S CORPORATION GROUP SUGGESTS LEGISLATIVE CHANGES.

The group's recommended changes include modifying the definition of passive income for purposes of sections 1362 and 1375 to exclude dividends received from active subsidiaries. Further, it suggests adding a statutory exception to the eligible shareholder rule in section 1361(b)(1)(B) to permit the momentary ineligibility that often occurs in a reorganization. And the group recommends that an exception be provided to the eligibility rules that will permit an S corporation to be owned by another S corporation, provided that the ownership is 100 percent.

The S Corporation Tax Study Group would like to commend you and your Committees on your efforts to simplify the Internal Revenue Code of 1986 (the Code). In particular, we would like to express our support for those provisions that originated in H.R. 2777 and S. 1394 (introduced in 1991 as the "Tax Simplification Bill of 1991") and that are now resident in H.R. 4287 (the Democratic Tax Proposal) relating to the taxation of S corporations and their shareholders (hereinafter referred to as the "Simplification Legislation").

As you may know, the S Corporation Tax Study Group is an informal group of tax practitioners in the Washington, D.C. area who meet regularly to discuss various technical and policy issues relating to the taxation of S corporations and their shareholders. In response to your request in February of 1990 for simplification proposals, we submitted a set of recommendations regarding S corporations (copy attached) that made a variety of suggestions, many of which were included in the above legislation.

As mentioned above, we generally support the provisions affecting S corporations that were included in this legislation. However, we are submitting these comments to suggest several technical changes that we believe will either make the provisions more workable or more consistent with their purpose. In addition, we have described below a limited number of additional proposals that we believe would result in significant additional simplification of the taxation of S corporations and their shareholders.

These comments have been prepared by the members of this group (copy of membership list attached) and represent their individual views. If it is appropriate, we would like to meet with the appropriate personnel to discuss these comments. I can be reached at (202) 822-4912.

Sincerely,

I. SUMMARY OF RECOMMENDATIONS

For the reasons described below, we recommend the following changes to the Simplification Legislation.

o The legislative history of section 4602 should clarify that the standard to be used in granting relief to invalid elections and untimely elections is the same as that used to grant inadvertent termination relief.

o With respect to section 4604 as it relates to the elimination of the affiliated group rule, a one-time extension of the two and one-half month election period in IRC section 1362(b)(1)(B) should be allowed that will permit affected corporations to elect S status as of the January 1, 1992 effective date.

o The definition of passive income for IRC sections 1362 and 1375 purposes should be modified to exclude dividends received from active subsidiaries.

In addition, we support H.R. 4287's removal of the provision in the original Simplification Legislation that required a closing of the S corporation's books upon the complete termination of a shareholder's interest

Finally, we recommend the addition of the following proposals to the Simplification Legislation.

o A statutory exception to the eligible shareholder rule in IRC section 1361(b)(1)(B) should be provided to permit the momentary ineligibility that often occurs in a reorganization.

o An exception should be provided to the shareholder eligibility rules in IRC section 1361(b)(1)(B) that will permit an S corporation to be owned by another S corporation, provided that the ownership is 100 percent.

II. COMMENTS ON H.R. 4287 PROVISIONS

A. ONE CLASS OF STOCK REQUIREMENT (Act Section 4601)

PRESENT LAW AND DESCRIPTION OF PROVISION. Under present law, a corporation is eligible to make an S election only if it has one class of stock. This requirement has been the subject of two different sets of proposed regulations. The first, issued in October 1990, contained rules that, in certain circumstances, would have treated a corporation as having more than one class of stock even where all of its outstanding shares of stock conferred identical rights to distributions and liquidation proceeds. In particular, such regulations provided that, in such circumstances, a corporation will be considered to have more than one class of stock if it makes "non- conforming distributions" (i.e., distributions that differ between shares with respect to timing or amount), unless certain limited exceptions applied. This approach would have been extremely draconian in its application because of the multitude of circumstances where the Internal Revenue Service could have argued that an actual or constructive distribution constituted a non-conforming distribution.

Section 401 of the original Simplification Legislation was intended to eliminate many of the problems and traps for the unwary that would have been created by non-conforming distribution rules. (See p. 71 of the Explanation to H.R. 2775). Specifically, section 401 of the Simplification Legislation provided that the corporation has only one class of stock if all outstanding shares confer identical rights to distribution and liquidation proceeds. This determination would be made by reference to the corporate charter, articles, bylaws, state laws, "and any agreements."

Subsequent to the introduction of the Simplification Legislation, the IRS revoked the first set of proposed regulations and issued new proposed one-class-of-stock regulations. The new proposed regulations, issued on August 13, 1991, deleted the provisions that would have treated a corporation as having more than one class of stock if it made non-conforming distributions, and adopted the approach taken in the Simplification Legislation. As a result, the new proposed regulations examine the intent of the shareholders as evidenced by agreements and actions that impact distribution or liquidation rights.

The most recent version of the Simplification Legislation, H.R. 4287, has continued the earlier approach that requires all outstanding shares to have equal distribution and liquidation rights. It acknowledges the action taken by the IRS in the second proposed regulations, and continues the language contained in earlier draft of this legislation that cites situations which would be treated as establishing equal or unequal rights.

COMMENTS AND RECOMMENDATIONS. While we believe that certain limited issues remain unresolved in the most recent proposed regulations, we believe that these regulations generally provide a workable solution to applying the single class of stock requirement. However, we do not think that this administrative action obviates the need for legislation in this area. Therefore, we support section 4601, as it provides a simple approach towards identifying the presence of more than one class of stock in an S corporation.

B. IRS AUTHORITY TO VALIDATE INVALID ELECTIONS (Section 4602)

PRESENT LAW AND DESCRIPTION OF PROVISION. Under present law, the Internal Revenue Service has the authority to waive a termination of a corporation's Subchapter S election upon a determination that the terminating event was inadvertent. However, the IRS does not have the authority to validate a corporation's inadvertently invalid Subchapter S election or to treat a Subchapter S election made after the 15th day of the third month of a taxable year as effective for such taxable year.

Under section 4602(a) of the Simplification Legislation, the IRS authority to waive the effect of an inadvertent termination is extended to allow the Service to waive the effect of an invalid election if the election was invalid because the corporation inadvertently did not qualify as a small business corporation or it did not obtain shareholder consents.

Under section 4602(b) of the Simplification Legislation, the IRS may treat a late Subchapter S election as timely if the Service determines that there was reasonable cause for the failure to timely make the election.

Section 4602 is effective for taxable years beginning after December 31, 1982.

COMMENTS AND RECOMMENDATIONS. This provision creates two additional categories of cases where the IRS has the authority to grant relief for failure to comply with the election and eligibility requirements of subchapter S: incomplete or otherwise invalid elections and late elections. We recommend that the legislative history of the provision provide that the IRS be reasonable in granting waivers, so that corporations whose S elections were inadvertently ineffective when made would be treated as S corporations as of the effective date of the election request. In addition, as described below, we believe that different standards may be appropriate for the two different categories of cases.

As to incomplete or otherwise invalid elections, we recommend that the legislative history clarify that in making a determination of inadvertentness the IRS apply rules similar to those provided in Proposed Regulation section 1.1362-5 for determining whether a terminating event was inadvertent.

With respect to the IRS authority to treat a late election as timely, there are several different standards that may be appropriate. Without specific direction in the legislative history, it might be expected that the IRS would adopt a standard similar to that currently used in the section 1.9100 regulations, that address the circumstances where the IRS will extend the period to make elections that are required by regulation. We are concerned, however, that this standard will be too restrictive because in virtually all cases this relief is limited to circumstances where the taxpayer has engaged an outside professional to make the election and the failure to make it timely is the fault of such professional. We believe that a large number of situations involving late elections that will merit relief will not qualify for such relief under this standard. An alternative standard would use the inadvertence test described above. We believe this standard is more appropriate because it could encompass situations where the taxpayer is at fault. Therefore, we recommend that the legislative history of section 4602(b) specify that the standard to be used in applying relief for late elections is the same as that currently used to waive inadvertent terminations.

Finally, we recommend that section 4602(b) be modified to require that the IRS secure the consent of the corporation and each person who was a shareholder in the corporation at any time during such year to make such adjustments, consistent with the treatment of the corporation as an S corporation, as it may require with respect to such year. Because this provision is retroactive to taxable years after December 31, 1982, such authority may be needed for closed years to secure consistent treatment of S corporation items by the corporation and its shareholders.

