FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman, Ranking Member McNulty, and distinguished Members of the Subcommittee:

I am pleased to appear before you today to discuss the various proposals to reform Subchapter S of the Internal Revenue Code.

The Benefits of Subchapter S

There is little dispute that small businesses are the cornerstone of the American economy. The millions of individuals who spend their time, energy, and resources pursuing ideas, taking risks, and creating value are instrumental to job creation and the growth of our economy. The entire Administration, including the IRS and the Department of the Treasury, is committed to working closely with the small business community and its representatives to help small businesses and the self-employed understand their tax obligations, ease unnecessary restrictions, and reduce their compliance burdens.

Subchapter S is an important tool for small businesses. Enacted in 1958, Subchapter S was designed to provide small businesses organized as state law corporations with a single-layer tax system similar to that enjoyed by partnerships.

Major reforms in 1982 and 1996 moved the tax treatment of S corporations closer to that of partnerships while easing restrictions on S corporation eligibility. Among the 1996 reforms were: (1) increasing the number of S corporation shareholders from 35 to 75; (2) allowing S corporations to own subsidiaries; (3) allowing certain types of tax-exempt organizations and trusts to own S corporation stock; (4) allowing banks to elect S corporation status; (5) allowing an S corporation to create an employee stock ownership plan; (6) allowing the IRS to provide relief for late or invalid S corporation elections; and (7) exempting S corporations from the unified audit and litigation procedures.

The 1982 and 1996 reforms appear to have enabled a greater number of businesses to operate as S corporations. Between 1982 and 2000, the percentage of non-farm businesses taxed as S corporations rose from less than 4 percent to more than 11 percent. Although this trend is, in all likelihood, due in part to the significant lowering of individual tax rates, S corporation reforms certainly played an important role.

S corporations are not, however, the predominant form of entity used by small businesses. As of 2000, less than 8 percent of non-farm businesses with gross receipts under $250,000 were operating in S corporation form. The vast majority (79 percent) were operating as sole proprietorships, while the remaining 13 percent were operating as C corporations, partnerships, and limited liability companies taxed as partnerships. We believe that this is due in no small measure to the relative simplicity of operating as a sole proprietorship rather than as a partnership or S corporation.

Conversely, it also appears that the S corporation form is more attractive to larger business than to small businesses. More than 37 percent of non-farm businesses with gross receipts over $1 million are S corporations and more than 25 percent of non-farm businesses with gross receipts over $50 million are S corporations.

The relative attractiveness of S corporations will, in all likelihood, have diminished somewhat as a result of the recently-enacted Jobs and Growth bill. Doing business as an S corporation, for those businesses that qualified, offered the advantage of a single layer of tax at the shareholder level. In contrast, C corporations were taxed on their income at the corporate level, while their shareholders were taxed a second time on dividends distributed by the C corporation. By reducing the rate of tax on dividends to 15 percent, the Jobs and Growth bill has lessened (but not eliminated) the double tax on corporate income, thereby reducing (but again not eliminating) the tax advantage offered by S corporations.

Recognizing that small businesses may choose a variety of organizational forms, the Administration has chosen to focus on broad-based tax initiatives that are not dependent on organizational structure. It is our belief that tax should not play a significant role in the selection of the form in which a business chooses to operate. As a result, the President and Congress have worked together to reduce income tax rates by 3 to 5 percent and to increase the amount of investment that may be immediately deducted by small businesses from $25,000 to $100,000. In the 2001 Act, Congress phased out the death tax, allowing innovative entrepreneurs to pass the fruits of their lives’ work to their children rather than the government. These changes will benefit 23 million small business owners, approximately 2 million of which are S corporations, providing cash for further investment and job creation. In addition, several regulatory changes have been made to ease the burdens on small businesses.¹

Although these legislative and regulatory reforms have provided much needed tax relief and simplification to small businesses, the complexity of the tax laws continues to plague small business owners. Our tax laws have become devastatingly complex in recent years. Many small business owners are unprepared to deal with this complexity and do not have the resources to hire sophisticated tax counsel to advise them. Tax law compliance drains the time, energy, and financial resources of small business owners and diverts their attention from the more important goal of building a business.

