Full Text: AICPA's Testimony At W&M Hearing On Miscellaneous Revenue Measures.

SUBCOMMITTEE ON SELECT REVENUE MEASURES

JUNE 22, 1993

INTRODUCTION

Good morning. I am Gerald W. Padwe, Vice President -- Taxation of the 320,000-member American Institute of Certified Public Accountants. Accompanying me today is the chairman of the AICPA S Corporation Taxation Committee, Mr. Samuel P. Starr.

We thank you for the opportunity to testify on a tax issue of high priority for the AICPA, the reform of Subchapter S. We especially want to thank Representative Cardin for proposing these suggested amendments to subchapter S for the consideration of this subcommittee. We further want to recognize Representative Payne for the interest he has shown in our effort to modernize this area of the Internal Revenue Code.

Subchapter S was first enacted in 1958 to help remove tax considerations from small business owners' decisions to incorporate. Electing "subchapter S corporations" (as they were then called) were not subject to the classic two-tier tax system, applicable to nonelecting corporations. This tax treatment was helpful to small business and especially to start-up businesses. But subchapter S, as originally enacted, was very limiting and contained a number of pitfalls and traps for the unwary.

It was not until 1982 that subchapter S became popular. In that year, after a multi-year, collegial effort on the part of the AICPA, members of the American Bar Association's Section of Taxation, and the staff of the Joint Committee on Taxation, subchapter S was substantially revised to remove many of its traps and some of its obsolete restrictions. Subsequently, changes made in the Tax Reform Act of 1986 made the election of subchapter S treatment highly desirable to many small businesses. Today, over 1.5 million small businesses, 42 percent of corporate tax return filers, are S corporations. /1/ In short, the tax system and the small business community have both been beneficiaries of these efforts.

We come to you now, eleven years after the enactment of the Subchapter S Revision Act of 1982, asking that you modernize subchapter S to enable S corporations to operate more on a par with partnerships and C corporations (those corporations without a subchapter S election in effect). Our colleagues in this effort include the U.S. Chamber of Commerce and, again, members of the American Bar Association's Section of Taxation. In addition, a number of other organizations have been supportive of our efforts to modernize subchapter S, including the National Federation of Independent Business, the National Association of Private Enterprise, and the Small Business Legislative Council.

We believe subchapter S should be amended to better reflect the way small business does business in the `90s. Many of the prohibitive restraints currently in subchapter S date back to its original enactment in 1958. The financial environment in the 1990's is far more complex, and 1950's legislative restraints are handicapping small business. A 90's small business does not operate the way a 50's small business did. Times (and financial transactions) were simpler then. Subchapter S requires a fresh 90's outlook.

For instance, with the traditional sources of debt financing -- commercial banks -- presently restricting their loans to small business, these businesses have had to turn to nontraditional sources of financing such as venture capitalists and pension funds. Typically, these sources of financing want either an equity stake in the business or, at a minimum, debt that can be converted into equity interests. A small business operating as a partnership or C corporation can offer these benefits to a financier and thereby utilize these sources of capital. An S corporation cannot offer a similar set of inducements to financiers. Restrictions in subchapter S limit or outright preclude tapping these sources of financing.

The proposal to amend subchapter S which we are discussing today contains twenty-six separate recommendations. A number are contained in H.R.13, the Tax Simplification Act of 1993, which was introduced earlier this year by Chairman Rostenkowski. The package of recommendations, taken as a whole, would modernize this area of the Internal Revenue Code by accomplishing four broad goals:

o Reform of S corporation fringe benefit rules,

o Expansion of the capital formation techniques available to S

o Preservation of family-owned businesses, and

o Removal of undesirable tax traps.

REFORM S CORPORATION FRINGE BENEFIT TREATMENT

PLACE S CORPORATION SHAREHOLDERS IN THE SAME POSITION AS OWNERS OF

Under current law, an S corporation, unlike a C corporation, is not permitted to provide shareholder-employees with certain tax- favored fringe benefits. Instead, for fringe benefits purposes, the S corporation is treated as a partnership and 2-percent shareholders are treated as partners. All other shareholder-employees of the S corporation are treated like employees of a regular corporation with respect to fringe benefits.