C. TREATMENT OF DISTRIBUTIONS DURING LOSS YEAR (Section 4603)

PRESENT LAW AND DESCRIPTION OF PROVISION. Under present law, the amount of the loss of an S corporation that one of its shareholders may take into account for a taxable year cannot exceed such shareholder's basis in his/her stock and any indebtedness of the corporation to such shareholder. In addition, to the extent that the distribution from an S corporation to its shareholder does not exceed the corporation's accumulated adjustments account (AAA), such distribution generally is tax-free to the shareholder to the extent of such shareholder's stock basis.

Currently, the adjustments to a shareholder's basis for items of loss (and deduction) of the corporation occur prior to the adjustments to the basis of such stock for distributions. As a result, if an S corporation has losses and also makes distributions to its shareholders during the year, the reduction in be shareholders' basis for the losses may cause the distributions to be taxable to the shareholders. This result is the opposite of the result that would result if the S corporation were a partnership, where distributions would be taken into account after adjustments for the partnership's items of income but prior to its items of loss. In addition, an S corporation's AAA is increased by items of income (gain) and decreased by items of loss (deduction) prior to determining the taxation of distributions during the year.

Section 4603 of the Simplification Legislation modifies the provisions of subchapter S, affecting the ordering of both the adjustments for losses and distributions and the adjustments to AAA. Under such provisions, the adjustments for distributions of the corporation would be made prior to the adjustments for its losses. In addition, if for any year the corporation's items of loss (and deductions) exceed its items of income (and gain), such corporation's AAA is adjusted only for items of income and gain (and not items of loss and deduction) before determining the taxation of the corporation's distributions during the year.

COMMENTS AND RECOMMENDATIONS. We recommend that this provision be adopted as drafted.

D. TREATMENT OF S CORPORATIONS AS SHAREHOLDERS IN C CORPORATIONS (Section 4604(a))

PRESENT LAW AND DESCRIPTION OF PROVISION. Currently, IRC section 1371(a)(2) provides that an S corporation in its capacity as a shareholder of another corporation is treated as an individual for purposes of subchapter C. The IRS has interpreted this provision as precluding an S corporation from making an election under section 338 upon the acquisition of a C corporation. This rule would also apparently preclude an S corporation from qualifying for tax-free treatment under IRC section 332 upon the liquidation of a subsidiary. These barriers place S corporations at a disadvantage to C corporations, that could utilize these provisions without limitation. As a result, S corporations are forced to engage in complicated tax planning strategies in an attempt to obtain the results that are unavailable as a result of section 1371(a)(2).

Section 4604(a) of the Simplification Legislation would repeal this provision, effective for taxable years beginning after December 31, 1991. As a result, an S corporation would be able to obtain tax- free treatment under IRC sections 337 and 332 upon the liquidation of a C corporation.

COMMENTS AND RECOMMENDATIONS. This is an important simplification provision affecting S corporations. The description of the proposal provides that an IRC section 338 election can be made. Presumably, this extends to section 332 elections and to an election under IRC section 338(h)(10). Although this might be obvious to some, it might be helpful if the legislative history makes this clear.

E. S CORPORATIONS PERMITTED TO HOLD SUBSIDIARIES (Section 4604(b))

PRESENT LAW AND DESCRIPTION OF PROVISION. Currently, a corporation is ineligible to make an S election if it owns 80 percent or more of the vote and value of the outstanding stock of another corporation. Section 4604(b) of the Simplification Legislation would repeal this prohibition and, thereby, permit S corporations to own 80 percent of more of the stock of a subsidiary provided that such corporation is a C corporation.

COMMENTS AND RECOMMENDATIONS. We agree that this proposed change will substantially simplify the options available to the S corporation in structuring its business organization. We wholeheartedly support this important and significant change to subchapter S.

However, we have a recommendation to further enhance this proposal. Under current law, S corporations with subchapter C earnings and profits that have net excess passive income are subject to a passive income tax (IRC section 1375) and face termination of S status after three successive years of passive income exceeding gross receipts (IRC section 1362). These rules were added to subchapter S to force distribution of subchapter C earnings and profits and are comparable to the personal holding company rules applicable to C corporations.

Under the current personal holding company rules, dividends received by parent holding companies from their more-than-50% subsidiaries are not considered to be personal holding company income (IRC section 542(b)(4)). Because the Simplification Legislation will now make parent holding companies eligible for S corporation status, we recommend that a similar exclusion be provided under IRC section 1362 for dividends received from active subsidiaries. If this modification is not adopted, C corporation holding companies could be eligible for S corporation status, but upon election would be subject to the IRC section 1375 tax, and ultimately suffer termination of their S status within three tax years.

In addition, the effective date of this provision as it is currently drafted poses a technical problem. As it currently stands, the provision will be effective for tax years beginning on January 1, 1992. However, it will effectively be impossible for the law to take effect on that date due to the limitations of IRC section 1362(b)(1)(b), which require an S election to be filed within two and one-half months from the beginning of a tax year. As a result, enactment after March 15, 1992 will preclude calendar-year corporations that would now be eligible to elect S status from doing so with a January 1, 1992 effective date -- the date the provision is to be effective. Further, each month that passes prior to enactment would push the "effective" effective date forward.

As a result, we suggest that the legislative history provide for an extended election period for corporations that would otherwise be eligible to elect S status in 1992, but are unable to do so as a result of the expiration of the two and one-half month period. As an alternative, we suggest that corporations be allowed to end their C year as of the date of enactment, and then elect S status going forward (this is not permitted under current IRS rules, which do not allow an S election after a short C period.)

F. ELIMINATION OF PRE-1983 EARNINGS AND PROFITS (Section 4604(c))

PRESENT LAW AND DESCRIPTION OF PROVISION. Prior to the Subchapter S Revision Act of 1982, a C corporation that made an S election could have two types of earnings and profits: subchapter C earnings and profits and subchapter S earnings and profits. The 1982 Act repealed this rule, but only for years beginning after December 31, 1982. Section 4604 of the Simplification Legislation would eliminate a corporation's accumulated subchapter S earnings and profits, thereby reducing the complexity of tracking separate earnings and profits accounts.

COMMENTS AND RECOMMENDATIONS. We recommend that this provision be adopted as drafted.

G. ITEMS OF INCOME IN RESPECT OF A DECEDENT (Section 4604(d))

PRESENT LAW AND DESCRIPTION OF PROVISION. Under present law, income in respect of a decedent (IRD) is includable in the income of the person acquiring the right to such income from a decedent. That person is also eligible for a corresponding deduction for any estate tax attributable to the item of IRD included in income.

The basis of property acquired from a decedent generally is stepped up to its date-to-death market value (unless an alternate valuation date is elected). However, items of IRD do not receive a stepped-basis.

The basis of corporate stock or a partnership interest acquired from a decedent generally is stepped up at death. For a partnership interest, the stepped-up basis must be reduced to the extent that its fair market value is attributable to items of IRD. However, even though S corporation income is includable in the income of its shareholders in a manner similar to the inclusion of partnership income in the income of the partners, current law is unclear about whether the stepped-up basis of S corporation stock acquired from a decedent must be reduced to the extent that its fair market value is attributable to items of IRD. To solve this problem, section 4604(d) of the Simplification Legislation proposes to reduce the basis of the S corporation stock received from a decedent to reflect any IRD attributable to that stock.

COMMENTS AND RECOMMENDATIONS. We support the adoption of this provision. We believe, however, that the legislative history should indicate that no inference regarding prior law is intended.

G. ALLOCATION OF INCOME (LOSS) WHERE SHAREHOLDER DISPOSES OF ENTIRE INTEREST

PRESENT LAW AND DESCRIPTION OF PROVISION. Current law provides an election in section 1377(a)(2) to allow an S corporation to close its books on the date that a shareholder terminates his interest in the corporation. Act section 404(d) as contained in the original Simplification Legislation would make this elective rule mandatory in situations where a shareholder sells its entire interest in the S corporation. However, the provision was removed in H.R. 4287.

COMMENTS AND RECOMMENDATIONS. We believe that a change from an elective rule to a mandatory rule in this area would create additional complexities, rather than simplification. Act section 404(d) would require a closing of the books each time a termination occurs. This would be an onerous provision, resulting in severe disruption of the business, if two or more terminations occurred on different dates in the taxable year.

In addition, many S corporation owners are not sophisticated with regard to tax law requirements. Business owners often consult their tax advisory only once a year, after year-end. Therefore, the advisory may be unaware that a termination had occurred until after year-end. In such cases, it would be very difficult to perform a retroactive closing of the books, as of the date that a shareholder terminated his interest. The problems would be compounded if the business maintains inventories because it is unlikely that an inventory count was taken on the date that a shareholder's interest terminated.

