AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
WRITTEN TESTIMONY SUBMITTED TO THE
& MEANS SUBCOMMITTEE ON SELECT REVENUE MEASURES
HEARING ON S CORPORATION MODERNIZATION
JUNE 19, 2003
The American Institute of Certified Public Accountants (AICPA) appreciates the time and effort invested by the House Ways & Means Subcommittee on Select Revenue Measures to explore the need to modernize Subchapter S of the Internal Revenue Code. We strongly believe that such a need exists and offer below our thoughts and suggestions on H.R. 1896, The Subchapter S Modernization Act of 2003, which we generally support.
Sections 101 and 104
Sections 102, 201, and 202
Sections 103, 401, 402, and 403
Sections 203 and 204
Sections 304, 305, 306, 307
Elimination of LIFO Recapture Tax
The Small Business Job Protection Act of 1996 and subsequent legislation has been very helpful in facilitating the use of S corporations. However, a number of additional reform measures are needed to: (1) clarify or correct existing legislation, or (2) recognize and remove the anti-competitive limitations on the growth of existing S corporations. Many of the needed changes have been addressed in the above-mentioned bill, but some have not.
H.R. 1896, The Subchapter S Modernization Act of 2003
Sections 101 and 104 : Members of family treated as 1 shareholder; Increase in number of eligible shareholders to 150. Both Sections 101 and 104 increase the number of permissible shareholders in an S corporation. Section 101 accomplishes this by providing that under certain circumstances, all members of a family are treated as a single shareholder. Section 104 simply increases the numeric limit.
We believe that an increase in the limit on the number of shareholders either numerically or through attribution to make Subchapter S more broadly available is generally a good policy. However, Section 101 is fairly complex and its benefits are narrower in scope relative to Section 104. It is not uncommon for a corporation to exceed the current limitation on the number of shareholders as a result of employee ownership; thus, while we are supportive of both provisions, we believe that Section 104 should be given precedence over Section 101. If an increase in the permissible number of shareholders to 150 does not meet the needs of those interested in the family shareholder provision, we suggest that the number be increased as appropriate, or in the alternative, that the limit on the number of eligible shareholders be removed entirely.
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Sections 102, 201 and 202 : Nonresident aliens allowed to be shareholders; Issuance of preferred stock permitted; Safe harbor expanded to include convertible debt. Each of these provisions is important because they would fundamentally change the way some S corporations raise funds to expand operations, hire employees, and expand research capacity for new product development. S corporations would find it easier to attract needed capital without complex structuring or loss of S status. To help achieve this goal, proposed Section 202(a) should be expanded to ensure that a loan from a venture capital firm or similar business can qualify for the straight debt safe harbor, even if such firm is primarily engaged in making equity investments.
Allowing nonresident aliens to be S corporation shareholders, or even holders of qualified preferred stock as defined in proposed Section 201(a), would eliminate a financing barrier that would have little cost to the government due to the extension of the partnership withholding rules, yet would help border state (and other) S corporations tremendously.
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Sections 103, 401, 402 and 403: Expansion of bank S corporation eligible shareholders to include IRAs; Exclusion of investment securities income from passive income test for bank S corporations; Treatment of qualifying director shares; Recapture of bad debt reserves. The AICPA generally supports these provisions.
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Sections 203 and 204: Repeal of excessive passive investment income as a termination event; Modifications to passive income rules. Termination of an S election simply because (1) the corporation has earnings and profits remaining from its history as a C corporation, regardless of whether the E&P was generated from passive income of the type prohibited by IRC section 1375, and (2) it earns too much passive income too often, does not further any rational policy goal. Consistent with the personal holding company (PHC) rules of section 541 of the Internal Revenue Code and following, the only penalty for generating the "wrong" kind of income should be an additional tax on the prohibited income, assuming a penalty must be imposed at all. Terminating the S election would be paramount to a double penalty that simply is not warranted. Repealing this terminating event will simplify the Code and S corporation record keeping.