The problem here is that S corporations operate at a disadvantage to C corporations with respect to fringe benefits paid to owner/employees. For owners of small businesses this is especially onerous because their fringe benefits are a greater portion of their overall compensation. Furthermore, owners of S corporations (like owners of partnerships and C corporations) are already governed by extensive antidiscrimination rules which make section 1372 treatment unnecessary.

Example: All the employees of a small retail store (including

To solve this problem, we recommend you repeal Code section 1372.

REPEAL RESTRICTIONS ON QUALIFIED PLAN LOANS MADE TO S CORPORATION

Under current law, a loan by a corporation's qualified retirement plan to a "disqualified person" is a prohibited transaction, subjecting the borrower to a penalty tax. For C corporations, a disqualified person includes any shareholder who owns ten percent or more of the corporation's stock. For an S corporation, however, any shareholder who owns FIVE PERCENT or more of the corporation's stock is a disqualified person.

The problem here is that when a C corporation makes an S election, any shareholder who owns between five and ten percent of the qualified retirement plan's corporate sponsor corporation must repay the loan before the effective date of the S election or face an automatic penalty tax. As a practical matter, very few people are aware that the restrictions on loans from qualified retirement plans are more stringent for an S corporation than for a C corporation. Consequently, five-to-ten-percent shareholders of a C corporation that elects S status may inadvertently find themselves subject to a penalty tax for failing to repay loans from qualified plans before the effective date of the S election.

Example: A small software development company operates as a C

We view this as a trap for the unwary, and recommend that the current, more restrictive limitation on S corporation shareholders be repealed. The definition of a "disqualified person", as including a ten-percent-or-greater shareholder, should apply uniformly to both C corporations and S corporations.

ACCELERATE CAPITAL FORMATION

INCREASE THE THIRTY-FIVE-SHAREHOLDER LIMITATION TO FIFTY

Under current law, an S corporation election is not valid if the business has more than 35 shareholders. This presents a problem for multi-generational, family-held businesses. This highly artificial limit on the number of shareholders prevents a corporation from continuing to operate as an S corporation as the number of shareholding generations increases. Also, some high-tech corporations that want to reward key employees are artificially limited to a thirty-five shareholder limitation.

Example: A furniture manufacturing company now owned by the

We recommend the current S corporation limit of 35 shareholders, which serves to restrict capital formation opportunities of smaller firms, be raised to 50 shareholders. /3/

PERMIT CERTAIN TAX-EXEMPT ORGANIZATIONS TO BE ELIGIBLE SHAREHOLDERS.

Under current law, a tax-exempt organization is not an eligible shareholder for purposes of a valid S corporation election. This presents a problem because tax-exempt organizations including pension plans, ESOPs (a qualified employee stock ownership plan), and university endowment funds are significant sources of capital for small closely-held businesses seeking to expand their operations. Because tax-exempt organizations are ineligible shareholders, these sources of capital are unavailable to S corporations, again placing them at a competitive disadvantage to C corporations.

Example: The founder of an S corporation wants to retire and

We recommend tax-exempt organizations become eligible to hold stock in S corporations. This proposal would allow the partnership flow-through approach to be used with exempt organization shareholders of an S corporation. For example, any trade or business income allocable to the exempt organization shareholder would be subject to the unrelated business income tax, or UBIT, but interest and dividend income would not.

ALLOW NONRESIDENT ALIEN SHAREHOLDERS TO OWN S CORPORATION STOCK.

Under current law, a nonresident alien is not an eligible shareholder for purposes of a valid S corporation election. This presents a problem for S corporations, because frequently, sources of capital or entre to foreign markets require an equity participation by a nonresident alien.

Example: A local S corporation manufacturer has an opportunity

We recommend that nonresident aliens (individuals only) be treated as eligible shareholders. Under this recommendation, any effectively connected U.S. income allocable to the nonresident alien should be subject to a withholding tax similar to the tax imposed on nonresident partners of a partnership.