Therefore, we recommend that the current elective rule be retained, and we support H.R. 4287's removal of this provision. If there is to be any legislative activity in this area, we would recommend that the rules be modified to be more consistent with the rules applicable to partnerships. As a result, we would recommend two changes. First, the election to close the books would be expanded so that it applies to any change in a shareholder's interest, not just to the termination of an interest. This would expand the usefulness of the current rule to other situations in which a closing of the books might be more simple or more equitable for the parties involved. Second, the current requirement that all shareholders consent to the election should be deleted. Agreement should only be required from AFFECTED shareholders. In the case of multiple shareholder changes during a year, this would reduce the time and effort involved in explaining the election to, and obtaining signatures from every shareholder of the S corporation for that year.

III. ADDITIONAL SIMPLIFICATION PROPOSALS

A. PROPOSAL TO ADD TRANSITORY INELIGIBLE SHAREHOLDER EXCEPTION

PRESENT LAW. Certain common business transactions to which an S corporation may be a party can cause the corporation to momentarily fail to qualify as a "small business corporation" within the meaning of Code section 1361(b). For example, a transaction such as the formation of a wholly-owned subsidiary in anticipation of a spin-off, the acquisition of all of the stock of a target corporation in an asset acquisition structured as a stock purchase followed by a merger or liquidation, or the incorporation of a partnership can result in a momentary situation in which the corporation either:

(i) is a member of an affiliated group, in violation of IRC section 1362(b)(2)(A).

(ii) has an ineligible shareholder, in violation of IRC section 1362(b)(1)(B), or

Section 4604 of the Simplification Legislation effectively addresses the first situation by repealing IRC sections 1371(a)(2) and 1361(b)(2)(A), which will permit much needed flexibility for S corporations involved in mergers or acquisitions. However, the Simplification Legislation does not address the second situation, in which stock of the S corporation is momentarily owned by an ineligible shareholder. We believe that this additional problem can be corrected by including a brief additional provision in the Simplification Legislation.

Although momentary stock ownership by an ineligible shareholder can occur in various situations, the incorporation of a partnership illustrates the problem. Under current law, there are at least three ways in which a partnership can incorporate its activities (Rev. Rul. 84-111, 1984-2 C.B. 88):

1. The partnership can liquidate, distributing its assets and liabilities to the partners, who then form a corporation and contribute the assets and liabilities to it in exchange for stock.

2. The partners can form a corporation and contribute all their partnership interests to it in exchange for stock. The partnership then terminates under IRC section 708(b)(1)(A) and the corporation then directly holds all of the assets and liabilities formerly held by the partnership.

3. The partnership can form a corporation and contribute its assets and liabilities to it in exchange for stock. The partnership can then liquidate, distributing the stock to the partners.

Under the first and second method, the new corporation is eligible to make an S election effective as of the first day of its existence. Under the last method, however, the partnership -- an ineligible shareholder under IRC section 1361(b)(1)(B) -- is a shareholder from the time the stock is issued until it is distributed to the partners in liquidation.

In Private Letter Ruling 9010042, involving the incorporation of a partnership under the last method, the Internal Revenue Service ruled that the partnership's transitory ownership of the corporation's stock would be disregarded for purposes of IRC section 1361(b)(1)(B). Accordingly, the corporation was permitted to make an S election effective as of its first day of existence. The ruling cited Rev. Rul. 72-320, 1972-1 C.B.270, in which the IRS introduced the concept of momentary or transitory ownership as an administrative exception to the statutory restriction on shareholder eligibility.

However, in Haley Bros. Construction Co., 87 TC 498 (1986), the Tax Court in dicta questioned the authority of the IRS to administratively carve out such an exception to a statutory provision. The court viewed the transitory ownership exception as being inconsistent with the statute and indicated that, if called upon to decide the issue, it would hold the administratively created exception invalid. The resulting uncertainty has been -- and remains -- a significant problem for taxpayers.

DESCRIPTION OF RECOMMENDATION. To eliminate the uncertainty that exists under current law, we believe that the simplification legislation should include a transitory-ownership exception. Such an exception should provide that for purposes of the IRC section 1361(b)(1)(B), but not for purposes of IRC section 1361(b)(1)(C), a corporation shall not be treated as having an ineligible shareholder if the period of stock ownership by the otherwise ineligible shareholder does not exceed a prescribed number of days.

One alternative would be to limit the permissible period of transitory ownership to not more than one day. In such cases, an ineligible shareholder would be treated as not owning the stock on that day. Instead, the shareholder or shareholders who receive the stock that was momentarily held by the ineligible shareholder would be treated as the owner or owners for that day. While such an exception would be simple to administer, a one-day period is less favorable to taxpayers than the thirty-day period of permissible transitory ownership that the IRS has administratively countenanced under certain circumstances for almost twenty years (Revenue Ruling 73-496, 1973-2 C.B. 312).

Another alternative would be to provide a longer period of permissible transitory ownership, perhaps thirty days, but require the ineligible shareholder to report its pro-rata share of S corporation flow-through items and any distributions. The Internal Revenue Service routinely requires similar treatment as a condition to granting inadvertent termination relief under IRC section 1362(f). See, for example, Private Letter Ruling 9138025.

We believe that a statutory amendment would be beneficial to both taxpayers and the government, without any adverse impact on revenues. From the perspective of taxpayers, such a provision would eliminate needless uncertainty and avoid unnecessary obstacles to legitimate business transactions. From the government's standpoint, such a provision would reduce the burden of issuing private letter rulings on transactions that the IRS routinely approves.

B. PERMIT S CORPORATIONS TO OWN 100% OF THE STOCK OF ANOTHER S CORPORATION

PRESENT LAW. Section 4604 of the Simplification Legislation amends IRC section 1361(b)(2) and permits S corporations to own up to 100 percent of the stock of a C corporation. However, an S corporation cannot be included in a group filing a consolidated return. Under the bill, if an S corporation holds 100 percent of the stock of a C corporation that, in turn, holds 100 percent of the stock of another C corporation, the two C corporations may elect to file a consolidated return, but the S corporation may not join in the election.

As described above, we unanimously support this proposal and agree that it generally allows more flexibility in corporate structuring and reduces a barrier to using the S corporation form of entity by providing more appropriate treatment of corporations with subsidiaries.

DESCRIPTION OF RECOMMENDATIONS. We believe that the simplification proposal should be revised to allow an S corporation to own 100 percent and not less of the issued and outstanding shares of stock of another S corporation or chain of S corporations without jeopardizing the S status of any of the affiliated corporations. It is further recommended that the affiliated group of S corporations should be required to file a single combined S corporation return with adjustments to eliminate intercompany transactions.

Business and tax planning as well as corporate structuring flexibility and record keeping are the primary reasons for this recommendation.

The general effect of the Tax Reform Act of 1986 (P.L. 99-514) was to restrict greatly the number of situation in which C corporation status is desirable from a tax viewpoint. The S corporation is a much more desirable form of doing business because of the tax pass-through treatment accorded S corporation shareholders. Consequently, corporations filing consolidated return find the S corporation very attractive, yet they are prohibited from electing S status.

Although brother-sister S corporation structures are currently available, it is more commonplace and natural for corporations to be structured as a group of an affiliated corporations with a common parent. This affords shareholders the ability, control, and ease of managing one corporate structure versus several brother-sister corporations.

From a record-keeping viewpoint, it is less difficult to maintain the books and records of a combined chain of S corporations than it is for brother-sister corporations. Individual shareholders may see preparation time reduced when preparing their individual income tax returns by filing a single combined return. In addition, the number of corporate state return filings could be reduced.

We suggest that several alternatives be considered for reporting the combined incomes of these entities:

o a single combined S corporation return reflecting adjustments to eliminate any intercompany transactions; the group would be treated as one reporting entity for purposes of the Internal Revenue Code.

o a combined filing, but the companies treated as separate companies for purposes of the Internal Revenue Code.

o a consolidated return of the separate entities generally conforming to the existing consolidated return rules including the elimination of intercompany transactions.

Pass-through of items of income, expense, credits, carryovers of disallowed losses as well as the shareholder's basis in stock and debt should continue to be determined under IRC section 1366. Transfers of property by a subsidiary S corporation to its parent with respect to its stock should not be subject to current taxation, but rather the basis of such property should carryover to the parent S corporation and should be taxable at such time as the property ultimately is removed from the parent S corporation.

S CORPORATION TAX STUDY GROUP

Comments on Statutory Disincentives to

A. LIMIT OF 35 SHAREHOLDERS

We believe that the present law 35-shareholder limit under Code section 1361(b)(1)(A) does not present any significant impediment to electing S corporation status. Even if the types of eligible shareholders were expanded to include, for example, corporations and partnerships as shareholders, a limitation on the total number of shareholders is justifiable from a tax policy perspective. In the absence of full corporate income tax integration, corporate flow- through benefits afforded by an S corporation election are appropriately limited to a closely-held corporation.