Increasing to 60 percent of gross receipts the amount of passive investment income an S corporation may receive without being subject to the passive investment income tax further and appropriately conforms this tax to the PHC regime. Additionally, we support the removal of capital gains on the sale of stocks and securities from the category of passive investment income, which hasn't been a part of the PHC regime for about 40 years.
We also suggest that IRC section 1375(a) be changed to lower the tax rate on passive investment income to 15 percent, rather than tying it to the highest rate in IRC section 11(b). We believe this was an oversight in recently enacted Section 302(e) of the Jobs and Growth Tax Relief and Reconciliation Act1, where the rates for both the PHC and the accumulated earnings tax were similarly reduced.
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Section 205: Adjustment to basis of S corporation stock for certain charitable contributions. We strongly support Section 205, which allows a stock basis increase for appreciated property contributed to a charity by an S corporation. Under current law, the Internal Revenue Service's position is that an S corporation shareholder must reduce his or her basis in the S corporation by the amount of any charitable contribution deduction flowing through from the S corporation to the shareholder. Thus, if an S corporation claims a fair market value deduction for a contribution of appreciated property, the S corporation shareholder must reduce his or her basis in the S corporation by such value. In the case of a partnership, the Internal Revenue Service has ruled that a partner's basis in his or her partnership interest should be reduced by his or her pro rata share of the partnership's basis in the property contributed. We believe that partnerships and S corporations should be treated similarly with respect to charitable contributions of property. Allowing a stock basis increase for appreciated property contributed to a charity by an S corporation would produce such a result and have the effect of preserving the intended benefit of a fair market value deduction for the contributed appreciated property, without recognition of the appreciation upon a subsequent sale of the stock. Section 205 would encourage charitable giving and remove a trap for unwary taxpayers who do not realize that gifting appreciated property through an S corporation effectively results in recognition of the gain inherent in the property when the stock of the S corporation is disposed of in a taxable transaction.
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Section 301: Treatment of losses to shareholders. Subsection (a) provides that when an S corporation shareholder recognizes a loss upon the liquidation of the corporation, the portion of the loss that does not exceed the ordinary income basis of the shareholder's stock in the S corporation shall be treated as an ordinary loss. This provision appears to have the objective of allowing a shareholder to claim an ordinary loss upon liquidation of an S corporation to the extent that his or her basis in the S corporation is attributable to amounts reported as ordinary income as a result of the complete liquidation. This provision is certainly taxpayer favorable, because an ordinary loss can offset ordinary income, which is generally subject to tax at a significantly higher rate as compared to capital gain income, and is also not subject to the limitations on the use of capital losses. However, it is important to note that the provision may have the effect of overriding certain ordinary income provisions that were enacted to address concerns about receiving capital gains benefits for amounts previously claimed as ordinary deductions (e.g., depreciation recapture under IRC section 1245).
Subsection (b) clarifies that a shareholder's ability to deduct suspended passive activity losses in any given year is not dependent on the fact that an S corporation is generally not permitted to carry items forward or back. This provision should be enacted, as it will reduce litigation regarding the use of passive activity losses upon conversion to S status.2
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Section 302: Transfer of suspended losses incident to divorce. IRC section 1366(d)(2) treats a shareholder's portion of S corporation suspended losses as incurred by the corporation with respect to that shareholder in the succeeding tax year. Under regulation section 1.1366–2(a)(5), the suspended losses are personal to a shareholder and cannot, in any manner, be transferred to another person. Thus, if a shareholder transfers 100 percent of his or her stock, his or her suspended losses are permanently disallowed. Accordingly, if, under IRC section 1041(a)(2), a shareholder transfers all of his or her stock in an S corporation to his or her former spouse as a result of divorce, any suspended losses or deductions with respect to such stock cannot be used by the spouse and, thus, disappear. This result is inequitable, unduly harsh, and needlessly complicates property settlement negotiations.
We support Section 302 because it allows for the transfer of a pro rata portion of the suspended losses when S corporation stock is transferred, in whole or in part, incident to divorce. We further support the expansion of Section 302 to cover all IRC section 1041 transfers to encourage legitimate tax-free transactions between spouses.