PERMIT S CORPORATIONS TO ISSUE PREFERRED STOCK. PAMPHLET, SECTION D.

Under current law, an S corporation is permitted to have only one class of stock. This presents a serious problem for S corporations seeking venture capital, because venture capitalists and other outside sources of funding generally require an equity position that provides a preferred return with the upside potential for capital gain to enhance the rate of return on investment.

Example: A small S corporation has developed a promising new

We recommend that S corporations be permitted to issue preferred stock, including convertible preferred stock. Under this proposal, only eligible S corporation shareholders would be allowed to own preferred stock.

PERMIT AN S CORPORATION TO OWN MORE THAN 80 PERCENT OF A C

Under current law, an S corporation may own as much as 79 percent of the stock of another corporation without jeopardizing the S election. Yet, for valid, nontax business reasons, corporations frequently establish subsidiaries to hold their different business activities. Normally, these would be wholly-owned subsidiaries. An S corporation is precluded from using this ownership structure because of the prohibition on affiliated companies. Currently, this business goal can only be accomplished by using inefficient and costly tax planning techniques.

Example: A local general construction company, organized as an S

We recommend that a corporation be permitted to elect S status regardless of the percentage of stock it owns in a C corporation subsidiary. However, we also recommend that no S corporation be permitted to participate in any consolidated returns. /4/

PERMIT S CORPORATIONS TO OWN S CORPORATION STOCK. PAMPHLET, SECTION

Under current law, S corporations are not permitted to have corporate shareholders. While the preceding proposal would allow wholly-owned subsidiaries, those subsidiaries would be denied flowthrough treatment. (The subsidiary could not itself be an S corporation because S corporations cannot have corporations as shareholders.) This defeats the objective of subchapter S in permitting flowthrough treatment for the entire business.

In the preceding example, the asbestos subsidiary, if organized, would be restricted to C corporation status. It is inappropriate to deny flowthrough treatment where business reasons necessitate the use of a subsidiary. To obtain flowthrough treatment under current law, the owners of the construction company could form a new "sister" corporation to engage in the asbestos removal business. This alternative is an unnecessarily inefficient and costly corporate structure.

We recommend that an S corporation be permitted to own 100 percent of the stock of another S corporation, as well as a chain of S corporations. The corporate group should not, however, be permitted to file consolidated returns.

EXPAND "SAFE HARBOR STRAIGHT DEBT" TO PERMIT CONVERTIBLE DEBT.

Under current law, it is possible that debt may be recharacterized as a second class of stock. However, an obligation that qualifies as "straight debt" is not considered a second class of stock and, thus, does not trigger a termination of the S election. For example, if the debt contains conversion and liquidation rights, which "straight debt" is not permitted to contain, the entity's S election could be in jeopardy.

The problem this presents is that in today's business world debt instruments frequently contain convertibility features. Under current law, S corporations are at risk that this convertible debt could be construed as a "second class of stock" which would terminate S status. This common debt feature should not terminate S status. While current regulations offer some flexibility, these rules do not adequately resolve this problem.

We recommend, therefore, that the "straight debt" safe harbor provisions be expanded to allow the issuance of convertible debt. However, the debt instrument in question should be required to continue to meet all of the other criteria of straight debt.

EXPAND "SAFE HARBOR STRAIGHT DEBT" TO PERMIT INELIGIBLE SHAREHOLDERS

Under current tax law, "straight debt" may only be owned by an individual, an estate, or a trust which is eligible to be an S corporation shareholder. This presents a problem because loans from financial institutions and other arms-length borrowing would not be treated as safe harbored straight debt.

To expand financing opportunities for S corporations, we recommend the definition of straight debt be expanded so that loans from financial institutions and other lenders not be subjected to greater restrictions than loans made by others.