It is our belief that Subchapter S remains a relatively simple, yet flexible, system in which small businesses can operate and thrive. We recognize the importance of enhancing its flexibility wherever and whenever possible. We are also concerned, however, that such flexibility should not be achieved at the cost of greater complexity. As a result, we analyze proposed changes to Subchapter S by asking whether the proposal would increase the complexity of Subchapter S and, if so, is such increased complexity more than offset by the benefits of the proposed change.

It is important to remember that Subchapter S is no longer the only way small businesses can achieve limited liability while paying only a single layer of tax. As a result of regulations issued in 1995, state law limited liability companies can now be taxed as partnerships. Many practitioners now tout the benefits of the more flexible limited liability company entity over the more restrictive S corporation entity.

Interestingly, however, between 1996 and 2000, growth in the number of S corporations has exceeded growth in the number of limited liability companies taxed as partnerships. We believe this is due in no small measure to the complexity of the partnership system compared with S corporations. Although S corporations must meet eligibility restrictions that do not apply to limited liability companies, these eligibility restrictions allow for a much simpler system of taxing S corporation income. In particular, the inordinately complex systems for determining a partner’s shares of partnership income do not apply to S corporations. In short, despite eligibility restrictions, an S corporation is perhaps the only organizational form available to small multi-member businesses that offers relative simplicity. Consequently, we hesitate to support proposals that would add additional complexity to Subchapter S.

H.R. 714, H.R. 1498, and H.R. 1896

Because of the large number of proposals included in the bills under consideration today, our testimony does not set out Treasury’s views on each provision. Instead, our testimony identifies the provisions that the Administration would not oppose on substance, and sets out our views on those provisions. To reiterate, our basic goal is to preserve the relative simplicity of Subchapter S while offering additional flexibility to businesses taxed as S corporations. We believe that these provisions are either consistent with, or not contrary to, that basic goal. We would also point out the need to exercise fiscal discipline in considering additional tax measures, and that any tax bill inclusive of these or other tax provisions should not increase the deficit further.

Allow shareholders of an S corporation to obtain the full benefit of a charitable contribution of appreciated property by the corporation (Section 11 of H.R. 714 and section 205 of H.R. 1896). In cases where an S Corporation donates appreciated property to charity, a shareholder’s basis in their S corporation stock reflects the basis of that appreciated property, whereas the amount contributed is the fair market value of the appreciated property. Under current law, an S corporation shareholder’s charitable deduction is limited to his or her stock basis. As a result, current law prevents some S corporation shareholders from obtaining the full benefit of the charitable contribution deduction. The proposal would allow an S corporation shareholder to increase the basis of their S corporation stock by the difference between the shareholder’s share of the charitable contribution deduction and the shareholder’s share of the basis of the appreciated property. This treatment is already provided to partnerships and limited liability companies. Therefore, this proposal would accomplish the twin goals of encouraging charitable giving and equalizing the treatment of S corporations and partnerships.

Permit a bank corporation’s eligible shareholders to include an IRA and allow shares held in an IRA to be purchased by the IRA owner (Section 103 of H.R. 1896). A corporation cannot elect S corporation status if its stock is held by an IRA, and income of an S corporation that is allocable to a tax-exempt entity generally is treated as unrelated business taxable income. The only exception is for employee stock ownership plans (ESOPs) which are themselves subject to special strict rules mandated by EGTRRA. In addition, an IRA owner cannot purchase assets held by the IRA without a special exemption. The proposal would permit an IRA to be a permissible shareholder of a bank S corporation. In addition, an IRA owner would be permitted to purchase S corporation shares held by the IRA without the need for a special exemption. These changes would only apply to shares held prior to enactment of the provision. This proposal would result in some additional complexity that it would be preferable to avoid. However, on balance, we believe that this complexity is outweighed by the flexibility that would be provided to IRAs currently owning bank shares. Our support, however, is explicitly conditioned on the S Corporation income earned in the IRA being treated as unrelated business taxable income. We are concerned that, if enacted, subsequent efforts will be made that would make such income not subject to UBIT (as was done in the case of ESOPs), thus eliminating any and all tax on such income.