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Section 303: Use of passive activity loss and at-risk amounts by qualified subchapter S trust income beneficiaries. IRC section 1361(c)(2) limits the types of trusts permitted to be S corporation shareholders. A qualified subchapter S trust (QSST) is one such permitted shareholder. For purposes of the IRC section 678(a) grantor trust rules, IRC section 1361(d)(1)(B) treats the QSSTs current income beneficiary as the owner of the portion of the trust consisting of S corporation stock. In effect, this causes the S corporation's items of income, loss, deduction and credit to flow directly to the income beneficiary.
When the QSST disposes of the S corporation stock, however, regulation section 1.1361–1(j)(8) treats the QSST, and not the income beneficiary, as the owner of the stock for purposes of determining and attributing the tax consequences of the disposition. This regulation is troublesome when the income beneficiary's flow-through losses are suspended under the IRC section 469 passive activity loss rules. Under IRC section 469(g), these suspended losses are freed up when a taxpayer's entire interest in a passive activity is transferred to an unrelated person in a fully taxable transaction. Because the income beneficiary is the taxpayer who is entitled to the suspended passive losses under the Code, but the trust is the taxpayer bearing the tax consequences of the gain on the stock sale under the regulations, current law is unclear about whether the QSST, the income beneficiary, or neither benefits from the suspended losses after the QSST disposes of the S stock. A similar problem arises where the losses are suspended under the IRC section 465 at-risk rules.
Section 303 treats the income beneficiary as the taxpayer that disposes of the stock and thus enables the beneficiary to utilize the suspended passive losses at least when the disposition of the S corporation stock represents a disposition of the beneficiary's entire passive activity. It also has the effect of increasing the income beneficiary's at-risk amount with respect to the S activity by the amount of gain recognized by the QSST on a disposition of S stock.
The AICPA supports this provision because the suspended losses would be freed up and utilized at the income beneficiary level and the QSST would have the proceeds of the sale to pay tax on the gain.
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Sections 304, 305, 306 and 307: Deductibility of interest expense incurred by an ESBT to acquire S corporation stock; Disregard unexercised powers of appointment in determining potential current beneficiaries of ESBT; Clarification of ESBT distribution rules; Allowance of charitable contributions deduction for electing small business trusts. Under IRC section 641(c)(2)(C), the S portion of an ESBT's taxable income is computed taking into account only (1) items required to be taken into account under IRC section 1366; (2) gains or losses from the disposition of S corporation stock; and (3) to the extent provided in regulations, state and local income taxes or administrative expenses allocable to items (1) or (2).
Current regulations provide that interest expense incurred by an ESBT to acquire stock in an S corporation is allocable to the S portion of the trust, but is not deductible because it is not an administrative expense of the trust. While the position taken in the regulations may be technically supportable, tax policy cannot support this result. All other taxpayers are entitled to deduct interest incurred to acquire an interest in a passthrough entity and to disallow an ESBT a deduction for such interest is patently unfair. There is no indication that Congress intended to place ESBTs at a disadvantage relative to other taxpayers. Section 304 appropriately remedies this significant problem, greatly reducing the barriers to using these family trusts. We note, however, that a retroactive effective date should be applied to this provision to enable interest deductions on amended returns of taxpayers unaware of this trap at the time they structured purchases of such stock.
In addition, the current definition of "potential current beneficiary" is generally troublesome. In the context of powers of appointment, typical provisions in such trusts, such definition literally threatens the very use of ESBTs as S corporation shareholders. A typical example of the problem it creates follows:
M creates a trust for the benefit of A. A also has a current power to appoint income or principal to anyone except A, A's creditors, A's estate, and A's estate's creditors. The potential current beneficiaries of the trust will be A, and all other persons except for A's creditors, A's estate, and A's estate's creditors. This number will clearly exceed the numerical shareholder limit, whether it remains at 75 or increases to any finite number.
Section 305 removes the instability and trepidation of using ESBTs that contain powers of appointment to plan for the succession of family-owned S corporations. Nevertheless, we question whether there exists a need for eligibility restrictions on using ESBTs since the ESBT is taxed at the highest marginal rate, currently 35 percent, thus minimizing abuse to which they might otherwise be susceptible.