PRESERVE FAMILY-OWNED BUSINESSES

EXPAND TRUSTS PERMITTED TO OWN S CORPORATION STOCK TO INCLUDE THOSE

Under current law, only certain types of trusts are permitted to become shareholders of an S corporation, the two most common types of eligible trust shareholders including the grantor trust and the "qualified subchapter S trust" (QSST). The problem this presents for S corporation owners is that the most common trusts used for estate planning purposes have multiple beneficiaries and sprinkling powers vested in the trustee. These trusts are not allowed to hold S corporation stock. As a result, S corporation shareholders do not have access to the same estate planning techniques available to C corporation owners.

Example: An S corporation owner has an ailing spouse and several

We recommend expansion of the definition of what constitutes a QSST. Under this expanded definition, single-tier trusts would be permitted to have multiple-income beneficiaries and to accumulate income from the S corporation at the trust level. Sprinkle trusts would be treated as eligible S corporation shareholders. Multiple beneficiaries would each, along with the trust, be counted as shareholders. However, the family attribution rules would apply in counting the number of shareholders.

COUNT ALL MEMBERS OF A SINGLE FAMILY WHO OWN AN S CORPORATION'S STOCK

Under current law, only a husband and wife are treated as one shareholder for purposes of the S corporation election. All other members of a family are treated as separate shareholders. For multi- generational, family-held businesses, an artificial limit on the number of shareholders prevents corporations from continuing to operate as an S corporation for future generations.

Example: A furniture manufacturing company now owned by the

We recommend the family attribution rules under Code section 267(c)(4) apply in the situation of the S corporation election. This means that all family members would be treated as one S corporation shareholder, in determining the if the current thirty-five (for our recommended fifty) shareholder limit is exceeded.

REMOVE UNDESIRABLE TAX TRAPS

PERMIT SHAREHOLDER PERSONAL GUARANTEES OF CORPORATE DEBT TO INCREASE

Under current tax law, a partner includes his or her share of partnership indebtedness in his or her basis (in the partnership) for loss deduction purposes. In contrast, an S corporation shareholder is not permitted to include indebtedness of the S corporation in his stock basis, even to the extent the shareholder has provided a personal guarantee of the corporate debt.

Current law emphasizes form over substance. When an S corporation needs additional funds, typically a commercial bank will make the loan directly to the corporation with the additional security of a shareholder guarantee. A well-advised S corporation owner would structure the financing arrangement so that the bank would make the loan to the shareholder who would then reloan the borrowed funds to the corporation. In both cases, the shareholder is economically exposed to repay the loan to the bank. Yet, basis is available only if the shareholder is well-advised before the loan is made.

Example: An S corporation nursery and landscaping business needs

We recommend that to the extent an S corporation shareholder personally guarantees indebtedness of the S corporation, the shareholder should be permitted to reflect the personal guarantee as part of basis in the entity for loss deduction purposes. To minimize the complexity of this proposal, we recommend that the guarantees available for this treatment be limited to those which have a single guarantor and specifically state the amount guaranteed.

PERMIT THE SECRETARY OF TREASURY TO TREAT INVALID ELECTIONS AS

Under current law, the IRS has the authority to waive the effect of an inadvertent S corporation termination, but not the authority to waive the effect of an invalid election caused by an inadvertent failure to qualify as an S corporation.

We believe the IRS should have the authority to waive an inadvertent invalid S corporation election for entities that have subsequently cured the defect. This new authority would be a broadening of the current IRS authority to waive the effect of an inadvertent S corporation termination. /4/

PROVIDE FOR AUTOMATIC WAIVER OF CERTAIN INADVERTENT TERMINATIONS.

Under current law, the IRS has the authority to waive the effect of an inadvertent S corporation termination and MAY have authority to AUTOMATICALLY waive such effect. A high percentage of private letter ruling requests on S corporations deal with the issue of inadvertent terminations. For many taxpayers, obtaining a waiver of their terminated S status can result in costly professional fees. Also, valuable time on the part of IRS personnel and tax professionals is lost on processing routine taxpayer waiver requests.

We recommend an automatic waiver procedure be authorized by Congress so that an entity would not lose its S corporation status due to a terminating event of a "ministerial" nature. An example of such an event is when a beneficiary fails to make a qualified subchapter S trust election.

