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AICPA tax division works to modernize subchapter S.

The AICPA Tax Division is deeply involved in developing a comprehensive proposal to modernize subchapter S of the Internal Revenue Code. Beginning in mid-1992, the AICPA Tax Division joined with the U.S. Chamber of Commerce's Taxation Committee and representatives of the American Bar Association (ABA) Tax Section's S Corporation Committee to work on a comprehensive list of proposals. The legislative package that resulted from the group's effort contains 26 proposed changes to subchapter S.

Official AICPA endorsement of the subchapter S modernization package occurred with the Tax Executive Committee's approval on Nov. 20, 1992. In addition to the U.S. Chamber and the ABA's S Corporation Committee, 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.

Background to subchapter S modernization

Subchapter S was last overhauled in 1982 after a similar 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. The Subchapter S Revision Act of 1982 substantially revised subchapter S 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% of corporate tax return filers) are S corporations.(1)

All the current interest in subchapter S springs from the conviction that the subchapter 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 1990s is far more complex than it was 35 years ago, and 1950s legislative restraints are handicapping small business. A '90s small business does not operate the way a '50s small business did. Times (and financial transactions) were simpler then. Subchapter S requires a fresh 1990s 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 avail itself of these sources of capital. An S corporation cannot offer a similar set of inducements; restrictions in subchapter S limit or outright preclude tapping these sources of financing.

Legislative efforts

Beginning in November 1992, representatives of the U.S. Chamber, the ABA and the AICPA had numerous meetings on Capitol Hill with congressmen, senators, and their staffs. Senators Pryor (D-Ark.) and Danforth (R-Mo.) have agreed to sponsor a bill encompassing 24 of the package's proposals; that bill will be introduced at an appropriate time in the near future (and may actually have been introduced by the time this column is published).

In the House of Representatives, Rep. Cardin (D-Md.) submitted the modernization proposals for consideration during a June 22 hearing of the Select Revenue Measures Subcommittee of the House Ways and Means Committee. Gerald W. Padwe, AICPA Vice President-Tax and Samuel P. Starr, Chairman of the S Corporation Taxation Committee, testified on behalf of the Institute.

At the hearing, Representatives Cardin, Payne (D-Va.) and Hoagland (D-Neb.) all expressed strong support for modernization of subchapter S along the lines proposed by the AICPA. Also, while the Treasury Department announced it "does not support" the subchapter S legislative package (at least in part because preliminary revenue estimates show a loss of government revenues), its statement indicated support for a comprehensive review of the present subchapter S structure.

The modernization package's specifics

A number of the recommendations contained in the comprehensive proposal to amend subchapter S are contained in H.R. 13, the Tax Simplification Act of 1993, introduced earlier this year by Ways and Means Chairman Dan Rostenkowski (D-Ill.). The package of recommendations, taken as a whole, would modernize the subchapter by accomplishing four broad goals:

* Reform of S corporation fringe benefit rules.

* Expansion of the capital formation techniques available to S corporations.

* Preservation of family-owned businesses.

* Removal of undesirable tax traps.

Reform S corporation fringe benefit treatment:

* Place S shareholders in the same position as owners of regular corporations with respect to fringe benefits.

* Repeal restrictions on qualified plan loans made to S shareholders.

Accelerate capital formation:

* Increase the 35-shareholder limitation to 50 shareholders.

* Permit certain tax-exempt organizations to be eligible shareholders.

* Allow nonresident alien shareholders to own S stock.

* Permit S corporations to issue preferred stock.

* Permit an S corporation to own more than 80% of a C corporation's stock.

* Permit S corporations to own S stock.

* Expand "safe harbor straight debt" to permit convertible debt.

* Expand "safe harbor straight debt" to permit ineligible shareholders to hold the debt. Preserve family-owned businesses:

* Expand trusts permitted to own S stock to include those with multiple income beneficiaries, the ability to accumulate trust income, and trustee powers to spray income among the beneficiaries.

* Count all members of a single family who own an S corporation's stock as a single shareholder. Remove undesirable tax traps:

* Permit shareholder personal guarantees of corporate debt to increase shareholder basis.

* Permit the Secretary of the Treasury to treat invalid elections as effective.

* Provide for automatic waiver of certain inadvertent terminations.

* Repeal excessive passive investment income as a termination event.

* Exclude trade or business income from the passive investment income definition.

Technical proposals:

* Treat losses on liquidation of S corporations as ordinary to the extent the loss is created by ordinary income passthrough triggered during liquidation.

* Allow a carryover of disallowed losses and deductions under Sec. 465 to the post-termination transition period.

* Expand the period of post-death S qualification for certain trusts.

* Modify order of adjustments to accumulated adjustments account (AAA) and stock basis.

* Permit consent dividend for AAA by-pass election.

* Permit subchapter C to apply to S corporations in certain circumstances.

* Elimination of pre-1983 subchapter S earnings and profits.

* Simplify the procedures for electing to close the books on the termination of a shareholder's interest.

* Expand the post-termination transition period.

More information on this legislative initiative can be obtained by sending a 9"x12" self-addressed envelope with $0.98 postage to Subchapter S Modernization, AICPA Tax Division, 1455 Pennsylvania Avenue, N.W., Suite 400, Washington, DC 20004. (1) These figures are for 1990, the most recent year for which data is available. See "Table 13.--Corporation Income Tax Returns: Balance Sheet, Income Statement and Tax Items for Specified Income Years, 1970-1990, " SOI Bulletin, Vol. 12, No. 4 (Spring 1993).

Editor's note: This department is written by the AICPA Tax Division's professional staff. It is designed to heighten awareness of the Division's work and keep readers apprised of Tax Division activities involving tax policy, technical issue practice support matters.
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Article Details
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Author:Woehlke, James A.
Publication:The Tax Adviser
Date:Aug 1, 1993
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