operation of any law or rule of 
     law (including res judicata), such refund or credit may 
     nevertheless be made or allowed if claimed therefor is filed 
     before the close of such period.
       (b) Treatment of Certain Elections Under Prior Law.--For 
     purposes of section 1362(g) of the Internal Revenue Code of 
     1986 (relating to election after termination), any 
     termination or revocation under section 1362(d) of such Code 
     (as in effect on the day before enactment of this Act) shall 
     not be taken into account.
                                  ____

  There being no objection, the additional material was ordered to be 
printed in the Record, as follows:

    S Corporation Reform Act of 2006--Section-by-Section Description

       The Subchapter S Modernization Act of 2006 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. 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 102. expansion of S corporation eligible shareholders to 
                              include iras

       The Act permits Individual Retirement Accounts (IRAs) to 
     hold stock in an S corporation. Currently this is permitted 
     only for S corporations that are banks.

 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

[[Page S8856]]

     in Sections 204 and 604 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. adjustment to basis of S corporation stock 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 the 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 basis in the S corporation stock.


section 302. deductibility of interest expense incurred by an electing 
       small business trust (esbt) 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. 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. 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 303. back-to-back loans as indebtedness

       This provision would remove a significant trap for unwary 
     shareholders of unsophisticated S corporations. The amount of 
     a shareholder's pro rata share of corporate losses that may 
     be taken into account are currently limited 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 
     numerous court cases and is an area of much uncertainty. The 
     Act will protect these taxpayers from an unfair and 
     unwarranted fate by providing that true indebtedness from an 
     S corporation to a shareholder (funds for which the 
     shareholder is truly obligated to either repay or for which 
     he/she experiences a true economic outlay) increases 
     shareholder debt basis, irrespective of the original source 
     of the funds to the corporation.

       TITLE IV--EXPANSION OF S CORPORATION ELIGIBILITY FOR BANKS


          section 401. treatment of qualifying director shares

       The Act clarifies that qualifying director shares of a 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 gain 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 an S corporation election.


              section 402. recapture of bad debt reserves

       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. 
     Under current law, banks that convert to S corporation status 
     must change from the reserve method of accounting for bad 
     debts to the specific charge-off method. The differential 
     must often be ``recaptured'' into income and 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 reserves 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. treatment of the sale of interest in a qualified 
                     subchapter s subsidiary (qsub)

       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.

                    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 S 
     corporations 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. the repeal of the lifo recapture tax

       Often the most significant hurdle faced by a corporation 
     desiring to elect S corporation status is the LIFO recapture 
     tax. 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, could avoid a corporate-level tax on LIFO 
     layers because the S corporation would only be subject to a 
     corporate-level tax on LIFO layers for the first 10 years 
     after conversion instead of indefinitely, as in the case of a 
     C corporation.
       These concerns are unfounded. Most corporations, whether S 
     or C, hold base LIFO layers far longer than the 10-year 
     recognition period (often holding them indefinitely). There 
     is no data to suggest that S corporations deplete such layers 
     any faster than their C corporation counterparts (for 
     example, in year 11 of the S election). Accordingly, the 
     making of an S election should not be grounds for a tax on 
     base LIFO layers. The Act would repeal this unwarranted 
     government windfall and properly put S corporations on par 
     with C corporations, which rarely pay tax on the old LIFO 
     layers.


      section 603. expansion of post-termination transition period

       The Act expands the post-termination transition period 
     (PTTP) to include the filing of an amended return for an S 
     year. The granting of the 120-day PTTP should be based on the 
     recognition that legitimate changes to an original return can 
     be made in several ways including through audit or through 
     the filing of a taxpayer-initiated amended return.


    section 604. reduction in tax rate on excess net passive income

       The Act would bring the punitive nature of the tax on 
     excess passive income closer in form and substance to the 
     personal holding company (PHC) rules by reducing the tax rate 
     on passive investment income to 15 percent as was recently 
     done for PHCs by Section 302(e) of the Jobs and Growth Tax 
     Relief Reconciliation Act of 2003.


      section 605. increase in cap on qualified small issue bonds

       The act would change the maximum size of a bond issuance 
     that would qualify as a ``small issue'' for S corporation 
     banks to $10 million, and $30 million. It also indexes this 
     number for inflation.


       section 606. reduced recognition period for built-in gains

       The effective recognition period for built-in gains of S 
     corporations is reduced from ten years to seven years.


               section 607. special rules of application

       If a refund or tax credit resulting from the application of 
     this act is prevented in the first year of its enactment, it 
     may still be taken as long as it is claimed within the year.
                                 ______