RECOMMENDATION: We believe that the 35 shareholder limitation should remain intact. Alternatively, if it is increased, the limitation should be no more than 100 shareholders.

B. NON-RESIDENT ALIEN SHAREHOLDERS

Under Code section 1361(b)(1)(C), an S corporation is not permitted to have a non-resident alien as a shareholder. We believe that this requirement presents an impediment to S corporation elections. Frequently, nonresident alien individuals could serve as a source of equity capital financing for start-up corporations otherwise eligible to elect S corporation status. If non-resident aliens were permitted to be shareholders, any effectively-connected U.S. income allocable to them should be subject to a withholding tax as already applies to nonresident partners in partnerships (Code section 1446).

RECOMMENDATION: We believe that non-resident aliens should be eligible to be S corporation shareholders. Code section 1361(b)(1)(C) should be repealed and Code section 1446 should be modified to include foreign shareholders of S corporations.

To the extent that withholding may be required in situations in which income flows through to the shareholders, but no distributions to shareholders are made, the second class of stock rules should be coordinated to assure that non-proportional withholding does not cause a second class of stock problem.

C. CORPORATIONS, PARTNERSHIPS AND TRUSTS AS SHAREHOLDERS

1. CORPORATIONS

Code section 1361(b)(1)(B) prohibits a corporation from holding stock in an S corporation. The prohibition of corporate shareholders is an impediment to S corporation status for start-up companies seeking venture capital. Frequently, venture capitalists are organized either as corporations or partnerships. In either case, they currently cannot make a direct equity investment in an S corporation. If the corporate shareholder restrictions were eliminated, equity capital would be more readily available to S corporations, putting them on a par with regular corporations and partnerships.

Regular corporations are subject to the federal corporate level tax and, therefore, any flow-through income from an S corporation investment would be taxable to the corporate shareholder at 34% (instead of 28% or 33% if flowed through to an individual shareholder). We believe that allowing regular corporations to invest in S corporations would not create a tax avoidance opportunity.

Because a regular corporation is a taxable entity, it should count only as one shareholder under the Code section 1361(b)(1)(A) 35-shareholder limit. Therefore, even a publicly traded company could invest in an S corporation.

The percentage of ownership that a regular corporation could hold in an S corporation should not present any problems other than the affiliated group (80% or more ownership) issues discussed in IV, below. The allocation and distribution rules under Code section section 1366 and 1368 would apply to regular corporations without modification.

RECOMMENDATION: We believe that regular corporations should be eligible to be shareholders of an S corporation.

2. PARTNERSHIPS

Code section 1361(b)(1)(B) prohibits a partnership from holding stock in an S corporation. The prohibition of partnership shareholders may act as an impediment to S corporation status. Because the partnership is itself a flow-through entity, it presents unique problems if permitted to be an eligible shareholder.

As a flow-through entity, a partnership does not pay an entity level tax. Therefore, its individual partners (under the aggregate theory of partnerships) should all be counted as shareholders for purposes of Code section 1361(b)(1)(A). Regular corporate partners would count as one shareholder (See corporate shareholder comments at I(C)(1)).

If an S corporation is limited to a specific number of shareholders, the partnership shareholder presents a problem if multi-tiered partnerships are permitted to invest in S corporations. Similarly, because partnerships could also have investors who would be otherwise ineligible shareholders, it would be difficult for the S corporation to track its own eligibility to operate under subchapter S. Therefore, if partnerships are to be permitted as eligible shareholders, only single-tier entities should be allowed. Although arbitrary, a single-tier restriction would be more easily administered.

Allowing partnerships to invest in S corporations would effectively allow shareholders to specially allocate S corporation income and create different classes of investment in the S corporation. However, because the partnership rules require that income allocation must have substantial economic effect, there should be no significant potential for abuse in allowing them to specially allocate S corporation income.

RECOMMENDATION: We believe that partnerships should be eligible to be S corporation shareholders. However, an eligible partnership should be limited to a single-tier entity. A "single-tier" entity would not be permitted to have another flow-through entity as an owner. Trust investors would be permitted as long as S corporation income is currently taxed.

3. S CORPORATIONS

Code section 1361(b)(1)(B) prohibits a corporation from holding stock in an S corporation. This prohibition also applies to one S corporation investing in another. Because the S corporation is a flow-through entity, it presents the same administrability issues as a partnership shareholder. Therefore, an S corporation should be permitted to hold stock in another S corporation as long as it is a single-tier entity.

RECOMMENDATION: We believe that S corporations should be eligible to be shareholders of other S corporations. However, they should be limited to a single-tier entity. See Partnership Recommendation at I(C)(2) for a definition of "single-tier" entity.

4. TRUSTS

Code section 1361(b)(1)(B) permits only certain trusts to hold stock in an S corporation. Eligible trust shareholders are further defined under Code section 1361(c)(2) and (d)(1). The two most common trust shareholders are the grantor or Code section 678 trust and the "qualified subchapter S trust."

The current trust rules assure that all S corporation income allocable to a trust shareholder is currently taxed to the income beneficiary. However, as long as trust income is currently taxed either to the trust or to the current income beneficiary, there is no tax avoidance by using trust shareholders in an S corporation. Therefore, the current prohibition against complex trusts holding S corporation stock should be eliminated.

Each beneficiary of a trust should be counted as a shareholder for purposes of the section 1361(b)(1)(A) limitation on the number of shareholders. A beneficiary should be counted if it has received or is currently receiving benefits from the trust. All beneficiaries must otherwise be eligible S corporation shareholders. Only single- tier trusts should be permitted as S corporation shareholders. (See Partnership Recommendation at I(C)(2) for definition of "single tier").

RECOMMENDATION: We believe that the "qualified subchapter S trust" rules under Code section 1361(d) should be repealed. Trusts should be permitted as eligible shareholders so long as S corporation income is taxed to trusts or to otherwise eligible beneficiaries. However, eligibility should be restricted to single-tier trusts only.

II. CORPORATE RESTRICTIONS

A. DOMESTIC CORPORATIONS

Code section 1361(b)(1) requires that an S corporation be a domestic corporation. The domestic corporation requirement does not appear to present any substantial restriction to electing S corporation statue. In keeping with an overall policy of subchapter S to be closely-held and "simple" to use, it would appear that this restriction should remain intact.

RECOMMENDATION: We believe that the domestic corporation requirement should be retained.

B. INELIGIBLE CORPORATIONS

Code section 1361(b)(2)(B) through (E) excludes certain corporations from electing S corporation status. These include banks, insurance companies, possessions corporations, DISCs and former DISCs. These restrictions do not appear to present any significant impediment to electing S corporation status.

RECOMMENDATION: We believe that the Code section 1361(b)(2)(B) through (E) ineligible corporation restrictions should be retained. Recommended changes to the Code section 1361(b)(2)(A) restriction on affiliated group membership are addressed in IV, below.

III. SINGLE CLASS OF STOCK

A. ONLY ONE CLASS OF STOCK PERMITTED

Code section 1361(b)(1)(D) allows an S corporation to have only one class of stock, although differences in voting rights are permissible. This restriction imposes a significant business hardship on many S corporations in obtaining venture capital and is a major disincentive to S elections. In the financial marketplace, S corporations are restricted from many types of equity and quasi- equity lending sources by their inability to issue equity instruments with varying liquidation and distribution rights. No similar restrictions apply to partnerships or C corporations.

The apparent historical reason for the one class of stock restriction is the perceived difficulty in properly allocating income and loss amounts among different classes of stock. Present law encourages complex and unnecessary arrangements, such as partnerships between S corporations and lenders to achieve the functional equivalent of preferred stock. While a complete removal of the restriction arguably could create unacceptable administrative complexities, we believe that a workable safe harbor could be provided.

RECOMMENDATION: We believe that current law should be amended to allow the issuance of preferred stock that, by its express written terms, pays a readily determinable rate of return. Consideration should also be given to permitting preferred stock to be convertible into common stock. Owners of "safe harbor" preferred stock would not be treated as shareholders for purposes of the flow-through rules of Code section 1366(a).

B. STRAIGHT-DEBT SAFE HARBOR

Code section 1361(c)(5) provides a safe harbor within which debt that satisfies certain requirements will not be treated as a second class of stock. One of those requirements is that the creditor must be an individual, an estate, or a trust that is eligible to be an S corporation shareholder. The current definition would not include, for example, a loan from a financial institution or other lender engaged in the trade or business of lending money. We believe that loans from such lenders, that otherwise satisfy the requirements of a safe-harbor loan should qualify as a safe-harbor loan.