REPEAL EXCESSIVE PASSIVE INVESTMENT INCOME AS A TERMINATION EVENT.

Under current law, subchapter S contains two disincentives to discourage "incorporated pocketbooks" from operating as S corporations. First a corporate-level tax is imposed on excess passive investment income. Second, S status is terminated if the corporation earns passive investment income that exceeds 25 percent of the entity's gross receipts for three consecutive taxable years and the entity has accumulated Subchapter C earnings and profits at the end of each of the three years.

While this result may be avoided through proper tax planning, many unadvised S corporations are caught unaware of these traps and lose their S status. The sanction of terminating S status when the entity has excessive passive income is unduly harsh.

Example: Due to business fluctuations, the operating business of

To the extent Congressional intent is to limit the passive income of an S corporation, we believe this legislative intent is sufficiently served through the current procedures of imposing a corporate-level tax on the S corporation's passive income. Therefore, the sanction of terminating the S election in the situation of excessive passive income should be repealed.

EXCLUDE TRADE OR BUSINESS INCOME FROM THE PASSIVE INVESTMENT INCOME

Under current law, the definition of passive investment income for S corporation purposes includes the types of income earned by a personal holding company, and many traditional types of active trade or business income earned by an operating company. By including certain types of active trade or business income in the passive investment income definition, many operating companies are precluded from making the S election.

Examples: Examples of such operating companies include certain

We recommend the income earned from the active conduct of a trade or business not be included in the S corporation definition of passive income. Instead, a facts and circumstances test should be adopted to determine what constitutes active as opposed to passive income. Examples of regulations that may be used in drafting a facts and circumstances test include Regulation sections 1.355-3(b) and 1.469-2T(c)(3)(i).

TECHNICAL PROPOSALS

TREAT LOSSES ON LIQUIDATION OF S CORPORATIONS AS ORDINARY TO THE

Under current law, if an S corporation sells an appreciated asset or distributes it to shareholders, the appreciation in value of the asset is generally taxed once -- at the shareholder level. The gain recognized in such dispositions can be characterized either as capital gain or ordinary income, depending on the asset being sold or distributed. Any recognized gain or income increases the basis of S corporation shareholders in their stock. If the S corporation liquidates, any loss on liquidation will generally be a capital loss, even if, in the process of liquidation, ordinary income is recognized on assets sold or distributed. In other words, a shareholder can receive a flowthrough of ordinary income and resulting increase in basis as a result of disposition of assets in liquidation. But any loss on the liquidation will generally be capital loss, even if the basis was created by a transaction resulting in ordinary income.

We recommend that the loss recognized by a shareholder on the complete liquidation of an S corporation be treated as ordinary rather than capital to the extent the shareholder's basis in the S corporation stock is attributable to ordinary income, that was recognized as a result of the liquidation.

ALLOW A CARRYOVER OF DISALLOWED LOSSES AND DEDUCTIONS UNDER SECTION

Under current law, losses of S corporation shareholders suspended by the subchapter S basis rules, may be recognized after the S election terminates and during the post-termination transition period if additional basis in the S corporation is generated during such period. S corporation losses may also be suspended under the at- risk rules. S corporations and their shareholders are treated in the same fashion as partners in partnerships under the at-risk rules. However, losses suspended through the application of the at-risk rules are NOT carried over to the post-termination transition period for the (former S corporation) entity.

The post-termination transition period rule allows a last-chance opportunity for S corporation shareholders to establish basis in the corporation and thus use losses that had passed through to them in previous years but that were nondeductible because of a lack of basis at that time. However, in some cases, S corporation shareholders have had enough basis to deduct losses, but the losses were suspended under the at-risk rules for which there is no post-terminations transition period opportunity. To provide a last chance opportunity for these losses, it is appropriate to extend current law treatment of losses suspended because of insufficient basis to losses suspended under the at-risk rules.

We recommend losses suspended in the application of the at-risk rules be permitted to be carried over to the post-termination transition period.

EXPAND THE PERIOD OF POST-DEATH S QUALIFICATION FOR CERTAIN TRUSTS.