Allow S corporation shareholders to transfer suspended losses on a divorce (Section 302 of H.R. 1896). Under current law, losses that exceed the shareholder’s basis in S corporation stock are suspended and may be carried over indefinitely and used when the shareholder acquires sufficient basis in the S corporation stock. The losses, though, cannot be transferred to another person. If, as a result of a divorce, a shareholder must transfer S corporation stock to his or her former spouse, the suspended losses associated with that stock are lost. Section 302 would remedy this unduly harsh result by allowing suspended losses to be transferred along with the S corporation stock transferred incident to divorce.

Allow beneficiaries of qualified subchapter S trusts (QSSTs) to use passive activity losses and at-risk amounts (Section 303 of H.R. 1896). Generally, the current income beneficiary of a QSST is taxed on S corporation income. Losses that flow through to the beneficiary from the S corporation may be limited under the passive activity loss or at risk rules. For most S corporation shareholders, losses that are limited under the passive activity loss or at risk rules carry over until the shareholder disposes of the activity generating the passive loss or at risk amount. At that time, the shareholder may take any remaining suspended passive activity and at-risk losses. Unfortunately, the S corporation rules provide that the QSST and not the income beneficiary is treated as the owner of the S corporation stock for purposes of determining the tax consequences of a disposition of the S corporation stock. Because the beneficiary is treated as the owner of the S corporation stock for income reporting purposes, but not for purposes of gain or loss on the disposition of S corporation stock, it is unclear whether losses flowing through to a QSST beneficiary that are suspended under the passive activity loss or at risk rules may be used on the disposition of the S corporation stock. This proposal would clarify that, for purposes of applying the passive activity loss and at risk rules, the disposition of S corporation stock by a QSST will be treated as the disposition of the stock by the income beneficiary of the QSST.

Permit an electing small business trust (ESBT) to claim an income tax deduction for any interest incurred to purchase S stock (Section 304 of H.R. 1896). This proposal would eliminate an existing distinction between an individual purchaser of S corporation stock and a trust purchaser, and would make the ESBT more attractive. Under current law, the only permissible deductions against an ESBT’s income are its administrative expenses, such as costs incurred in the management and preservation of the trust’s assets; interest incurred to acquire S corporation stock is not deductible. Treasury does not oppose this proposal, but we believe that the interest deduction should be no more generous to an ESBT purchaser of S corporation stock than the interest deduction available to an individual purchaser of that stock. We would be pleased to work with the Subcommittee to achieve that result.

Disregard unexercised powers of appointment in determining the potential current beneficiaries of an ESBT (Section 305 of H.R. 1896). This proposal would significantly improve the ESBT rules by removing a technical impediment that currently prevents many trusts from making the ESBT election. Many existing trusts grant to an individual the ability to name additional persons and entities as trust beneficiaries (for example, as substitute beneficiaries in the event of the death of a current beneficiary, or a change in circumstances that renders a current beneficiary “unworthy” of receiving benefits from the trust). Usually, the group of permissible appointees is described as an identified class of persons or entities, such as the descendants of the grantor’s grandparents or any charitable organizations. Such a class of permissible appointees has an almost unlimited number of members. Current law limits the number of shareholders of an S corporation to 75, and all of the members of the class of potential appointees count toward that 75-person limit. As a result, if an ESBT election is made for a trust that grants such a power of appointment, the S election of the corporation will be terminated, even though that power of appointment may never be exercised. This proposal would disregard such powers so long as they were not exercised.

Allow the S corporation’s charitable contributions to be deducted from its gross income (Section 307 of H.R. 1896). Under current law, an individual S corporation shareholder may claim an income tax charitable deduction for his or her share of a charitable contribution made by the S corporation. However, because of the rules regarding charitable deductions of trusts, a shareholder whose S corporation stock is held in a trust will receive no comparable tax benefit from that contribution. Section 307 would explicitly add charitable contributions to the items that can be deducted in computing the ESBT’s income tax on its S corporation income. This proposal would encourage charitable giving by S corporations and would eliminate a significant difference in the tax treatment of an S corporation’s individual and non-individual shareholders. We suggest that this Subcommittee consider expanding the application of this provision to other pass-through entities making charitable contributions. This could be accomplished by amending the trust rules to provide that trusts may deduct charitable contributions made by all types of pass-through entities in a way that is comparable to the charitable deduction available to individuals (and subject to the same limitations).

