II

106TH CONGRESS

1ST SESSION S. 1415

To amend the Internal Revenue Code of 1986 to provide for S corporation

reform, and for other purposes.

IN THE SENATE OF THE UNITED STATES

JULY 22, 1999

Mr. HATCH introduced the following bill; which was read twice and referred

to the Committee on Finance

A BILL

To amend the Internal Revenue Code of 1986 to provide

for S corporation reform, and for other purposes.

1 Be it enacted by the Senate and House of Representa2 tives of the United States of America in Congress assembled,

3 SECTION 1. SHORT TITLE; AMENDMENT OF 1986 CODE;

4 TABLE OF CONTENTS.

5 (a) SHORT TITLE.—This Act may be cited as the

6 ‘‘Subchapter S Revision Act of 1999’’.

7 (b) AMENDMENT OF 1986 CODE.—Except as other8 wise expressly provided, whenever in this Act an amend9 ment or repeal is expressed in terms of an amendment

10 to, or repeal of, a section or other provision, the reference
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1 shall be considered to be made to a section or other provi2 sion of the Internal Revenue Code of 1986.

3 (c) TABLE OF CONTENTS.—The table of contents is

4 as follows:

Sec. 1. Short title; amendment of 1986 code; table of contents.

TITLE I—ELIGIBLE SHAREHOLDERS OF AN S CORPORATION

Sec. 101. Members of family treated as 1 shareholder.

Sec. 102. Nonresident aliens allowed to be shareholders.

TITLE II—QUALIFICATION AND ELIGIBILITY REQUIREMENTS OF

S CORPORATIONS

Sec. 201. Issuance of preferred stock permitted.

Sec. 202. Safe harbor expanded to include convertible debt.

Sec. 203. Repeal of excessive passive investment income as a termination event.

Sec. 204. Repeal of passive income capital gain category.

Sec. 205. Allowance of charitable contributions of inventory and scientific property.

Sec. 206. C corporation rules to apply for fringe benefit purposes.

TITLE III—TAXATION OF S CORPORATION SHAREHOLDERS

Sec. 301. Treatment of losses to shareholders.

TITLE IV—EFFECTIVE DATE

Sec. 401. Effective date.

5 TITLE I—ELIGIBLE SHARE6 HOLDERS OF AN S CORPORA7 TION

8 SEC. 101. MEMBERS OF FAMILY TREATED AS 1 SHARE9 HOLDER.

10 Paragraph (1) of section 1361(c) (relating to special

11 rules for applying subsection (b)) is amended to read as

12 follows:

13 ‘‘(1) MEMBERS OF FAMILY TREATED AS 1

14 SHAREHOLDER.—
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1 ‘‘(A) IN GENERAL.—For purpose of sub2 section (b)(1)(A)—

3 ‘‘(i) except as provided in clause (ii),

4 a husband and wife (and their estates)

5 shall be treated as 1 shareholder, and

6 ‘‘(ii) in the case of a family with re7 spect to which an election is in effect

8 under subparagraph (E), all members of

9 the family shall be treated as 1 share10 holder.

11 ‘‘(B) MEMBERS OF THE FAMILY.—For

12 purpose of subparagraph (A)(ii), the term

13 ‘members of the family’ means the lineal de14 scendants of the common ancestor and the

15 spouses (or former spouses) of such lineal de16 scendants or common ancestor.

17 ‘‘(C) COMMON ANCESTOR.—For purposes

18 of this paragraph, an individual shall not be

19 considered a common ancestor if, as of the later

20 of the effective date of this paragraph or the

21 time the election under section 1362(a) is

22 made, the individual is more than 6 generations

23 removed from the youngest generation of share24 holders.
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1 ‘‘(D) EFFECT OF ADOPTION, ETC.—In de2 termining whether any relationship specified in

3 subparagraph (B) or (C) exists, the rules of

4 section 152(b)(2) shall apply.