Under current law, a testamentary trust is permitted to be a shareholder of an S corporation for a period not to exceed 60 days following the death of a deceased S corporation shareholder. There is also a similar 2 year rule for grantor trusts and deemed grantor trusts. After the 60-day period, the trust must transfer ownership of the shares to an eligible S corporation shareholder or (if qualified) become a Qualified Subchapter S Trust. There is a two-year rule for those trusts with corpus included in grantor's estate.

The requirement that the trust transfer ownership of its S corporation shares within the 60-day period is a significant compliance and administrative burden for many taxpayers. The trustee may be unaware of the need to transfer the S corporation stock until advised to do so by a tax advisor who is involved in the administration of the decedent's estate. Often, this may not occur until more than sixty days following the decedent's death.

Example: The owner of a 20% interest in the stock of an S

The period of time that the trust may own the S corporation stock should be extended to two years (the same as for grantor trusts). By enacting a two-year period, Congress would be taking positive steps to relieve compliance and inadvertent termination problems.

MODIFY ORDER OF ADJUSTMENTS TO ACCUMULATED ADJUSTMENTS ACCOUNT (AAA)

Under current law, adjustments are made to the basis of an S corporation shareholder's stock in the sequence of income first, losses second, and distributions third. On the other hand, partnership basis is adjusted first by income, second by distributions, and third by losses.

We believe the subchapter K rules involving the ordering of adjustments to basis should also apply in determining the basis of S corporation stock and the S corporation AAA. Thus, for purposes of subchapter S, distributions under this proposal would be taken into account before losses. /4/

PERMIT CONSENT DIVIDEND FOR AAA BY-PASS ELECTION. NOT INCLUDED IN

Under current law, certain adverse consequences, including termination of the S election caused by excess passive investment income, can accrue to an S corporation which retains earnings and profits from the time it was a C corporation. C corporation earnings and profits can be purged from the corporation by making a shareholder distribution. Normally, such distributions are first made out of AAA. However, an election is available to by-pass AAA and make the distribution out of C corporation earnings and profits. Proposed regulations under section 1368, if finalized, would permit a corporation to elect consent dividend treatment to by-pass the AAA and distribute out its C corporation earnings and profits. (A consent dividend allows the corporation to make a deemed distribution to shareholders followed by a deemed contribution by those shareholders back to the corporation.)

Without a consent dividend procedure, distributions must be made with cash or other assets which, frequently, are not available at the appropriate time to make a distribution. A consent dividend procedure solves this problem. But some argue there may not be sufficient administrative authority to provide a consent dividend procedure in the regulations.

We support the consent dividend treatment provision of the proposed regulations and, therefore, recommend this particular provision of the regulations be codified.

PERMIT SUBCHAPTER C TO APPLY TO S CORPORATIONS IN CERTAIN

Under current law, 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 taken the position that this prevents the tax-free liquidation of a C corporation into an S corporation under the rationale a C corporation cannot liquidate tax- free when owned by an individual. Recently, the Service has indicated that it may be changing this position, /5/ but we believe this latter position should be codified.

We recommend repeal of the rule which treats an S corporation in its capacity as a shareholder of another corporation as an individual. Under this recommendation, the liquidation of a C corporation into an S corporation will be governed by the generally applicable subchapter C rules. /4/

ELIMINATION OF PRE-1983 SUBCHAPTER S EARNINGS AND PROFITS. NOT

Under current law, the accumulated earnings and profits of a corporation are not increased for any year in which an election to be treated as an S corporation is in effect. However, under the subchapter S rules in effect prior to 1983, a corporation electing S status for a taxable year increased its accumulated earnings and profits if, for the year, they exceeded both taxable income and distributions out of that year's earnings and profits. The Subchapter S Revision Act of 1982 repealed this rule for earnings attributable to taxable years beginning after 1982 but did not do so for previously accumulated S corporation earnings and profits.

