Testimony of
                              
              The Honorable Thomas M. Sullivan
                 Chief Counsel for Advocacy
             U.S. Small Business Administration
                              
                              
                U.S. House of Representatives
                 Committee on Small Business
       Subcommittee on Regulatory Reform and Oversight
                              
                              
                  June 27, 2006, 10:00 A.M.
          Room 2360, Rayburn House Office Building
                      Washington, D.C.
                              
        S Corporations - Their History and Challenges
                              
     Good morning Chairman Akin and Members of the
Subcommittee, I thank you for this opportunity to appear
before you today.  My name is Thomas M. Sullivan, and I am
the Chief Counsel for Advocacy at the U.S. Small Business
Administration (SBA).  The Committee invited me here today
to discuss the importance of S-corporations in the U.S.
economy, recent legislative proposals, and the Internal
Revenue Service's (IRS) audit study of S-corporations.

     Congress established the Office of Advocacy (Advocacy)
to represent the views of small business before Congress and
Federal agencies.  The Office of Advocacy is an independent
office within the SBA, and therefore the comments expressed
in this statement do not necessarily reflect the position of
the Administration or the SBA.  This statement was not
circulated to the Office of Management and Budget (OMB) for
comment.  Advocacy takes its direction from small
businesses, therefore this statement is based on the
interests and concerns communicated to us by small business
groups.

Small Business and the U.S. Economy
     Small businesses are a driving force in the U.S.
economy.  They comprise 99.7 percent of all employer firms
in the U.S., employ half of all the private sector workers,
and have generated 60 to 80 percent of the net new jobs
annually over the last decade.(1)  Small firms pay 45
percent of the total U.S. private payroll, and create about
half of the non-farm private gross domestic product.(2)
Small businesses also tend to innovate at a higher rate than
medium or large businesses,(3) producing 13 to 14 times more
patents per employee.(4)  Furthermore, small firm patents
are more likely to be driven by leading-edge technology than
large firm patents.(5)  Finally, during economic downturns,
small businesses fare better than their larger counterparts.
Increases in small business employment and self-employment
often help steer the economy out of recessions.
     
     Just as small businesses are the cornerstone of the
U.S. economy, S-corporations are the cornerstone of the
small business economy.  According to IRS Statistics of
Income for tax year 2002 there were approximately 3.1
million S-corporation returns filed, making up 59.6 percent
of all corporate returns.  S-corporations generated $3.9
trillion in annual revenue.  According to the Bureau of
Census 1997 statistics, S-corporations are the second
largest employer, employing approximately 21 million
Americans.(6)

Proposed Legislation - H.R. 4421
     S-corporations were created in 1958.  They were
developed to enhance entrepreneurial activity and to
eliminate the negative effects of double taxation
experienced by taxable corporations (C-corporations).(7)  C-
corporations are subject to double taxation because the
corporation itself is liable for income tax on its earnings,
then when dividends are distributed to the shareholders the
shareholders must pay income tax on those dividends.  To
receive favorable tax treatment, entities electing S status
must adhere to many restrictions, including:
      the number of shareholders,
    type of shareholder,
    class of stock and
    domesticity requirements for S-corporation elections.

     In the half century since the creation of S-
corporations, the U.S economy and the world's economies have
changed.  With the advent of technology, globalization of
the economy has become more of a reality.  Policymakers
considering changes to tax policy must take a broader view
that includes tax policies around the world.  To ensure
America's entrepreneurs remain competitive, in a global
marketplace, we must adopt tax policies that remove barriers
to their success.

     S-corporations are a large segment of the U.S. economy.
To ensure their continued success H.R. 4421, the "S
Corporation Reform Act of 2005," was introduced by
Congressmen Clay Shaw and Jim Ramstad.  The legislation is
intended to reform the provisions that control S-
corporations so that S-corporations can reach their full
potential.  H.R. 4421 contains provisions that are advocated
and supported by the American Institute of Certified Public
Accountants and others.

     Take the Sting out of the Sting Tax
     Current law penalizes S-corporations if they earn too
much passive investment income (this rule is commonly known
as the "sting tax").(8)  Specifically, if an S-corporation
that previously was a C-corporation has undistributed
dividends, and earns 25 percent of its gross receipts as
passive investment income, then two things will happen.
First, the S-corporation is taxed on its income at the
highest corporate rate.  Second, if the S-corporation earns
too much passive investment income for three consecutive
years, then the S election is terminated all together.  The
result is that the S-corporation becomes subject to double
taxation.  Double taxation is the penalty for earning too
much of the wrong type of income (i.e. passive investment
income) and/or earning that income too often, thus
eliminating the purpose for electing S status.