5 ‘‘(E) ELECTION.—An election under sub6 paragraph (A)(ii)—

7 ‘‘(i) must be made with the consent of

8 all shareholders,

9 ‘‘(ii) shall remain in effect until termi10 nated, and

11 ‘‘(iii) shall apply only with respect to

12 1 family in any corporation.’’.

13 SEC. 102. NONRESIDENT ALIENS ALLOWED TO BE SHARE14 HOLDERS.

15 (a) NONRESIDENT ALIENS ALLOWED TO BE SHARE16 HOLDERS.—

17 (1) IN GENERAL.—Paragraph (1) of section

18 1361(b) (defining small business corporation) is

19 amended—

20 (A) by adding ‘‘and’’ at the end of sub21 paragraph (B),

22 (B) by striking subparagraph (C), and

23 (C) by redesignating subparagraph (D) as

24 subparagraph (C).
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1 (2) CONFORMING AMENDMENTS.—Paragraph

2 (4) and (5)(A) of section 1361(c) (relating to special

3 rules for applying subsection (b)) are each amended

4 by striking ‘‘subsection (b)(1)(D)’’ and inserting

5 ‘‘subsection (b)(1)(C)’’.

6 (b) NONRESIDENT ALIEN SHAREHOLDER TREATED

7 AS ENGAGED IN TRADE OR BUSINESS WITHIN UNITED

8 STATES.—

9 (1) IN GENERAL.—Section 875 is amended—

10 (A) by striking ‘‘and’’ at the end of para11 graph (1),

12 (B) by striking the period at the end of

13 paragraph (2) and inserting ‘‘, and’’, and

14 (C) by adding at the end the following new

15 paragraph:

16 ‘‘(3) a nonresident alien individual shall be con17 sidered as being engaged in a trade or business

18 within the United States if the S corporation of

19 which such individual is a shareholder is so en20 gaged.’’

21 (2) APPLICATION OF WITHHOLDING TAX ON

22 NONRESIDENT ALIEN SHAREHOLDERS.—Section

23 1446 (relating to withholding tax on foreign part24 ners’ share of effectively connected income) is

25 amended by redesignating subsection (f) as sub-
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1 section (g) and by inserting after subsection (e) the

2 following new subsection:

3 ‘‘(f) S CORPORATION TREATED AS PARTNERSHIP,

4 ETC.—For purposes of this section—

5 ‘‘(1) an S corporation shall be treated as a

6 partnership,

7 ‘‘(2) the shareholders of such corporation shall

8 be treated as partners of such partnership; and

9 ‘‘(3) any reference to section 704 shall be treat10 ed as a reference to section 1366.’’

11 (3) CONFORMING AMENDMENTS.—

12 (A) The heading of section 875 is amended

13 to read as follows:

14 ‘‘SEC. 875. PARTNERSHIPS; BENEFICIARIES OF ESTATES

15 AND TRUSTS; S CORPORATIONS.’’

16 (B) The heading of section 1446 is amend17 ed to read as follows:

18 ‘‘SEC. 1446. WITHHOLDING TAX ON FOREIGN PARTNERS’

19 AND S CORPORATION SHAREHOLDERS’

20 SHARE OF EFFECTIVELY CONNECTED IN21 COME.’’

22 (4) CLERICAL AMENDMENTS.—

23 (A) The item relating to section 875 in the

24 table of sections for subpart A of part II of
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1 subchapter N of chapter 1 is amended to read

2 as follows:

‘‘Sec. 875. Partnerships; beneficiaries of estates and trusts; S corporations.’’

3 (B) The item relating to section 1446 in

4 the table of sections for subchapter A of chap5 ter 3 is amended to read as follows:

‘‘Sec. 1446 Withholding tax on foreign partners’ and S corporation shareholders’ share of effectively connected income.’’