RECOMMENDATION: We believe that Code section 1361(c)(5)(B)(iii) should be amended to include as an eligible creditor any person which is actively and regularly engaged in the business of lending money. (Similar language is used in the Code section 46(c)(8)(D) definition of "qualified nonrecourse financing.")

Related to our recommendations that corporations, partnerships, trusts and nonresident alien individuals be permitted to be S corporation shareholders, we also believe that Code section 1361(c)(5)(B)(iii) should be amended to permit any eligible shareholder to be a creditor on safe-harbor straight debt.

IV. MEMBERSHIP IN AN AFFILIATED GROUP OF CORPORATIONS

A. INELIGIBILITY OF MEMBERS OF AN AFFILIATED GROUP TO ELECT S STATUS

Under Code section 1361(b)(2)(A), an ineligible corporation includes a member of an affiliated group of corporations (determined under section 1504 without regard to the exceptions contained in section 1504(b)). Accordingly, a member of an affiliated group may not make an election to be an S corporation.

A corporation is a member of an affiliated group if it is a subsidiary (i.e., at least 80% of its stock by vote and value is owned by another corporation or members of an affiliated group) or it directly owns at least 80% of the stock of another corporation. A corporation that is a subsidiary would also be barred, under Code section 1361(b)(1)(B), from electing S status because of the presence of a corporate shareholder. The restrictions on permissible shareholders is addressed in I(C), above; this section deals primarily with the restrictions on a corporation from electing S status by reason of it being an owning member.

Under current law, an S corporation may own 79% of the stock of another corporation without endangering its S status. If, however, it acquires an additional 1% of the other corporation's stock, the S status is terminated. The rationale for such a result is not clear. It appears from the Finance Committee Report to the Technical Corrections Act of 1958 (which first enacted subchapter S) that Congress intended S corporations to be ineligible to file a consolidated return with another corporation (Senate Report No. 1953, 85th Cong. 2nd Sess., 1958-3 C.B. 1009). This objective, however, could have been accomplished more directly by simply adding S corporations to the list, in Code section 1504(b), of corporations excepted from the definition of an "includible corporation."

By allowing an S corporation to hold 80% or more of another corporation's stock, uncertainty created by the dicta in the Tax Court's opinion in Haley Bros. Construction Corp., 87 TC 498 (1986), would be resolved. The opinion stated that notwithstanding the IRS position in Rev. Rul. 73-496, 1973-2 C.B. 3, permitting temporary affiliation, the Code forbids an S corporation from owning 80% of another corporation's stock, even if the ownership lasts "only 30 days." If an S corporation could hold any percentage of another corporation's stock without jeopardizing its S status, the problem addressed in Haley Bros. and Rev. Rul. 73-496 would become a non- issue.

RECOMMENDATION: We believe that a corporation should be eligible to make an S election regardless of the percentage of stock that it owns in a subsidiary. Accordingly, we believe that up to 100% ownership should be permitted and that Code section 1362(b)(2)(A) should be repealed.

A 100%-owned subsidiary of an S corporation should be eligible, but not required, to make an S election.

Even if it becomes permissible for an S corporation to have a corporate shareholder, we believe that, in the interest of simplicity, a corporation that is a member of an affiliated group of corporations that files a consolidated return should not be permitted to be an S corporation.

B. S CORPORATION CONSOLIDATED RETURNS

If tiered S corporations become permissible, the next issue that arises is whether a group of S corporations should be permitted to file an "S corporation consolidated return." This suggestion has not been greeted with overwhelming enthusiasm. The concept should not be rejected out of hand, although upon analysis, it may be determined that such a provision is not advisable.

The major effect of filing a consolidated return is the netting of income or losses of one member against income or loss of another. If a Parent and subsidiary can each elect S corporation status, then the netting effect is accomplished at the rules and all the additional baggage those rules entail. Furthermore, other consolidated rules which treat certain corporate attributes as consolidated items (e.g., consolidated NOLs, consolidated dividends received deductions and consolidated charitable contribution deductions), are simply inapplicable to S corporations. Also, concepts such as separate return limitation years, that limit the use of a subsidiary's attributes from pre-acquisition years, are similar inapplicable under subchapter S, which disallows the use of attributes from C years to S years. More troubling, however, would be the need to resolve conflicts between the rules under the consolidated return regulations and subchapter S. For example, the basis adjustment rules under the consolidated return regulations use earnings and profits to adjust basis, whereas Code section 1367 uses taxable income. Finally, a consolidated S corporation return would alter the computation of the corporate level taxes under Code sections 1374 and 1375. These effects are another consequence to consider before S corporations are granted permission to file consolidated returns.

RECOMMENDATION: We believe that S corporations should not be permitted to file consolidated returns.

Assuming that S corporation consolidated returns are not permissible, one aspect of the consolidated return rules, which can, and perhaps should be made available to tiered S corporations is the ability to defer gain or loss on intercompany transactions. Such a rule can be created without incorporating all the consolidated return baggage. A provision could simply state that gain or loss on transactions between tiered S corporations are deferred under the principles of the consolidated return regulations. (See Code section 267(f) for similar language.)

C. DEFINITION OF INACTIVE SUBSIDIARY

Under Code section 1361(c)(6), an S corporation is permitted to own 80% or more of the stock of an inactive subsidiary without violating the prohibition against affiliated corporations. Under prior rules, it was clear that the inactive subsidiary had to be inactive from its inception. In other words, any business activity at any time during its existence would preclude it from qualifying as an "inactive" corporation. The current rules are not clear, but can be interpreted to permit formerly active corporations, however now dormant, to be inactive subsidiaries. We prefer this interpretation and believe that it presents no potential for abuse.

RECOMMENDATION: We believe that Code section 1361(c)(6) should be amended to allow formerly active corporations to qualify as inactive subsidiaries as long as they remain dormant during their affiliation with a parent S corporation.

D. LIQUIDATIONS OF 80%-OWNED SUBSIDIARIES

If the Code is amended to permit an S corporation to own 80% or more of another corporation's stock, questions regarding the tax consequences of a liquidation of the subsidiary should also be addressed. The position of the IRS National Office, as expressed in LTR 8818049, is that liquidation of a temporarily owned subsidiary does not qualify for treatment under Code section 332 or 337(a). Rather, the liquidation would be taxed under Code sections 331 and 336(a). Similarly, the IRS currently takes the position that an S corporation that purchases at least 80% of another corporation's stock is not eligible to make an election under Code section 338. In support of these positions, Code section 1371(a) is cited. That subsection reads:

"(a) Application of Subchapter C Rules. --

(1) In General. -- Except as otherwise provided in this title, and except to the extent inconsistent with this subchapter, subchapter C shall apply to an S corporation and its shareholders.

(2) S corporation as shareholder treated like individual. -- For purposes of subchapter C, an S corporation in its capacity as a shareholder of another corporation shall be treated as an individual."

The 1982 Senate Finance Committee Report describes the provision as follows:

"Generally, subchapter C will apply, except that a subchapter S corporation will be treated in the same manner as an individual in transactions, such as the treatment of dividends received under Code section 301, where the corporation is a shareholder in a regular corporation."

Thus, the amount of a distribution to which Code section 301 applied, received by an S corporation, would be determined under the rules of Code section 301 of the 1954 Code as it applied to individuals, as opposed to corporations. The conclusion is entirely consistent with the computation of an S corporation's income in the same manner as in the case of an individual, under Code section 1363(b). For example, the corporation may not claim a dividends- received deduction under Code section 243 and is not subject to the special rules relating to corporate tax preferences under Code section 291.

Treatment of an S corporation as an individual, for these purposes, is in contrast to the treatment of an S corporation as a corporation, for purposes of the reorganization provisions of subchapter C. For example, until its repeal as deadwood by the 1988 Act, Code section 1363(e) described the inapplicability of gain recognition rules on the distribution of appreciated property to the extent of "property permitted by Code section 354, 355, or 356 to be received without the recognition of gain."

There is no dispute that an S corporation may be a transferee in a transaction to which Code section 381(a)(2) applies. That is, an S corporation may be the acquiring corporation in a reorganization under Code section 368(a)(1)(A), (C), (D), (F), or (G). The transferor could be either a C corporation or another S corporation. If the transferor is a C corporation, Code section 1374(d)(8) will apply to the assets received. The question under current law, and as a matter of policy for future law, is whether an S corporation should be treated as an individual, or as a corporation, when it is a distributee in a transaction to which Code section 381(a)(1) may arguably apply (i.e., a liquidation of a subsidiary).