Allow banks to exclude investment securities income from passive investment income (Section 3 of H.R. 714 and section 401 of H.R. 1896). S corporations with accumulated C corporation earnings and profits are subject to a corporate-level tax on passive investment income that exceeds 25 percent of the corporation’s gross receipts for any year. Additionally, a corporation’s S corporation status is terminated if the 25 percent limit is exceeded for three consecutive years. Gross receipts derived in the ordinary course of a banking business are not considered passive investment income for this purpose. Income from investment assets, however, is treated as derived in the ordinary course of a banking business only if the investment assets are needed for liquidity or loan demand. The amount of investment assets needed for liquidity or loan demand may be subject to disagreement. This provision would eliminate this uncertainty by providing that passive investment income would not include any interest income earned by a bank, bank holding company, or qualified subchapter S subsidiary (in the case of H.R. 1896 only) or dividends on assets required to be held by such bank, bank holding company, or qualified subchapter S subsidiary (in the case of H.R. 1896 only) to conduct a banking business. We recommend that this proposal be clarified to apply only to a bank, bank holding company, or a qualified subchapter S subsidiary of a bank or a bank holding company.

Allow a bank to recapture its bad debt reserves on either its first S corporation or its last C corporation return (Section 6 of H.R. 714 and section 403 of H.R. 1896). Under current law, banks that use the reserve method of accounting are ineligible to make the S corporation election. If a bank makes an S corporation election, the bank is automatically switched to the specific charge-off method of accounting for bad debts. This change in accounting method results in recapture of the bad debt reserve over four years. The recapture of the reserve by the bank S corporation is treated as built-in gain subject to a special corporate-level tax. Under the built-in gain provisions, tax on the built-in gain must be paid both at the corporate and shareholder level in the year of recognition. In contrast, a C corporation would pay tax on the recapture amount at the corporate level but the shareholders would not have to pay tax on that amount until the C corporation paid dividends. By allowing banks to take the recapture of the bad debt reserves into account in the last C corporation year, rather than the first S corporation year, the proposal would eliminate the current imposition of a second layer of tax. This provision is similar to a provision of the Code designed to recapture LIFO reserves on the conversion of a C corporation to an S corporation. Under that provision, the LIFO recapture amount is taken into account in the year before the conversion to S corporation status, but the corporation is allowed to pay the tax on the recapture amount over 4 years. We recommend that similar principles be applied to address the recapture of bad debt reserves and would be happy to work with this Subcommittee to draft an appropriate provision.

Allow the IRS to provide relief for inadvertently invalid qualified Subchapter S subsidiary (QSub) elections and terminations (Section 501 of H.R. 1896). Section 1362(f) authorizes the Secretary to provide relief for inadvertent invalid S corporation elections and inadvertent terminations of S corporation elections. This provision has saved hundreds of taxpayers from the consequence of procedural mistakes; invalid elections and inadvertent terminations are common because S corporations and their shareholders are often unfamiliar with the technical requirements of eligibility. Under current law, however, there is no comparable relief available for QSubs. Allowing the Secretary to grant relief for inadvertent invalid QSub elections and terminations would prevent shareholders from suffering significant negative consequences for mere procedural errors.

Provide that a sale of an interest in a QSub is treated as a sale of a pro rata share of the QSub’s assets, followed by a contribution of those assets to a corporation (Section 503 of H.R. 1896). A QSub must be wholly owned by a single S corporation. Under current law, if an S corporation sells more than 20 percent of the stock of a QSub, the S corporation will recognize gain and loss on all of the assets of the QSub. The proposal would change this to align the treatment of the sale of an interest in a QSub with the treatment of the sale an interest in a limited liability company that is treated as a disregarded entity.