Section 306 conforms the ESBT distribution rules as they apply to the S and non-S portions of this unique trust to normal Subchapter J concepts regarding the treatment of separate shares.
It appears that Section 307 is intended to allow the S portion of an ESBT to claim a charitable contribution deduction for gifts of S corporation stock. It is unclear as to whether or not Section 307 accomplishes this and we believe that it may be necessary to modify the language to ensure the desired result and avoid unanticipated results. We would be happy to work with you in drafting appropriate revisions to this language.
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Section 309: Back to back loans as indebtedness. The AICPA strongly supports Section 309. This provision removes a significant trap for the unwary, especially shareholders of small S corporations. IRC section 1366(d)(1) limits the amount of a shareholder's pro rata share of corporate losses that may be taken into account to the sum of (1) the basis in the stock, plus (2) the basis of any shareholder loans to the S corporation. The debt must run directly to the shareholder for the shareholder to receive basis for this purpose; the creditor may not be a person related to the shareholder. It is not uncommon for the shareholders of an S corporation to own related entities. Often times, loans are made among these related entities. Under current law, it is extremely difficult for the shareholders of an S corporation to restructure these loans in order to create basis in the S corporation against which losses of the S corporation may be claimed. The ability to create loan basis through the restructuring of related party loans has been the subject of substantial litigation and is an area of much uncertainty. Section 309 will protect these taxpayers from an unfair and unwarranted fate by providing that true indebtedness from an S corporation to a shareholder increases IRC section 1366(d) basis, irrespective of the original source of the funds to the corporation.
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Section 501: Relief from inadvertently invalid qualified subchapter S subsidiary (QSub) elections and terminations. Under IRC section 1362(f), the IRS has authority to grant relief if a taxpayer inadvertently terminates its S corporation election or inadvertently makes an invalid S corporation election. The proposed QSub regulations would have allowed taxpayers to seek similar relief in the case of inadvertent terminations of QSub status. However, the final QSub regulations eliminated this relief because of IRS concerns about the scope of its statutory authority. It is virtually certain that taxpayers will inadvertently make invalid QSub elections or terminate QSub status. Section 501 will be very helpful because it permits the Service appropriate discretion to grant relief in such cases, applying standards similar to those currently used in the case of inadvertently invalid S corporation elections and terminations.
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Section 503: Treatment of the sale of interest in a qualified subchapter S subsidiary. Under current law, an S corporation may be required to recognize 100 percent of the gain inherent in a QSub's assets if it sells anywhere between 21 and 100 percent of the QSub stock. Many taxpayers that sell less than 100 percent will be unpleasantly surprised by this trap for the unwary. This result is counter to sound tax policy because the S corporation, in effect, is required to recognize gain on assets without making any disposition of those assets. The QSub regulations include an example suggesting that this result can be avoided by merging the QSub into a single member LLC prior to the sale, then selling an interest in the LLC (as opposed to stock of the QSub). The law should be simplified to remove this trap and to eliminate needless restructuring to avoid an inappropriate tax result. Section 503 causes an appropriate percentage of gain to be recognized while removing the complicated and needless restructuring requirement.
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Section 504: Exception to application of the step transaction doctrine for restructuring in connection with making qualified subchapter S subsidiary elections. The intent of Congress seemed clear in 1996 when it explained "[U]nder the provision, if an election is made to treat an existing corporation…as a qualified subchapter S subsidiary, the subsidiary will be deemed to have liquidated under IRC sections 332 and 337 immediately before the election is effective."3 This "guarantee" of tax-free QSub elections is expected by S corporation taxpayers who are not accustomed to the complex judicial doctrines of Subchapter C and, if respected, would eliminate a trap created from the Service's interpretation of the statute. We note that while there may be technical justification for application of the step transaction doctrine, congressional intent, simplicity concerns inherent in S corporations, and the fact that most S corporation taxpayers would unintentionally subject their transactions to significant and avoidable taxation, warrants the statutory clarification proposed in Section 504.