     The sting tax is out of step with today's tax
provisions.  Tax policy has been moving away from double
taxation and toward a system of single taxation.  C-
corporations which are subject to double taxation have not
been growing as rapidly as entities that are not subject to
a single layer of tax (theses entities are commonly known as
passthrough entities).(9)  The sting tax was created to
mirror rules that applied to C-corporations that were
personal holding companies (PHC).  PHCs are no longer
prohibited from generating passive investment income from
gain on the sale of stock or securities.  Additionally, PHCs
are permitted to earn up to 60 percent of their gross
revenue as passive investment income.  The sting tax does
not affect other passthrough entities, such as partnerships
and limited liability companies.  This puts S-corporations
at a competitive disadvantage with other passthrough
entities.  S-corporations that were previously C-
corporations should not suffer harsher treatment simply
because they earn the wrong type of income.  H.R. 4421 seeks
to remedy this inequity by reforming the sting tax.

     In addition to the disparate treatment S-corporations
receive as compared to PHCs, the sting tax has other
negative effects.  Small and family-owned businesses are
often not aware of the sting tax.  Thus, the sting tax
punishes the unwary.  Small business owners have many laws
and regulations to be aware of as they conduct their
business.  Our tax code should not set up traps for the
unwary.

     All These Restrictions - How Can We Grow?
     Under current law, S-corporations can have only one
class of stock, debt can not be converted to stock, and
shareholders can neither be a nonresident alien nor an
individual retirements account (IRA).  In today's business
environment, these restrictions build unique barriers for
planning for the future of the family business, and restrict
the S-corporation's access to capital.  H.R. 4421 would
remove these restrictions.

     It is common to plan for the next generation of
leadership of a family business, by issuing preferred shares
to the generation that is leaving the business as a means to
provide for their retirement and their orderly withdrawal
from the enterprise.  However, because S-corporations may
not have more than one class of stock, this practice is
prohibited.  Thus, family owned businesses must incur
additional expense to ensure that the retiring generation is
provided for.  Prohibiting nonresident aliens and IRAs from
being shareholders adds to the complicated planning.  H.R.
4421 would allow S-corporations to issue qualified preferred
stock which will enhance succession planning for many small
family-owned businesses.

     America's families are changing.  It is not uncommon
for today's American family to include nonresident aliens.
When an S-corporation's related shareholders include a
nonresident alien, it faces additional planning to ensure
that the nonresident alien is provided for and that the S
election is not violated.  Both chambers of Congress are
working diligently to take the bite out of estate planning;
the reforms in H.R. 4421 enhance those efforts.

     H.R. 4421 recognizes the need to enhance the growth
potential for S-corporations by removing outdated
restrictions.  Provisions of H.R. 4421 would remove the
limit on one class of stock, the prohibition against debt
convertible to stock, and would permit nonresident aliens
and IRAs to be shareholders of an S-corporation.  Together
these provisions decrease the complexity of planning for the
future of the small family business and increase the growth
potential of S-corporations by removing barriers to access
to capital.
     
     Everyone Makes Mistakes
     To have a valid S election the electing corporation and
its shareholders must take the necessary steps to perfect or
complete the election within a specified period of time.  If
the election is not timely completed or is defective, the
Treasury Secretary may excuse the imperfection if the
electing corporation and its shareholders take the necessary
steps to ensure the S election requirements are met.
Obtaining an excuse for an imperfect election is not
guaranteed.  Additionally, the time period that is covered
by the excuse is not certain.  H.R. 4421 recognizes that not
every taxpayer is savvy, nor represented by sophisticated
tax counsel.  The bill provides additional protection for
invalid elections or terminations of an S election.
Specifically, H.R. 4421 permits the Treasury Secretary to
extend the excuse for an invalid election or inadvertent
termination of an election for a period of time that covers
tax years for which a refund or credit has not expired.
     
     The importance of this protection is amplified when
there is an attempted acquisition of an S-corporation.
Acquiring a business requires a high degree of due
diligence.  One area that must be investigated when
attempting to acquire an S-corporation is whether the S
election has always been valid.  Without this assurance, an
acquirer takes the risk that the rules against passive
investment income (and other rules) may increase the cost of
their investment.  Having the assurance that an inadvertent
violation of the S rules is not fatal to the S election will
limit the risk a potential acquirer must consider when
purchasing an S-corporation.

