S corporation reform bill of 1995

S. 758 was introduced in the Senate on May 4, 1995 by Senators Pryor and Hatch, members of the Senate Finance Committee. The Bill is designed to improve access to capital markets by S corporations and make it easier to pass family-owned businesses from generation to generation. The Bill is the outgrowth of work done by the American Bar Association's Tax Section S Corporation Committee, the AICPA's Tax Division S Corporation Taxation Committee, and the US Chamber of Commerce. The following is a summary of its provisions.

Shareholder and Corporate Eligibility

Types and Number of Shareholders

Section 101 of the Bill would increase the number of permitted shareholders from 35 to 50.

Section 102 of the Bill would permit an election to have all members of one family treated as a single shareholder. A family would be defined as the lineal descendants of a common ancestor (and their spouses and former spouses) who could not be more than six generations removed from the youngest generation of shareholder. The election would be available to only one family per corporation and would require the consent of all shareholders.

Tax exempt entities allowed as shareholders

Section 111 of the Bill would permit as shareholders tax exempt organizations described in Code Sections 401(a) and 501(c)(3). Items of income or loss would flow through to the tax exempt organizations for purposes of the unrelated business income tax in a manner similar to the flow-through to tax exempt organizations that are partners in partnerships under present law.

Financial institutions as shareholders

Under Section 112 of the Bill, a financial institution would be allowed to be an S corporation unless such institution uses a reserve method of accounting for bad debts described in Section 585 (the experience method generally available to small banks) or Section 593 (the percentage of taxable income method generally available to domestic savings and loan associations, mutual savings banks, and certain cooperative banks).

Nonresident aliens allowed to be shareholders

Section 113 of the Bill would permit a nonresident alien to be a shareholder in an S corporation. Any effectively connected US income allocable to such shareholder would be subject to a withholding tax in a manner similar to the treatment of such income allocable to nonresident aliens that are partners in US partnerships under present law.

Expansion of types of trusts eligible to be shareholders

Section 113(114) of the Bill would permit an "electing small business trust" to be a shareholder of an S corporation if it acquired its stock in a carryover basis transaction (gift, bequest, etc.). This would permit trusts with more than one beneficiary ("sprinkling trusts") to be shareholders. The trust would need to elect to be treated as an electing small business trust. The beneficiaries must be otherwise qualified to be shareholders of an S corporation. For purposes of the number of shareholders test, all potential beneficiaries would be counted. If there were no potential current beneficiaries, the trust itself would be treated as the shareholder. A qualified Subchapter S trust with respect to which an election is in effect and a tax exempt trust would both be ineligible to qualify as an electing small business trust.

The portion of the electing small business trust that consists of stock in one or more S corporations would be treated as a separate trust or purposes of income taxation. The trust would be taxed at the highest individual tax rate on that portion of the trust's income. That would include flow-through items from the S corporation as well as gain or loss from the sale or exchange of S corporation stock. No deduction would be allowed for amounts distributed to beneficiaries and no income would flow through to the beneficiaries' income tax returns. On the termination of all or a portion of an electing small business trust, any loss carryovers or excess deductions would be taken into account by the entire trust subject to the normal rules on termination of the entire trust.

Holding period for testamentary trusts

Section 121 of the Bill would extend the holding period for all testamentary trusts to two years.

Preferred stock permitted

Section 201 of the Bill would permit the issuance by an S corporation of "qualified preferred stock" as defined in Code Section 1504(a)(4) which is issued to a person eligible to hold common stock of an S corporation. Section 1504(a)(4) includes stock which is not entitled to vote, is limited and preferred as to dividends, does not participate in corporate growth to any significant extent, has redemption and liquidation rights which do not exceed the issue price of such stock (except for a reasonable redemption or liquidation premium), and is not convertible into another class of stock. Payments made on such preferred stock would be treated as interest income to the holder and would be deductible as interest expense to the corporation.

Definition of Straight Debt expanded

Straight debt is not treated as a second class of stock. Section 202 of the Bill would expand the definition of straight debt in two ways:

* Debt that is convertible into the stock of the corporation under terms that are substantially the same as terms that could have been obtained from an unrelated person would be included in the definition.

* The definition would be expanded to include debt held by creditors (other than individuals) that are actively and regularly engaged in the business of lending money.