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Section 601: Elimination of all earnings and profits attributable to pre–1983 years. Section 1311 of the Small Business Job Protection Act of 1996 eliminated certain pre–1983 earnings and profits of S corporations that had S corporation status for their first tax year beginning after December 31, 1996. This provision should apply to all corporations (C and S) with pre–1983 S earnings and profits without regard to when they elect S status. There seems to be no policy reason why the elimination was restricted to corporations with an S election in effect for their first taxable year beginning after December 31, 1996.
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Section 602: No gain or loss on deferred intercompany transactions because of conversion to S corporation or qualified subchapter S subsidiary. We support this provision because it is consistent with the policy behind the consolidated return provisions relating to intercompany transactions, which is that the gain should be deferred until property leaves the economic unit consisting of the consolidated group. Simply electing S corporation or QSub status should not cause a triggering of these gains. We note, however, that a modification to IRC section 1374, relating to the built-in gain tax, may be warranted to ensure that such gains do not inappropriately escape corporate level taxation.
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Other Legislative Recommendations
H.R. 1896, if enacted, would address many of the issues currently faced by S corporations and corporations desiring to elect S corporation status. However, there are other concerns that are not addressed by the legislation. Two of these concerns are discussed below.
Elimination of LIFO Recapture Tax. Often times the most significant hurdle faced by a corporation desiring to elect S corporation status is the LIFO recapture tax under IRC section 1363(d). In many cases, this tax makes it cost-prohibitive for a corporation to elect S status. The LIFO recapture tax was enacted in 1987 in response to concerns that a taxpayer using the LIFO method of accounting, upon conversion to S corporation status, would avoid corporate level tax on LIFO layers established while the corporation was a C corporation. While this may be a legitimate policy concern, to require the inclusion of the LIFO reserve into income upon conversion to S status to address this concern appears unwarranted. We recommend that IRC section 1363(d) be repealed and that IRC section 1374 be amended to provide that the ten year recognition period not apply with respect to any LIFO inventory held by a corporation on its date of conversion to S status.
Expansion of post-termination transition period to include filing of amended return. We also suggest that the post-termination transition period of IRC section 1377(b)(1) be expanded to include the filing of an amended return for an S year. We recognize that there is no statutory provision permitting the filing of an amended return; such a return is a "creature of administrative origin and grace." If it is not possible to codify the above recommendation, the bill should require the Secretary of the Treasury to prescribe this result by regulation. To prevent abuses, it may be advisable to limit the amount of losses that may be taken into account under IRC section 1366(d)(3) and the amount of distributions that may be taken into account under IRC section 1371(e) to the net increase in a shareholder's basis resulting from the adjustments made on the amended return giving rise to the post-termination transition period.
Ability to elect fiscal years. We recognize the difficulties—particularly in today's economic environment—for start-up businesses to make it through the first several years of their existence. A very substantial percentage of those new businesses are S corporations. One of the barriers to efficient operation of these start-ups is the artificial requirement that, generally, all such new S corporations (and partnerships) must use a calendar year as their tax year, regardless of what their "natural" business year would be.
Therefore, we would like to call your attention to, and express our appreciation for, the efforts of Congressman Shaw, to promote legislation that proposes to give most small business start-ups an additional tool to successfully navigate its start-up life cycle by providing the flexibility to adopt any fiscal year-end from April through December. Such flexibility would (1) allow start-ups to spread their workloads and ease recordkeeping burdens; (2) maximize their access to professional advisors; and (3) provide them with additional operating resources. With the continued interest that small businesses have in electing S corporation status and with the important progress S corporations will achieve with the enactment of the H.R. 1896 provisions, allowing S corporations fiscal year flexibility will likewise enhance small business survival.
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Thank you for taking the time to request and consider our input as a part of today's hearing on S Corporation Modernization. The AICPA would be happy to work with this Subcommittee and its staff as it explores the possibility of moving these important changes forward. You may contact Robert Zarzar, Chair of the Tax Executive Committee at (202) 414–1705; Kenneth N. Orbach, Chair of the S Corporation Taxation Technical Resource Panel at (561) 297–2779; or Marc A. Hyman, AICPA Technical Manager at (202) 434–9231.