6 (C) PERMANENT ESTABLISHMENT OF

7 PARTNERS AND S CORPORATION SHARE8 HOLDERS.—Section 894 (relating to income af9 fected by treaty) is amended by redesignating

10 subsection (c) as subsection (d) and inserting

11 the following new subsection after subsection

12 (b):

13 ‘‘(c) PERMANENT ESTABLISHMENT OF PARTNERS

14 AND S CORPORATION SHAREHOLDERS.—If a partnership

15 or S corporation has a permanent establishment in the

16 United States (within the meaning of a treaty to which

17 the United States is a party) at any time during a taxable

18 year of such entity, a nonresident alien individual or for19 eign corporation which is a partner in such partnership,

20 or a nonresident alien individual who is a shareholder in

21 such S corporation, shall be treated as having a permanent

22 establishment in the United States for purposes of such

23 treaty.’’
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1 TITLE II—QUALIFICATION AND

2 ELIGIBILITY REQUIREMENTS

3 OF S CORPORATIONS

4 SEC. 201. ISSUANCE OF PREFERRED STOCK PERMITTED.

5 (a) IN GENERAL.—Section 1361 is amended by add6 ing at the end the following new subsection:

7 ‘‘(f) TREATMENT OF QUALIFIED PREFERRED

8 STOCK.—

9 ‘‘(1) IN GENERAL.—For purposes of this

10 subchapter—

11 ‘‘(A) qualified preferred stock shall not be

12 treated as a second class of stock, and

13 ‘‘(B) no person shall be treated as a share14 holder of the corporation by reason of holding

15 qualified preferred stock.

16 ‘‘(2) QUALIFIED PREFERRED STOCK DE17 FINED.—For purposes of this subsection, the term

18 ‘qualified preferred stock’ means stock which meets

19 the requirements of subparagraphs (A), (B), and (C)

20 of section 1504(a)(4). Stock shall not fail to be

21 treated as qualified preferred stock merely because

22 it is convertible into other stock.

23 ‘‘(3) DISTRIBUTIONS.—A distribution (not in

24 part or full payment in exchange for stock) made by

25 the corporation with respect to qualified preferred
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1 stock shall be includible as ordinary income of the

2 holder and deductible to the corporation as an ex3 pense in computing taxable income under section

4 1363(b) in the year such distribution is received.’’

5 (b) CONFORMING AMENDMENTS.—

6 (1) Paragraph (1) of section 1361(b) is amend7 ed by inserting ‘‘, except as provided in subsection

8 (f),’’ before ‘‘which does not’’.

9 (2) Subsection (a) of section 1366 is amended

10 by adding at the end the following new paragraph:

11 ‘‘(3) ALLOCATION WITH RESPECT TO QUALI12 FIED PREFERRED STOCK.—The holders of qualified

13 preferred stock (as defined in section 1361(f)) shall

14 not, with respect to such stock, be allocated any of

15 the items described in paragraph (1).’’

16 (3) So much of clause (ii) of section

17 354(a)(2)(C) as precedes subclause (II) is amended

18 to read as follows:

19 ‘‘(ii) RECAPITALIZATION OF FAMILY20 OWNED CORPORATIONS AND S CORPORA21 TIONS.—

22 ‘‘(I) IN GENERAL.—Clause (i)

23 shall not apply in the case of a recapi24 talization under section 368(a)(I)(E)
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1 of a family-owned corporation or S

2 corporation.’’

3 (4) Subsection (a) of section 1373 is amended

4 by striking ‘‘and’’ at the end of paragraph (1), by

5 striking the period at the end of paragraph (2) and

6 inserting ‘‘, and’’, and by adding at the end the fol7 lowing new paragraph:

8 ‘‘(3) no amount of an expense deductible under

9 this subchapter by reason of section 1361(f)(3) shall

10 be apportioned or allocated to such income.’’