S corporations permitted to hold subsidiaries

Section 221(a) of the Bill would permit an S corporation to own 80% or more of the stock of another corporation. Dividends received by the S corporation from its C corporation subsidiary in which it holds an 80% or greater ownership would not be treated as passive investment income to the extent that the dividends are attributable to the earnings and profits of the C corporation derived from the active conduct of a trade or business.

Also, under Section 221(b) of the Bill, an S corporation would be allowed to own 100% of another S corporation. The qualified S corporation subsidiary would not be treated as a separate corporation, and all of its assets, liabilities, income, deductions, and credits would be treated as those of the parent S corporation. If the subsidiary ceases to be a qualified S corporation subsidiary (i.e. is not wholly-owned by the S corporation), the subsidiary will be treated as a new corporation acquiring all of its assets and assuming all of its liabilities immediately before the transaction which causes it to no longer be a qualified S corporation subsidiary.

Elections and Terminations

Authority to validate certain invalid elections Section 211(a) of the Bill would extend the authority of the IRS to waive the effect of an invalid election caused by an inadvertent failure to qualify as an S corporation or to obtain the required shareholder consents (including the consents of qualified Subchapter S trust beneficiaries).

Section 211(b) of the Bill would also allow the IRS to treat a late Subchapter S election as being timely filed when the IRS determines that there was a reasonable cause for the failure to make a timely election.

These provisions would apply retroactively to taxable years beginning after 1982, the effective date of the current law provision regarding inadvertent terminations added by the Subchapter S Revision Act of 1982.

The IRS would also be directed to adopt an automatic waiver procedure with respect to terminations in those cases that it deems appropriate for years beginning after 1995.

Election to terminate year for allocation of S corporation items

Section 212 of the Bill would provide that the election to close the books of the S corporation upon the termination of a shareholder's interest would be made by, and apply to, only affected shareholders rather than by all shareholders. For this purpose, affected shareholders would mean any shareholder whose interest is terminated and all shareholders to whom such shareholder has transferred shares during the year. If a shareholder transfers shares to the corporation, then affected shareholders would be defined as including all persons who were shareholders during the year.

Expand the post-termination transition period

After an S corporation election has been terminated, a corporation has a limited time period, the post-termination transition period, when it can make tax-free Subchapter S distributions.

Section 213(a) of the Bill would expand the definition of post-termination transition period to also include the 120-day period beginning on the date of any determination pursuant to an audit of the taxpayer that follows the termination of the S corporation's election and that adjusts a Subchapter S item of income, loss, or deduction of the corporation during the period of time that it was an S corporation.

In addition, the definition of "determination" would be expanded to include all items included in Code Section 1313(a). This would add to the definition a final disposition of a claim for refund and also certain agreements signed by the Secretary of Treasury relating to tax liability of the taxpayer.

Repeal of special audit provisions

Bill Section 213(c) would repeal the TEFRA audit provisions applicable to S corporations and would provide other rules to require consistency between the tax returns of the S corporation and its shareholders. If the treatment of an item on a shareholder's return is different from that as shown on the Subchapter S return (Form 1120S - Schedule K-1) then the shareholder would be required to file a statement identifying the inconsistency. Presumably, Form 8082 would continue to be used for this purpose.

Excess passive investment income

Section 214 of the Bill would increase the passive investment income threshold from 25% of gross income to 50% of gross income for purposes of the Section 1375 corporate level tax on passive investment income.

The provision would also eliminate the rule that terminates an S corporation's status when it has excess passive investment income for three consecutive years.

For taxable years after 1995, if an S corporation has excessive passive investment income for more than three consecutive taxable years, the rate of corporate tax applicable to such income under Code Section 1375 would be increased by ten percentage points for each succeeding taxable year with a maximum of a fifty percentage point increase after the seventh consecutive year.

Other Provisions

Treatment of distributions during loss years

Section 222 of the Bill would provide that the adjustments for distributions made by an S corporation during a taxable year are taken into account before applying the loss limitation for the year. Thus, distributions during the year would reduce the adjusted basis for purposes of determining the allowable loss for the year, but the loss or the year would not reduce the adjusted basis for purposes of determining the tax status of distributions made during that year.

The Bill would also provide that, in determining the accumulated adjustment account (AAA) for purposes of determining the tax treatment of distributions made during a tax year by an S corporation having accumulated earnings and profits, the net negative adjustments (i.e. the excess of losses and deductions over income) for that taxable year are disregarded.

Permit consent dividends to bypass the AAA

Section 223 of the Bill would codify the Treasury regulation that allows an election for deemed dividends of C corporation earnings and profits to bypass the accumulated adjustments account. Any such distribution to a tax-exempt organization described in Section 511(a)(2) would be treated as unrelated business taxable income to such organization.