Eliminate the earnings and profits earned by a corporation as an S corporation prior to 1983 (Section 601 of H.R. 1896). Prior to 1983, income earned by an S corporation gave rise to earnings and profits. Concluding that it was inconsistent with the modern view of S corporations to continue to view pre-1983 S corporation income as giving rise to earnings and profits, in 1996 Congress eliminated pre-1983 earnings and profits for any corporation that was an S corporation prior to 1983, but only if the corporation was an S corporation in its first taxable year beginning after December 31, 1996. Section 601 would eliminate pre-1983 earnings and profits arising during an S corporation year, regardless of whether the corporation was an S corporation in its first taxable year beginning after December 31, 1996. In our view, relief from pre-1983 S corporation earnings and profits should not be dependent on whether the corporation continued to be an S corporation after 1996.

Allow charitable contribution carryforwards and foreign tax credit carryforwards to offset the corporate-level tax on built-in gains (Section 603 of H.R. 1896). Under current law, an S corporation may use net operating loss carryforwards and capital loss carryforwards to offset the tax on built-in gains under section 1374. It is our view that charitable contribution carryforwards and foreign tax credit carryforwards should also be available to offset section 1374 built-in gains.

Expand the number of permissible S Corporation shareholders (Section 4 of H.R.. 714 and section 104 of H.R. 1896). These proposals would increase the number of permissible S Corporation shareholders from 75 to 150. Treasury cannot support such a dramatic increase, which we believe would run counter to the goal of maintaining Subchapter S as the simplest of systems for businesses with more than one owner. Increasing the number of shareholders will, inevitably, bring increased pressure to liberalize other facets of Subchapter S which will, in turn, increase the complexity of the provisions. It is important to keep in mind that the number of permissible shareholders was more than doubled, from 35 to 75, just a few years ago. For these reasons, we urge this Subcommittee to refrain from dramatic expansion of these rules.

* * *

We believe that the proposals outlined here could provide solid technical reforms that would be faithful to the spirit of subchapter S. Consistent with the goal of subchapter S to provide simple rules for small business, these rules would decrease taxpayer burden, while offering increased flexibility. We would be pleased to work with the Committee to develop these or other S corporation reform proposals.

This concludes my prepared statement. I would be pleased to answer any questions the Subcommittee may have.

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⁽¹⁾ The Administration’s efforts to decrease burdens on small business are not limited to legislative initiatives. For example, last year, the IRS and Treasury issued a revenue procedure permitting certain businesses with gross receipts of less than $10 million to use the cash method of accounting. We expect that the revenue procedure will eliminate most disputes concerning the use of the cash method by small business taxpayers, allowing those taxpayers to focus on growth, not tax compliance. Other recently implemented burden reduction projects benefiting small businesses include:

1. Exempting 2.6 million small corporations from filing Schedules L, M-1 & M-2, reducing burden by 61 million hours annually. (April 2002)
2. Reducing the number of lines on Schedules D, Forms 1040 and 1041, resulting in estimated burden reduction of 9.5 million hours for 22.4 million taxpayers. (January 2002)
3. Eliminating the requirement for filing Part III of Schedule D (capital gains), Form 1120S for 221,000 S-Corporation taxpayers, reducing burden by almost 600,000 hours. (November 2002)

The IRS has also streamlined many of its procedures to make compliance less burdensome for small business taxpayers. A few examples include:

1. The establishment of a permanent special group to work with payroll services to resolve problems before notices are issued and penalties are assessed against the individual small businesses serviced by these bulk and batch filers. (October 2002)
2. Business filers can now e-file employment tax and fiduciary tax returns, and at the same time, pay the balance due electronically by authorizing an electronic funds withdrawal.
3. Business preparers can now e-file their clients' employment tax returns.
4. The IRS has continued to improve its Web site to offer its customers the ability to both order, and in many cases, utilize its Small Business Products online.

It is the long-term and continuing goal of the IRS and the Treasury to ease the burden of small businesses to the greatest extent practical, consistent with the law as enacted by Congress. We look forward to working with this committee on those efforts.