We recommend that a corporation's accumulated earnings and profits be solely attributable to taxable years for which an S election was not in effect. This recommendation involves the elimination of S corporation earnings and profits attributable to periods preceding the effective date of the Subchapter S Revision Act of 1982. /4/

SIMPLIFY THE PROCEDURES FOR ELECTING TO CLOSE THE BOOKS ON THE

Under current law, a corporation may elect to close its books at the date of complete termination of a shareholder's interest. All shareholders (including those who held shares at any time during the year) must give their consent to this election. This requirement imposes compliance burdens in the preparation and filing of timely corporate tax returns. According to the holding in an IRS private letter ruling, even if a corporation does not have the consensus of unaffected shareholders, it still may be in "substantial compliance" with the tax law when the allocations were prepared correctly.

Under current law, all shareholders of the corporation must consent to this election, including those that are unaffected. The necessity of obtaining the signatures of these unaffected shareholders imposes an unreasonable administrative burden, especially when the corporation is owned by multiple shareholders. Rather, the election should only be made by those affected shareholders, that is, those who were involved in a stock transaction during the year.

Example: A small manufacturing business is owned by 24

Instead of having to obtain the consent of all shareholders, we recommend the closing of a corporation's books be permitted if both the affected shareholders and corporation consent.

EXPAND THE POST-TERMINATION TRANSITION PERIOD. PAMPHLET, SECTION

Under current law, if an entity loses its S corporation status, it may distribute cash to shareholders during the post-termination transition period. The distribution is then applied against the adjusted basis of the stock. The shareholder receives the cash tax free to the extent the amount distributed does not exceed the Accumulated Adjustments Account (AAA). If there is excess, it is treated as capital gain. Also, the AAA ceases to exist for tax purposes at the end of the post-termination transition period. Distributions made after the post-termination transition period are taxed under the regular Subchapter C provisions.

Because of the large number of occurrences that can terminate a corporation's S election, an S corporation and its shareholders may be unaware of a termination until an IRS examination in a subsequent year brings the facts to light. In such situations where inadvertent termination relief may not be available, the period within which to make post-termination distributions may already have elapsed.

Example: A shareholder of an S corporation irrevocably

We recommend a broadening of the definition of post-termination transition period with respect to the 120-day period following a determination that the corporation's election had terminated for a previous taxable year.

EXPANSION OF RECOVERY PERIOD FOR NONRESIDENTIAL PROPERTY

The present Budget Reconciliation Bill contains a provision extending the depreciable life (the "recovery period") of nonresidential realty from its present 31.5 years to 39 years. We have previously testified in opposition to this provision. If, however, Congress believes it important to lengthen the life of business realty, we believe you should consider the following. As the building life for tax depreciation approaches its economic life, tenants and landlords paying for leasehold improvements may become more disadvantaged. Tenants with short-term leases must depreciate improvements for which they pay over the statutory life (which would now be 39 years), even though a lease may be for only 10 or 15 years.

As to landlords, improvements are usually specialized to the particular tenant's needs and do not usually have much, if any, economic value at the conclusion of the lease period. As a result of this, landlords who are already disadvantaged by the present 31.5 year recovery period would be put at an even greater disadvantage as a result of the requirement to use a 39-year life for leasehold improvements.

Example: Assume a landlord agrees to invest $390,000 for tenant

If the cost recovery period for business real estate IS extended to 39 years, we believe Congress should legislate a separate, shorter, depreciation class for leasehold improvements and for other KNOWN shorter-life assets, which presently are keyed to the recovery period of the overall building.

* * *

Once again, we appreciate the opportunity to present our views here today and we stand ready to assist you in any way.

FOOTNOTES

/2/ References to the pamphlet are to the Joint Committee on Taxation Staff Description (JCS-8-93) of Miscellaneous Tax Proposals Scheduled for Hearings June 17, 22, and 24, before House Ways and Means Select Revenue Subcommittee, Issued June 16, 1993.

/3/ This proposal was included in H.R. 11, the Revenue Act of 1992, which was vetoed by President Bush.

/4/ This proposal was included as a measure in H.R. 13, the Tax Simplification Act of 1993.

/5/ See, Technical Advice Memorandum 9245004 (July 28, 1992), a form of nonprecedential administrative guidance.