House introduces legislation to modify S corporation regulations.

A bill was introduced in the House that would ease regulations governing S corporations. HR 2039, sponsored by E. Clay Shaw (R-Fla.), is designed to expand access to capital as well as protect the ability to leave closely held businesses to heirs.

In June, witnesses testifying at hearings on the Senate bill to modify S corporation legislation (S 758) strongly supported the legislation's reforms. Senator Orrin Hatch (R-Utah), chair of the Taxation and Internal Revenue Service Subcommittee, said S 758 was designed to help small businesses get started, grow and create jobs and "ease outdated, unreasonable or burdensome tax compliance requirements."

Samuel P. Starr, partner of Coopers & Lybrand in Washington, D.C., and a member of the American Institute of CPAs tax executive committee, told the Journal that although S corporation reform legislation provided some benefits to larger businesses, its primary beneficiaries would be small businesses. "S 758 would give small businesses flexibility when structuring their businesses and accessing different kinds of capital," Starr said.

Starr, who testified before the Senate hearing, said S corporations currently were not permitted to issue preferred stock, making it difficult for them to seek venture capital. "Venture capitalists making an investment in a closely held business like to take an equity interest in the form of convertible preferred stock. This legislation would level the playing field for S corporations competing with limited liability companies, which do not have to face the same obstacles when accessing venture capital."

Besides expanding available capital formation techniques, S corporation reform packages in both the House and the Senate would modernize the current law by accomplishing three other broad goals:

* Preserve family-owned businesses by increasing the 35-shareholder limitation to 50 shareholders (Senate bill) or 75 shareholders (House bill).

* Reform S corporation fringe benefit rules, placing S corporation shareholders in the same position as owners of C corporations.

* Remove undesirable tax traps by expanding the period of post-death S qualification for certain trusts and provide for automatic waiver of certain inadvertent terminations, for example.

Glen A. Kohl of the Treasury Department told the Senate subcommittee that the Clinton administration supported S corporation reform and simplification but was concerned it would create undue complexity and increase opportunities for large regular corporations to escape taxation. (For more on this issue, see Highlights on page 4.)

Assets and Income

Percentage of assets and income of the 1.9 million S corporations registered in the United States compared with the assets and income of all corporations in 1993

Net income   11.1%
Assets        4%

Source: Senate Committee on Finance, Subcommittee on Taxation and IRS Oversight

RELATED ARTICLE: Highlights

TREASURY'S S CORPORATION REFORM PROPOSAL: GOOD FOR SMALL BUSINESSES, BUT

HARD ON LARGER ONES

The U.S. Treasury Department has come up with a proposal to allow S corporations to convert to partnerships on a simple, tax-free basis. However, to offset revenue lost under this proposal, the Treasury is considering imposing taxes or a toll charge on large C corporations converting to S status.

"If you are a small business, this is a great proposal," said Theodore B. Stone, partner of Ernst & Young in Vienna, Virginia, and chair of the American Institute of CPAs S corporation taxation committee. "If you are a big business, this proposal is terrible."

Making the conversion harder on C corporations

In a letter to Senator Orrin G. Hatch (R-Utah), sponsor of the Senate's S corporation reform bill, Leslie B. Samuels, assistant secretary of the U.S. Treasury for tax policy, said he was concerned that certain provisions of the S Corporation Reform Act of 1995 (S 758) would "provide increased opportunities for large taxable C corporations to escape corporate taxation by electing S corporation status." Samuels proposed treating the conversion of a C corporation to an S corporation as it would if the C corporation were converting to a partnership. "The Treasury wants to treat the C corporation conversion as a liquidation," said Stone. "This would create a double tax."

The Treasury expressed similar concerns at the Senate hearings on the bill in June. "The Treasury believes this bill is going to benefit big business more than it should," said Stone. "But the proposal does not specifically say how the proposed toll charge would be computed or when it would have to paid. It also fails to say how the Treasury will differentiate between a large and a small C corporation."

Good news for small business

Current subchapter S rules contain a steep tax liability to discourage S corporations from converting to partnerships. For example, converting S corporations must pay tax on their built-in gain. The Treasury's proposal would eliminate or reduce the tax costs of the conversion. It also would allow S corporations to elect to be treated as partnerships for federal tax purposes simply by checking a box on a return. "The check-the-box system has been praised by taxpayers and tax practitioners," said Samuels. "It would enable S corporations to achieve partnership tax treatment without incurring the transaction costs involved in actually converting to a partnership."

Samuels' proposal is intended to level the playing field for S corporations and limited liability companies. "For most new enterprises seeking extended flow-through treatment, an LLC will likely become the preferred entity," said Samuels. The Treasury and the Internal Revenue Service have already proposed a check-the-box system allowing LLCs and other unincorporated entities to choose partnership treatment.

COMING NEXT MONTH

The October Journal contains a comprehensive review of the 19 leading tax software packages for 1995. It also looks at how auditors can identify the warning signs of financial statement misstatement, how CPAs can plan family loans carefully to ensure they withstand Internal Revenue Service scrutiny and how CPAs can more easily expand into personal financial planning.