[Congressional Record (Bound Edition), Volume 147 (2001), Part 10]
[Extensions of Remarks]
[Pages 14073-14075]
[From the U.S. Government Publishing Office, www.gpo.gov]



                 SUBCHAPTER S MODERNIZATION ACT OF 2001

                                 ______
                                 

                         HON. E. CLAY SHAW, JR.

                               of florida

                    in the house of representatives

                        Thursday, July 19, 2001

  Mr. SHAW. Mr. Speaker, today over 2 million businesses pay taxes as S 
corporations

[[Page 14074]]

and the vast majority of these are small businesses. The Subchapter S 
Modernization Act of 2001 is targeted to these small businesses by 
improving their access to capital, preserving family-owned businesses, 
and lifting obsolete and burdensome restrictions that unnecessarily 
impede their growth.
  Even after the relief provided in 1996, S corporations face 
substantial obstacles and limitations not imposed on other forms of 
entities. The rules governing S corporations need to be modernized to 
bring them more on par with partnerships and limited liability 
companies. For instance, S corporations are unable to attract the 
senior equity capital needed for their survival and growth. This bill 
would remove this obsolete prohibition and also provide that S 
corporations can attract needed financing through convertible debt.
  Additionally, the bill helps preserve family-owned businesses by 
counting all family members as one shareholder for purposes of S 
corporation eligibility. The bill also increases the limit on the 
number of shareholders from 75 to 150. Also, nonresident aliens would 
be permitted to be shareholders under rules like those now applicable 
to partnerships.
  The Subchapter S Modernization Act of 2001 includes the following 
provisions to help: improve capital formation opportunities for small 
businesses, 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 one shareholder

       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.


       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 an 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 corporations to raise more capital 
     and plan for the future without endangering their S 
     corporation status.

          Title II--Qualification and Eligibility Requirements


           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 amounts 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 appointment 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

[[Page 14075]]

     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 chairty 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.

       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 income 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. This provision should apply to all 
     corporations (C and S) with pre-1983 S earnings and profits 
     without regard to when they elect S status. There seems to be 
     no policy reason why the elimination was restricted to 
     corporations with an S election in effect for their first 
     taxable year beginning after December 31, 1996.


  Section 602. No gain or loss on deferred intercompany transactions 
   because of conversion to S corporation or qualified 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.


               Section 605. Special rules of application

       The effective dates of some amendments made by the Act may 
     occur in years in which it is too late to file a claim for 
     refund arising in such years from applying the amendments. 
     The Act grants a 1-year extension beginning on the date of 
     enactment in which to file such claims for these closed 
     years.

  Mr. Speaker, I urge my fellow members to review and support the S 
Corporation Modernization Act, which will help create a level playing 
field for small businesses. I look forward to working with my 
colleagues on the Ways and Means Committee to enact this bill.




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