Notwithstanding the current IRS position, which denies the application of Code section 332 to a liquidation, S corporations can still achieve the same results, but only through careful planning. In the typical case, the owners of an S corporation decide that the corporation should purchase another business. The S corporation has cash, but the owners do not. The potential target is a C corporation and its owners will sell only stock, not assets, because they do not want to bear the burden of a corporate-level tax. The unsophisticated might have the S corporation purchase the target's stock and then immediately liquidate the target. Under such a scenario, a Code section 336 tax will be imposed upon the target. The well advised, will either (i) have the S corporation merge downstream into the target after the purchase (Rev. Rul. 70-223, 1970-1 C.B. 79), or (ii) have the S corporation lend money to its shareholders who purchase the target and then merge the S corporation into the target.

RECOMMENDATION: We believe that a review of subchapter S should include a review of the characterization of an S corporation, as an individual or as a corporation, in its capacity as a distributee in liquidation. The policy question is whether the receipt of 80% or more of a corporation's assets by an S corporation, in a liquidating distribution, is more akin to a reorganization to which Code section 381(a)(2) applies, or to a dividend distribution to which Code section 301 applies. If the former approach is adopted, Code section 1374(d)(8) clearly would apply to any assets received in the liquidation.

E. APPLYING SECTION 338(h)(10) TO S CORPORATION TARGETS

Under current law, an election under Code section 338(h)(10) is available only if a subsidiary of an affiliated group filing a consolidated return is purchased by another corporation. The effect of the election is to allow the parties to a stock sale to treat the transaction as an asset sale, followed by a liquidation of the target company. The provision was intended to assist purchasers and sellers of corporations that have non-tax restrictions on the sale of assets, but would arrange an asset sale if not for these restrictions, to jointly elect to have asset sale treatment, on both sides of the transaction, for tax purposes.

No similar election, however, is currently available for S corporations. Assume that a corporation elected S status before 1987 and that the three-year period under old Code section 1374 has expired. If the corporation sells its assets and liquidates, there will not be a corporate level tax. The shareholders will recognized gain on the asset sale, which will increase their stock basis. Liquidation of the corporation after the sale will be taxed under Code section 331.

Assume, however, that for non-tax reasons, assets can not be sold. If stock is sold, and the purchasing corporation elects to treat the sale as an asset sale under Code section 338(a), a one day C corporation return will be generated, on which a corporate level gain will be imposed. In a case in which a corporate level gain would not be imposed by an actual asset sale, there should be a mechanism to achieve a similar result by an election under Code section 338. Of course, if Code section 1374 or Code section 1371(d)(2) would cause a corporate level tax to be paid, the tax should not avoidable through an election. On the other hand, when non-tax conditions restrict options for actual asset sale, the Code should contain a mechanism, as it does under Code section 338(h)(10), to treat the transaction as an asset sale.

RECOMMENDATION: We believe that an election similar to the election under Code section 338(h)(10) should be available when an S corporation is acquired.

V. PERIOD OF TIME FOR MAKING AN S ELECTION

Under current law, an S election must be made on or before the 15th day of the third month of the year to which the election is to be effective.

The only corporations that are adversely effected by this requirement are those which do not have access to sophisticated tax advice. Many new corporations will not be aware of subchapter S at all. Corporations operating without outside advisors may know of subchapter S, but are not likely to know that the election must be made so early in the year.

A possible policy argument against extending the election period is that it would allow "gaming", i.e., allow the taxpayer to wait until it knows the results of its first year of operations to decide whether it would be beneficial to make an S election. However, in most other areas of current law, elections are made on the return. For example, the election out of the installment method, the election to adopt the LIFO method of accounting and the section 754 election are all made after the end of the year to which they apply. None of these has been viewed in the past as particularly abusive as a result of their being made on a look-back basis.

RECOMMENDATION: We believe that, consistent with all the other elections that a new corporation makes, the period of time for newly- formed corporations to file S election should be extended to the due date of the return (including any extensions).

VI. AUTOMATIC WAIVER FOR CERTAIN TYPES OF INADVERTENT TERMINATIONS

A. INADVERTENT TERMINATIONS

More that half of the recent private letter rulings in the S corporation area deal with inadvertent terminations. In enacting Code section 1362(f), Congress clearly wanted to avoid imposing undue hardship (i.e., irrevocable termination of the election) on a corporation that acted in the good faith belief that it was in S corporation, but in fact no longer met the qualifications.

RECOMMENDATION: In order to reduce the burden on both the IRS and taxpayers in dealing with all of these ruling requests, it would be beneficial to provide an automatic procedure under which a termination may be ignored once the terminating event has been rectified. This could be done, for example, by attaching a statement to the corporation's tax return detailing the terminating event and the corrective action that has been taken. It should leave with the IRS the option, upon examination, of reallocating income or loss between the corporation and its shareholders in situations where that may be deemed appropriate to avoid abuse or retroactive tax planning.

This automatic procedure might best be limited to situations in which the terminating event is ministerial in nature, e.g., failure of a beneficiary to make a qualified subchapter S trust election under Code section 1361(d)(2). Since this is the most common type of inadvertent termination ruling, providing the procedure solely for these situations would nevertheless result in a significant reduction in the number of inadvertent termination ruling requests.

B. DEFECTIVE ELECTIONS

There is currently no procedure provided for curing an inadvertently defective S election; for example, a corporation that was not a qualified business corporation at the time the election was made.

RECOMMENDATION: We believe that a provision similar to Code section 1362(f) should be added to provide that if a corporation, in good faith, inadvertently failed to qualify as a small business corporation at the time it elected to be an S corporation, but the defect is subsequently cured, the election should be effective retroactively.

VII. EXCESS PASSIVE INVESTMENT INCOME PROBLEMS

A. TERMINATION OF S ELECTION

Code section 1362(d)(3) provides that a corporation's S election terminates if passive investment income exceeds 25% of gross receipts for three consecutive taxable years and the corporation has subchapter C earnings and profits. While less draconian than pre-1983 law, which terminated a subchapter S election if for even a single taxable, year more than 20% of a corporation's gross receipts were passive investment income, the current rule remains both a disincentive for S elections and a potential trap for unwary S corporations.

The legislative history of the Subchapter S Revision Act of 1981 indicates that the termination provision, although modified, was retained to prevent a former C corporation operating company from being converted to an S corporation holding company without penalty.

"The committee believes that corporations should continue to be allowed to elect subchapter S without the imposition of a tax which would normally apply if the corporation liquidated and continued business as a partnership. However, in order to prevent a "bail out" of undistributed corporate earnings and profits, the bill will continue dividend treatment for distributions of these earnings. Also the passive income test (as modified) is retained for corporations with accumulated earnings and profits to prevent the conversion of a regular corporation's operating company into a holding company whose income is not subject to a corporate level tax, without the imposition of any shareholder tax on accumulated corporate earnings as would occur if the corporation was liquidated. However, to reduce the likelihood of a termination of election, the bill, rather than terminating the election, would impose a corporate level tax in certain circumstances where the test is not met." (S. Rep. No. 640, p.6, 97th Cong., 2d Sess. (1982)).

RECOMMENDATION: We believe that the stated congressional objective is achieved by the imposition of a corporate-level penalty tax on excess passive investment income under Code section 1375. The additional sanction of terminating a corporation's S election, in our view, is both unnecessary and unduly harsh. We believe that Code section 1362(d)(3) should be repealed. Subparagraphs (B) through (E) of section 1362(d)(3), defining subchapter C earnings and profits, gross receipts, passive investment income and containing a special rule for options and commodity dealings, should be included under section 1375(b)(3):

B. CORPORATE-LEVEL PENALTY TAX

The existence of the section 1375 corporate-level penalty tax on an S corporation that has (i) subchapter C earnings and profits at the close of its taxable year and (ii) gross receipts more than 25% of which are passive investment income, generally is perceived by taxpayers as a disadvantage of an S election. Nevertheless, we believe that if Congress remains concerned that the conversion of C corporation operating companies into S corporation holding companies presents potential tax avoidance problems the tax on excess passive investment income is a reasonable and appropriate response.

RECOMMENDATION: If Congress continues to perceive a potential tax avoidance problem, the section 1375(a) tax should be retained. However, the definition of "passive investment income" should be amended.

C. THE CURRENT DEFINITION OF "PASSIVE INVESTMENT INCOME" INCLUDES ACTIVE TRADE OR BUSINESS INCOME.

For purposes of Code sections 1362(d)(3) and 1375, the term "passive investment income" is defined as gross receipts derived from royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities (Section 1362(d)(3)(D)(i)). This definition is consistent with the stated congressional intent, referred to above, of preventing the conversion of a regular C corporation's operating company into a holding company whose income is not subject to corporate-level tax.