11 SEC. 202. SAFE HARBOR EXPANDED TO INCLUDE CONVERT12 IBLE DEBT.

13 Subparagraph (B) of section 1361(c)(5) (defining

14 straight debt) is amended by striking clauses (ii) and (iii)

15 and inserting the following:

16 ‘‘(ii) in any case in which the terms of

17 such promise include a provision under

18 which the obligation to pay may be con19 verted (directly or indirectly) into stock of

20 the corporation, such terms, taken as a

21 whole, are substantially the same as the

22 terms which could have been obtained on

23 the effective date of the promise from a

24 person which is not a related person (with-
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1 in the meaning of section 465(b)(3)(C)) to

2 the S corporation or its shareholders, and

3 ‘‘(iii) the creditor is—

4 ‘‘(I) an individual,

5 ‘‘(II) an estate,

6 ‘‘(III) a trust described in para7 graph (2), or

8 ‘‘(IV) a person which is actively

9 and regularly engaged in the business

10 of lending money.’’

11 SEC. 203. REPEAL OF EXCESSIVE PASSIVE INVESTMENT IN12 COME AS A TERMINATION EVENT.

13 (a) IN GENERAL.—Section 1362(d) (relating to ter14 mination) is amended by striking paragraph (3).

15 (b) CONFORMING AMENDMENTS.—

16 (1) Section 1362(f)(1) is amended by striking

17 ‘‘or (3)’’.

18 (2) Clause (i) of section 1042(c)(4)(A) is

19 amended by striking ‘‘section 1362(d)(3)(C)’’ and

20 inserting ‘‘section 1375(b)(4)’’.

21 SEC. 204. REPEAL OF PASSIVE INCOME CAPITAL GAIN CAT22 EGORY.

23 Subsection (b) of section 1375 is amended by striking

24 paragraphs (3) and (4) and inserting the following new

25 paragraphs:
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1 ‘‘(3) SUBCHAPTER C EARNINGS AND PROF2 ITS.—The term ‘subchapter C earnings and profits’

3 means earnings and profits of any corporation for

4 any taxable year with respect to which an election

5 under section 1362(a) (or under section 1372 of

6 prior law) was not in effect.

7 ‘‘(4) PASSIVE INVESTMENT INCOME DE8 FINED.—

9 ‘‘(A) IN GENERAL.—Except as otherwise

10 provided in this paragraph, the term ‘passive

11 investment income’ means gross receipts de12 rived from royalties, rents, dividends, interest,

13 and annuities.

14 ‘‘(B) EXCEPTION FOR INTEREST ON

15 NOTES FROM SALES OF INVENTORY.—The term

16 ‘passive investment income’ shall not include in17 terest on any obligation acquired in the ordi18 nary course of the corporation’s trade or busi19 ness from its sale of property described in sec20 tion 1221(1).

21 ‘‘(C) TREATMENT OF CERTAIN LENDING

22 OR FINANCE COMPANIES.—If the S corporation

23 meets the requirements of section 542(c)(6) for

24 the taxable year, the term ‘passive investment

25 income’ shall not include gross receipts for the
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1 taxable year which are derived directly from the

2 active and regular conduct of a lending or fi3 nance business (as defined in section

4 542(d)(1)).

5 ‘‘(D) TREATMENT OF CERTAIN DIVI6 DENDS.—If an S corporation holds stock in a

7 C corporation meeting the requirements of sec8 tion 1504(a)(2), the term ‘passive investment

9 income’ shall not include dividends from such C

10 corporation to the extent such dividends are at11 tributable to the earnings and profits of such C

12 corporation derived from the active conduct of

13 a trade or business.