Treatment of S corporations under Subchapter C

Section 224 of the Bill would repeal the rule that treats an S corporation in its capacity as a shareholder of another corporation as an individual. Thus, the liquidation of a C corporation into an S corporation would be governed by the generally applicable Subchapter C rules, including the provisions of Sections 332 and 337 allowing the tax-free liquidation of a corporation into its parent corporation. Following a tax-free liquidation, the built-in gains of a liquidating corporation may later be subject to tax under Section 1374 upon a subsequent disposition. An S corporation will also be eligible to make a Section 338 election (assuming all other requirements are met) resulting in immediate recognition of all the acquired C corporation's gains and losses and the resulting imposition of a tax. The repeal of the rule would not change the general rules governing the computation of income of an S corporation (e.g. it would not permit an S corporation to claim a dividends received deduction).

Elimination of pre-1983 earnings and profits of S corporations

Bill Section 225 would provide that any accumulated earnings and profits of an S corporation that occurred while the corporation was a Subchapter S corporation for years beginning before 1983 (prior to the Subchapter S Revision Act of 1982) would be eliminated. Thus, the corporation's accumulated earnings and profits would be solely attributable to tax years when the S election was not in effect.

Allowance of charitable contributions of inventory and scientific property

Section 226 of the Bill would provide that S corporations would be treated the same as C corporations with respect to charitable contributions of (1) certain inventory used by the donee solely for the care of the ill, needy, or infants, and (2) certain scientific property used for research.

The Bill would also allow an increase in the basis of S corporation stock for the excess of the deduction for charitable contributions over the basis of the property contributed by the corporation.

C corporation rules to apply for fringe benefit purposes

Bill Section 227 would treat an S corporation as a C corporation rather than as a partnership for fringe benefit purposes. However, 2% or more shareholders would be treated as self-employed individuals for purposes of the deduction for medical insurance so that their deduction would be limited to 30% of their cost.

Prohibited transactions for owner-employees

Section 301 of the Bill would repeal the restriction on loans from qualified plans for 5% or more shareholders of an S corporation.

Treatment of losses on liquidation of S corporation

Bill Section 302(a) would provide that loss recognized by a shareholder in complete liquidation of an S corporation would be treated as ordinary loss to the extent that the shareholder's adjusted basis in the S corporation stock is attributable to ordinary income that was recognized as a result of the liquidation.

Bill Section 302(b) would provide that losses of an S corporation that are suspended under the at-risk rules of Section 465 would be carried forward to the S corporation's post-termination transition period.

Effective Date and Transition Rule

Bill Section 401 would provide that the changes made, except as otherwise provided, would be effective for taxable years beginning after 1995.

In addition, the Treasury would waive the five year waiting period for making a new Subchapter S election for corporations that terminated their elections prior to enactment of the Bill.

Companion Bill in House

On July 13, 1995, Representatives E. Clay Shaw and Robert Matsui introduced a similar bill in the House of Representatives. The bills are substantially the same with the following exceptions:

* The number of permitted shareholders would be increased from 35 to 75.

* An S corporation would be permitted to issue convertible preferred stock; under the Senate bill, it would only be permitted to issue "plain vanilla" preferred stock.

NOTE

1. Portions of this Outline are adapted from the author's looseleaf tax service, The S Corporation Planning and Operation, published by Panel Publishers(C) All Rights Reserved

About the Author

Sydney S. Traum practices law as owner of Sydney S. Traum, PA, which is o counsel to Semet, Lickstein, Morgenstern, Berger, Friend, Brooke & Gordon, PA, in Coral Gables, Florida. He is licensed as a CPA and an attorney in both New York and Florida. Mr. Traum is president of the Florida Association of Attorney-CPAs and past president of the American Association of Attorney-Certified Public Accountants, Inc., the Greater Miami Tax Institute, and the FICPA Dade County chapter. He is author of The S Corporation, Planning and Operation Qs well as The S Corporation Answer Book, both published by Panel Publishers, Inc., NY: Mr. Traum has lectured extensively on S Corporations and presented continuing education programs at AAA-CPA meetings. He received a BBA degree from CCNY, a JD degree from Harvard Law School, and a LLM degree in Taxation from NYU Law School.

Copyright American Association of Attorney-Certified Public Accountants Fourth Quarter 1995
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