The problem with the current definition of passive investment income however, is that it includes not only passive income of a type earned by a holding company, but also many types of income earned by an operating company in the active conduct of its trade or business. As a consequence, many operating corporations are effectively precluded from making S elections. For example, a corporation that earns royalty income by actively engaging in the trade or business of franchising a product, process or service generally is treated for purposes of sections 1362(d)(3) and 1375 as receiving passive investment income. Limited exceptions are provided for certain copyright royalties, mineral, oil and gas royalties, and certain computer software royalties (Prop. Reg. section 1.1362-3(d)(5)(ii)).

Similarly, a corporation actively engaged in the trade or business of owning and operating rental real estate or leasing equipment is treated as receiving rental income unless it provides significant services to renters in return for rental payments. The fact that the corporation may be actively engaged in business operations such as managing and maintaining the rental property, marketing the property to prospective renters, negotiating leases, collecting rents, etc. is not relevant under existing law. Only services to occupants are taken into account for purposes of the "significant services" test. And they count only to the extent that they go beyond services that are customarily rendered in connection with the rental of rooms or other space for occupancy only.

RECOMMENDATION: We recommend that the definition of passive investment income exclude all income earned from the active conduct of a trade or business.

The problem is how to draft an exclusion provision that would achieve the intended objective without eviscerating the passive investment income limitation. One approach would be to adopt a facts and circumstances test to determine whether a particular income- producing activity rises to the level of the active conduct of a trade or business. In our opinion, this would be the better approach. It provides the greater degree of flexibility and simplicity.

Regulations section 1.355-3(b), adopted in January 1989, provides as excellent model for a facts and circumstances test. It treats a corporation as engaging in "the active conduct of a trade or business" if the assets and activities of the corporation satisfy the following three conditions.

1. TRADE OR BUSINESS. A corporation shall be treated as engaged in a trade or business if a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such group include every operation that forms a part of, or a step in, the process of earning income or profit. Such group of activities ordinarily must include the collection of income and the payment of expenses.

2. ACTIVE CONDUCT. The determination whether a trade or business is actively conducted will be made from all of the facts and circumstances. Generally, the corporation is required itself to perform active and substantial management and operational functions. Generally, activities performed by the corporation itself do not include activities performed by persons outside the corporation, including independent contractors. A corporation may satisfy the requirements of this subdivision through the activities that it performs itself, even though some of its activities are performed by others.

3. LIMITATIONS. The active conduct of a trade or business does not include:

(a) The holding for investment purposes of stock, securities, land, or other property, or

(b) The ownership and operation (including leasing) of real or personal property used in a trade or business, unless the owner performs significant services with respect to the operation and management of the property.

We believe that a substantially similar test would be both appropriate and workable for defining a trade or business income exclusion from the definition of passive investment income.

A somewhat similar approach is found in the passive activity loss regulations. Regulation section 1.469-2T(c)(3)(i) provides that passive activity income does not include portfolio income. For purposes of that provision, portfolio income is defined as all gross income, OTHER THAN INCOME DERIVED IN THE ORDINARY COURSE OF A TRADE OR BUSINESS, that is attributable to interest, annuities, royalties, dividends, income from certain flow-through entities, dispositions of property that produce any of the foregoing types of income, and dispositions of investment property.

The term "gross income derived in the ordinary course of a trade or business" is defined for purposes of the provision as including only:

(1) Interest income on loans and investments made in the ordinary course of a trade or business of lending money.

(2) Interest on accounts receivable arising from the performance of services or the sale of property in the ordinary course of a trade or business of performing such services or selling such property, but only if credit is customarily offered to customers of the business;

(3) Income from investments made in the ordinary course of a trade or business of furnishing insurance or annuity contracts or reinsuring risks underwritten by insurance companies;

(4) Income or gain derived in the ordinary course of an activity of trading or dealing in any property if such activity constitutes a trade or business (but see paragraph (c)(3)(iii)(A) of this section);

(5) Royalties derived by the taxpayer in the ordinary course of a trade or business of licensing intangible property (within the meaning of paragraph (c)(3)(iii)(B) of this section);

(6) Amounts included in the gross income of a patron of a cooperative (within the meaning of section 1381(a), without regard to paragraph (2)(A) or (C) thereof) by reason of any payment or allocation to the patron based on patronage occurring with respect to a trade or business of the patron; and

(7) Other income identified by the Commissioner as income derived by the taxpayer in the ordinary course of a trade or business.

We believe that rental income derived in the ordinary course of a trade or business should also be added to this list.

An alternative, although, in our opinion, less desirable approach would be to adopt an objective test of the active conduct of a trade or business. Various analogous tests appear in other sections of the Code. (In one case, the test is already reflected in Section 1362. The proposed regulations under section 1362 adopt two others.) Generally, these objective tests require that more than a specified percentage of gross income be derived from a specified source and that related trade or business expenses exceed a prescribed percentage of gross income from that source. Examples of objective tests include:

1. Section 46(e)(3)(B): Investment tax credit is allowed to noncorporate lessors only if section 162 deductions (other than rents and reimbursed amounts) exceed 15% of rental income produced by the property.

2. Sections 465(c)(4) and (5): Certain closely-held equipment leasing corporations are excluded from the at risk limitation only if 50% or more of gross receipts is derived from equipment leasing. Certain corporate groups are excluded if they have (i) 80% or more of gross receipts from equipment leasing, (ii) at least three employees, (iii) at least five separate leasing transactions, and (iv) at least $1 million of gross receipts from leasing.

3. Section 542(c)(6): A lending or finance company is excluded from the definition of a personal holding company if (i) 60% or more of ordinary gross income is directly derived from the active and regular conduct of a lending or finance business, and (ii) directly allocable expenses equal or exceed 15% of the first $500,000 of gross income and 5% of any excess. (The exception for lending or finance companies in Section 1362(d)(3)(D)(iii) utilizes this test.)

4. Sections 543(a)(3) and (4): Certain mineral royalties and copyright royalties are excluded from the definition of personal holding company income if (i) 50% or more of the corporation's adjusted gross income is from such royalties, and (ii) certain prescribed trade or business expenses equal or exceed 15% of adjusted ordinary gross income (for mineral royalties) or 25% of adjusted ordinary gross income (for copyright royalties).

5. Section 543(d): Computer software royalties are excluded from the definition of personal holding company income if (i) the corporation is actively engaged in certain prescribed software activities, (ii) royalty income constitutes at least 50% of the corporation's ordinary gross income and (iii) section 162, 174 and 195 deductions equal or exceed 25% of ordinary gross income.

Under the objective-test approach, for example, a modified form of the "active business computer software royalties" rule of section 543(d) could be adopted with respect to other types of income. Such a rule might generally exclude from the definition of passive investment income any income:

1. received by a corporation engaged in the active conduct of a trade or business;

2. directly related to the operation of the trade or business;

3. constituting at least X% of the corporation's ordinary gross income for the taxable year; and

4. with respect to which the corporation incurs deductible trade or business expenses aggregating at least Y% of the ordinary gross income for the taxable year (or the average of such deductions for a prescribed period of prior taxable years is at least Y% of average ordinary gross income).

IX. TAX IMPOSED ON BUILT-IN GAINS

S corporation elections are impeded for C corporations that own substantially appreciated assets, because the Code section 1374 built-in gains tax (BIG tax) imposes two levels of current tax on the disposition of appreciated assets which are held by the corporation on the day the corporation's S election becomes effective. Under Code section 1374, a corporate level tax is first imposed on the S corporation at a flat rate of 34% on net recognized built-in gains. A second tax is then imposed at the shareholder level on the income (reduced for the corporate-level Code section 1374 tax) passing through from the corporation to the shareholder. The result is an effective Federal income tax rate of up to 52.5% (.34 + [(1-.34) X .28]) on the disposition of build-in gain assets, regardless of whether the corporation distributes any of the proceeds of the sale to its shareholders. The same disposition of appreciated property by a C corporation would result in only one level of current tax at an effective Federal rate of up to 34% (assuming that the proceeds from the sale are retained by the corporation). Note further, that C corporations (other than personal service corporations) may use the graduated rate structure of Code section 11, while an S corporation's net recognized built-in-gains are taxed at the top Code section 11 rate.

The lack of regulatory guidance under the BIG tax also operates as an impediment to C corporations contemplating a conversion to S status since the amount of potential built-in gains tax cannot be computed with any reasonable certainty.