IRS National Research Program (NRP)
     In February 2006, the IRS announced the results of its
tax year 2001 NRP study of high wealth individuals and small
businesses that file Schedule C.  The results of the NRP
indicate that there is a net tax gap of approximately $290
billion.(10)  The tax gap is defined as the difference
between what taxpayers owe and pay on time and what actually
gets paid on a timely basis.  The net tax gap is the
remaining gap after IRS enforcement actions and other late
payments are made.  The IRS reported the study results and
attributed the majority of the tax gap to small businesses
which file Schedule C, despite not having updated data on
other types of taxpayers such as partnerships and C-
corporations.

     On July 25, 2005, the IRS announced its plans to
conduct an NRP compliance audit study of 5,000 S-corporation
returns from tax years 2003 and 2004.  Commissioner Mark
Everson justified this new study based on the fact that the
number of S-corporations has grown between 1985 and 2002
from approximately 724,000 corporations to about 3.1 million
corporations.  S-corporations only account for approximately
19 percent of corporate revenue.(11)  Along with auditing
the S-corporation returns, the IRS plans to audit all
returns of S-corporation shareholders with 20 percent or
more ownership interest in the corporation under audit.  The
small business community is concerned they are the only
sector that is being subjected to an in-depth audit study.
The Office of Advocacy shares small business' concerns.
     
     America's small businesses succeed because of their
ingenuity and innovation.  Research sponsored by Advocacy
continues to show that the cost of tax compliance is 67
percent higher in small firms than in large firms.(12)
Facing an audit increases the costs of tax compliance by
requiring business owners to incur the expense of
representation and it takes time away from their business to
answer IRS inquiries.  Small businesses take their
responsibility to pay their fair share of taxes seriously.
No one wants to defend those that deliberately cheat the
system.  However, IRS' approach may punish those that
voluntarily comply with the law, based on the failures of
those that do not.
     
     In summary, small businesses have a long history of
contributing greatly to the American economy.  S-
corporations play a critical role in keeping the economy
strong.  To ensure their continued success, government has
to be wary of taking steps that may stifle the
entrepreneurial growth of S-corporations.  Legislation
introduced to reform S-corporation provisions should be
based on tax policy that enhances entrepreneurial
competitiveness H.R. 4421 accomplishes this.  As the IRS
strengthens tax compliance efforts, attention should be
given to why taxpayers become noncompliant so that
recommendations are tailored to meet those challenges.

     Thank you for allowing me to present these views.  I am
happy to answer any questions.

ENDNOTES

1.  Frequently Asked Questions, Office of Advocacy, U.S.
Small Business Administration, 2006, available at
http://www.sba.gov/advo/stats/sbfaq.pdf.
2.  Joel Popkin and Company, Small Business Share of NAICS
Industries, study funded by the Office of Advocacy, U.S.
Small Business Administration (2002), available at
http://www.sba.gov/advo/research/rs218tot.pdf.
3.  U.S. Small Business Administration, The State of Small
Business: A Report to the President (2005).
4.  CHI Research, Inc., Small Serial Innovators: The Small
Firm Contribution to Technical Change, study funded by the
Office of Advocacy, U.S. Small Business Administration
(2003), available at www.sba.gov/advo/research/rs225tot.pdf.
5.  Id.
6.  Table 7.  Statistics for All U.S. Firms by Major
Industry Group and Legal Form of Organization: 1997.  This
is the most recent data available.  Data for 2002 is
expected to be released before the end of the year.
7.  Other legal forms of taxpayers that are subject to a
single layer of tax, such as partnerships and limited
liability companies, are commonly known as passthrough
entities.  Generally, this means that the entity itself is
not taxed on its earnings, but the owners of the entity must
report the earnings on their personal income tax return.
8.  Internal Revenue Code section 1362(d)(3)(C) defines
passive investment income as receipts derived from rents,
royalties, dividends, interest, annuities and gains from the
sale of stock or securities.
9.  IRS Statistics of Income; S Corporation Returns, 2002
(from 1986 to 2002 C-corporation returns have declined on
average 1.3 percent annually).
10. IRS Updates Tax Gap Estimates, 2006 TNT 31-6 (February
15, 2006).
11. Id. note 9.
12. The Impact of Regulatory Costs on Small Firms, Crain, W.
M., September 2005, U.S. Small Business Administration,
Office of Advocacy (SBHQ-03-M-0522), available at
http://www.sba.gov/advo/research/rs264tot.pdf (tax
compliance cost large firms $780 per employee).