April 29, 2005

> Hon. Connie Mack III, Chairman
>
> Hon. John Breaux, Vice Chairman
>
> The President's Advisory Panel on Federal Tax Reform
>
> 1440 New York Avenue, NW, #2100

Washington, DC 20220

Dear Chairman Mack and Vice Chairman Breaux:

> On behalf of the S Corporation Association ("S-CORP"), which
> represents a large and growing portion of more than 2.5 million
> Subchapter S businesses around the country, I want to commend you and
> your fellow panelists for your efforts to make the increasingly
> complex federal income tax code more simple and fair while enhancing
> opportunities for these companies to contribute to U.S. economic
> growth and competitiveness.
>
> As you know, Congress created the Sub S structure to promote
> entrepreneurship by linking corporate taxes to owners in the early
> 1950s; S corporations have become major success stories as a result. S
> corporations tend to be small and family-owned businesses, and have
> historically been major job-generators in virtually every industry and
> in every state of the nation.
>
> That said, these companies are severely restrained by now-outdated and
> often cumbersome rules that in many cases only apply to S
> corporations. As such, S corporations face significant business and
> administrative challenges that other corporate structures do not, and
> it is our hope that the Tax Reform Commission will work to address
> these challenges by equalizing the rules between and among S
> corporations and limited liability corporations, which have evolved
> only recently and which are not subject to many of the same
> restrictions. This is particularly important because S corporations
> cannot simply convert from their status to the more flexible operating
> status of an LLC absent enormous economic penalties. Thus, making S
> corporation rules more equitable relative to those for LLCs is
> critical, in our view and that of our members.
>
> It has been our pleasure to work in recent years with Senator Breaux,
> a longstanding champion of S corporation modernizations and supporter
> of key legislative initiatives to enhance the productivity and
> job-creating capabilities of America's S corporations.
>
> Among others, the provisions detailed below -- many of which we have
> worked on in the past with Senator Breaux and others of his colleagues
> from both the House and Senate, across the political spectrum \--
> would help greatly in putting S corporations on a more level playing
> field while also supporting the panel's goals of simplification and
> enhanced economic productivity.
>
> *Priority Provisions to Level the S Corporation "Playing Field"*
>
> **Built-in gains tax relief**
>
> Under current law, businesses that convert from C corporation status
> to S corporation status are penalized for a period of ten years if
> they sell any asset that has built-in gain as of the date of
> conversion. This "built-in gains" tax penalty makes the sale and
> reinvestment of these assets prohibitively expensive for S
> corporations, effectively forcing our businesses to retain
> unproductive and inefficient assets rather than face a double-tax
> burden. In some states, this double-tax burden (i.e., the federal and
> state corporate level built-in gains tax plus the mandatory additional
> federal and state shareholder taxes) can exceed of the gain. Clearly,
> this is unsustainable and limits the corporation's cash flow,
> liquidity, and ability to invest in order to grow the business and
> create jobs.
>
> Legislation will be introduced in the House and the Senate this year
> to reduce the 10 year holding period to 7 years. While we would
> certainly prefer the elimination of the built-in gains tax altogether,
> reducing the holding period to 7 years (in order to keep the revenue
> cost down) would be a great beginning to allow S corporations to
> access their capital and assets without an onerous double tax burden.
>
> **Modification of the passive income rules**
>
> We believe that a profit-making entity should not have to regulate the
> nature of its profits for fear of losing S status. The tax code is not
> consistent with regard to the application of the excess passive income
> sections. Corporations that elect Subchapter S status from their
> creation are not subject to these tests or their resulting tax effects
> and losing their Subchapter S status. Modifying these rules would
> improve capital formation opportunities for small businesses, preserve
> family-owned businesses and eliminate unnecessary and unwarranted
> traps for taxpayers.
>
> **Second class of debt/equity**
>
> Under current law, an S corporation is permitted to have only one
> class of debt and equity. This presents a serious problem for S
> corporations seeking venture capital. We support permitting S
> corporations to issue qualified preferred stock and debt that may be
> converted into stock of the corporation. All other entity structures
> are allowed to access such types of capital. These provisions would
> put S corporations on an equal footing.
>
> **IRA as a Permissible S Corporation Shareholder**
>
> Last year, Congress enacted legislation that permits an IRA to hold
> stock in S corporation banks. We would like to extend this provision
> to apply to all S corporations to allow S corporations to better
> protect themselves against losing their S status. For example, under
> current law, if an employee leaves the company and, unbeknownst to the
> company transfers his ownership in the company into an IRA, the
> company is at risk of losing its S corporation status.
>
> **Non-Resident Alien Shareholders**
>
> Similarly, nonresident aliens are currently not allowed to hold stock
> in S corporations. Thus, if one S corporation shareholder in a
> family-owned business were to marry a nonresident alien, the S
> corporation would be at risk of losing its status. Fixing these
> provisions of current law would significantly reduce compliance and
> administrative costs allowing S corporations to spend their capital
> and assets to grow their businesses.
>
> We appreciate your attention to the policy changes that, in our view,
> are most needed to create a tax policy regime for S corporations that
> is both fair and consistent with the regime applied to LLCs. Please do
> not hesitate to contact S-CORP if we can provide further details about
> these proposals.
>
> Sincerely,
>
> *Stephanie Silverman*
>
> Stephanie E. Silverman
>
> President and Executive Director