RECOMMENDATIONS: We believe that the CURRENT tax liability imposed at the shareholder level upon dispositions by the S corporation of built-in gain assets should be eliminated. Instead, the recognition of a BIG could be treated just as though the corporation were a C corporation. That is, a corporate-level tax would be imposed at the applicable Code section 11 rate on the corporation's net recognized built-in gain. Then, rather than the flowing the income from the sale of BIG assets (net of any corporate- level taxes) through to the corporation's shareholders, the earnings and profits of the S corporation would be adjusted upward in the same manner as if the corporation were still a C corporation. The corporation's accumulated adjustments account (AAA) would not be adjusted for the built-in gains recognized. Under this option, the S corporation would be treated as a C corporation with regard to the disposition of built-in gain assets. The corporation's shareholders would pay taxes on any built-in gains recognized by the corporation only to the extent they received a distribution in excess of the corporation's AAA.

We further believe that regulatory guidance should be published as quickly as possible under Code section 1374 which (1) is simple and straightforward, (2) to the extent possible, relies on available information to value assets, (i.e., inventory could be valued at cost plus the expenses required to hold the inventory); and (3) is cognizant of valuation problems and sensitive to costs of litigation and settlement with respect to valuation issues.

X. TAX IMPOSED ON RECAPTURE OF LIFO RESERVE

The LIFO recapture tax in Code section 1363(d) is a significant deterrent to making an S election for corporations using the LIFO inventory method. The acceleration of tax payable with respect to a corporation's LIFO reserve under Code section 1363(d) deters an S corporation election by C corporations on LIFO even though the additional tax may be paid in installments over the three succeeding taxable years.

RECOMMENDATION: We believe that Code section 1363(d) should be repealed. If the BIG tax is retained the repeal of Code Section 1363(d) will return the treatment of LIFO inventory to pre-1987 Act law. Under this approach, any built in gain associated with the LIFO inventory would be recognized for Code section 1374 purposes only if a "C corporation layer" of LIFO inventory is invaded during the recognition period. See Announcement 86-128 which interpreted pre- 1987 Act law and stated that:

"The Service will issue regulations providing that, for purposes of section 1374(d)(2)(A), the inventory method used by the taxpayer for tax purposes (FIFO, LIFO, etc.) shall be used to identify whether goods disposed of following conversion to S corporation status were held by the corporation at the time of conversion. Thus, for example, a corporation using the LIFO inventory method will not be subject to the built-in gain tax with respect to sales of inventory except to the extent that a LIFO layer existing prior to the beginning of the first taxable year as an S corporation is invaded after the beginning of that year."

The repeal of Code section 1363(d) will put S corporations on par with C corporations with respect to the liquidation of C corporation LIFO layers during the ten-year recognition period under Code section 1374.

XI. BASIS PROBLEMS

Shareholders in an S corporation are not able under current law to include indebtedness of the entity in their outside basis (i.e., their basis in the entity) for loss deduction purposes. Such is the case even when the shareholder is ultimately liable on such indebtedness to the outside creditor. We believe this to be significant inappropriate distinction between the treatment of a shareholder in an S corporation and a partner in a partnership under current law.

As a result of this unfavorable treatment of the S corporation shareholder under current law, the well-advised shareholder often finds it necessary to engage in complicated back-to-back loan arrangements in order to acquire basis. On the other hand, the ill- advised shareholder, unaware of the IRS's repeated victories in litigation on this issue, falls into the trap of thinking that a guarantee of the entity's debt will work to give the shareholder basis.

The treatment of the S corporation shareholder is to be contrasted with the treatment accorded a partner in a partnership with respect to entity-level debt. The partner in a partnership includes in such partner's outside basis a share of the recourse liabilities of the partnership to the extent that such partner bears the ultimate economic risk of loss with respect to such obligation. In addition, a partner includes his or her share of the nonrecourse liabilities of the partnership in such partner's outside basis.

Given the application of both the at-risk rules and the passive loss provisions, there appears no reason to treat shareholders of an S corporation differently from partners in a partnership. The economic risk of loss analysis under Code section 752, as developed in Temporary Regulations section 1.752-1T(d)(3), provides a readily available set of rules equally valid in the S corporation context to determine whether a shareholder bears the ultimate economic risk of loss with respect to a liability of the corporation. Likewise, the principles of the rules dealing with the allocation of nonrecourse liabilities in a partnership are transferable to the S corporation context.

RECOMMENDATION: We believe that section 1366(d) of the Internal Revenue Code should be amended to allow shareholders of an S corporation to include in outside basis the amount of any liabilities of the corporation for which such shareholders agree to undertake ultimate personal liability to the creditor. In addition, shareholders of an S corporation should be allowed to include their share of the nonrecourse liabilities of the S corporation in their outside basis.

XII. CONFUSION OVER THE MEANING OF CODE SECTION 1372

Code section 1372(a) provides that, for purposes of any Federal income tax provisions relating to employee fringe benefits, an S corporation shall be treated as a partnership and any shareholder who owns more than 2% of the outstanding stock of the S corporation shall be treated as a partner in such partnership. While it is not entirely clear from the legislative history of the Subchapter S Revision Act of 1982 precisely how Congress intended this rule to apply, it appears intended to deny more-than-2% shareholder employees certain fringe benefits exclusions available to employees of C corporations and to 2%-or-less shareholder/employees of S corporations.

It also appears intended to deny an B corporation a deduction for the expense of fringe benefits provided to more-than-2% shareholders, but not included in their W-2 compensation. It is unclear whether Code section 1372(a) is intended to deny an S corporation a deduction for fringe benefits included in the W-2 compensation of a more-than-2% shareholder. It is also unclear whether the provision is intended to have the "double whammy" effect of being nondeductible by the S corporation and includible in income by the more-than-2% shareholder.

The potential loss of C corporation fringe benefit treatment is a significant disincentive to many C corporations considering making an S election. So is the uncertainty surrounding the meaning of the provision.

RECOMMENDATION: We believe that the continued need for Code section 1372 should be reconsidered. In the absence of a current policy justification, we believe that it should be repealed. However, if it is determined that the restrictions should be retained, we believe that the provision should be redrafted to clarify its application.

XIII. S CORPORATION SHAREHOLDER LOANS FROM QUALIFIED PLANS

Unlike partnerships and C corporations, an S corporation's qualified deferred compensation plan is prohibited from making loans to any shareholder/employee who owns more than 5% of the stock of the corporation (Code section 4975(d)). Violation of this prohibition can jeopardize the status of the plan and result in the imposition of a 5% excise tax.

A C corporation that is considering making an S election therefore must ensure that shareholder loans are repaid before the S election takes effect. The loan repayment requirement can create financial problems for shareholders and a potential tax trap if the parties are unaware of the existence of the repayment requirement.

RECOMMENDATION: We believe that the restriction on qualified plan loans to S corporation shareholder/employees should be repealed.

XIV. ACCUMULATED ADJUSTMENT ACCOUNT PROBLEMS

Under Code section 1368, the Accumulated Adjustment Account (AAA) is a corporate level account, representing income that has been taxed to S corporation shareholders in prior years, but has not been withdrawn through distributions or redemptions. To the extent that an S corporation has a positive AAA balance, distributions may be made tax free to shareholders during any S year or during the post- termination transaction period.

While the concept of a corporate level "holding account" used to measure retained S corporation earnings is sound, certain problems and complications exist in current law which could potentially act as a disincentive to electing S status.

In addition, lack of guidance from the IRS in applying this concept to S corporation transactions has created numerous "grey areas" in the application of existing statutory authority to taxpayer situations. We recognize that regulations are forthcoming in this area, which may address many of these questions. However, the current lack of guidance may also act as a disincentive to electing S status.

Code section 1368(e), by reference to Code section 1367(a), contains a set of ordering rules requiring that AAA be adjusted first for profit and loss for the year, and then for distributions during the year. To the extent that these distributions are less than or equal to the AAA balance at the beginning of the year adjusted for the year's income or loss, the distributions will be tax-free to the extent of basis. To the extent that distributions exceed that amount they may be a dividend, return of capital or a capital gain to the shareholder.

This ordering rule essentially requires an S corporation which plans to distribute current income to shareholders to determine its income or loss for the year on the last day of the year. If not, and if distributions are made after year end based upon a later determination of income or loss for the year, these distributions must be compared with profit or loss for that succeeding year, and potentially could result in a taxable dividend or capital gain to the shareholder, even though they would have been tax-free had they been made by year end.

RECOMMENDATION: In order to allow time to make a determination of income for the year, we believe that should be permitted to make S corporations which make distributions within two and one half months after year end to treat those distributions as made prior to year- end. This extended distribution period would permit an orderly closing of the books to determine the amount of the year's income available for distribution.