14 ‘‘(E) COORDINATION WITH SECTION

15 1374.—The amount of passive investment in16 come shall be determined by not taking into ac17 count any recognized built-in gain or loss of the

18 S corporation for any taxable year in the rec19 ognition period. Terms used in the preceding

20 sentence shall have the same respective mean21 ing as when used in section 1374.’’
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1 SEC. 205. ALLOWANCE OF CHARITABLE CONTRIBUTIONS

2 OF INVENTORY AND SCIENTIFIC PROPERTY.

3 (a) IN GENERAL.—Section 170(e) (relating to certain

4 contributions of ordinary income and capital gain prop5 erty) is amended—

6 (1) by striking ‘‘(other than a corporation

7 which is an S corporation)’’ in paragraph (3)(A),

8 and

9 (2) by striking clause (i) of paragraph (4)(D)

10 and by redesignating clauses (ii) and (iii) of such

11 paragraph as clauses (i) and (ii), respectively.

12 (b) STOCK BASIS ADJUSTMENT.—Paragraph (1) of

13 section 1367(a) (relating to adjustments to basis of stock

14 of shareholders, etc.) is amended by striking ‘‘and’’ at the

15 end of subparagraph (B), by striking the period at the

16 end of subparagraph (C) and inserting ‘‘, and’’, and by

17 adding at the end the following new subparagraph:

18 ‘‘(D) the excess of the deductions for char19 itable contributions over the basis of the prop20 erty contributed.’’

21 SEC. 206. C CORPORATION RULES TO APPLY FOR FRINGE

22 BENEFIT PURPOSES.

23 (a) IN GENERAL.—Section 1372 (relating to partner24 ship rules to apply for fringe benefit purposes) is repealed.

25 (b) PARTNERSHIP RULES TO APPLY FOR HEALTH

26 INSURANCE COSTS OF CERTAIN S CORPORATION SHARE-
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1 HOLDERS.—Paragraph (5) of section 162(l) is amended

2 to read as follows:

3 ‘‘(5) TREATMENT OF CERTAIN S CORPORATION

4 SHAREHOLDERS.—

5 ‘‘(A) IN GENERAL.—This subsection shall

6 apply in the case of any 2-percent shareholder

7 of an S corporation, except that—

8 ‘‘(i) for purposes of this subsection,

9 such shareholder’s wages (as defined in

10 section 3121) from the S corporation shall

11 be treated as such shareholder’s earned in12 come (within the meaning of section

13 401(c)(1)), and

14 ‘‘(ii) there shall be such adjustments

15 in the application of this subsection as the

16 Secretary may by regulations prescribe.

17 ‘‘(B) 2-PERCENT SHAREHOLDER DE18 FINED.—For purposes of this paragraph, the

19 term ‘2-percent shareholder’ means any person

20 who owns (or is considered as owning within

21 the meaning of section 318) on any day during

22 the taxable year of the S corporation more than

23 2 percent of the outstanding stock of such cor24 poration or stock possessing more than 2 per-
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1 cent of the total combined voting power of all

2 stock of such corporation.’’

3 (b) CONFORMING AMENDMENT.—The table of sec4 tions for part III of subchapter S of chapter 1 is amended

5 by striking the item relating to section 1372.

6 TITLE III—TAXATION OF S

7 CORPORATION SHAREHOLDERS

8 SEC. 301. TREATMENT OF LOSSES TO SHAREHOLDERS.

9 (a) LIQUIDATIONS.—Section 331 (relating to gain or

10 loss to shareholders in corporate liquidations) is amended

11 by redesignating subsection (c) as subsection (d) and by

12 inserting after subsection (b) the following new subsection:

13 ‘‘(c) LOSS ON LIQUIDATIONS OF S CORPORATION.—

14 ‘‘(1) IN GENERAL.—The portion of any loss rec15 ognized by a shareholder of an S corporation (as de16 fined in section 1361(a)(1)) on amounts received by

17 such shareholder in a distribution in complete liq18 uidation of such S corporation which does not exceed

19 the ordinary income basis of stock of such S cor20 poration in the hands of such shareholder shall not

21 be treated as a loss from the sale or exchange of a

22 capital asset but shall be treated as an ordinary loss.

23 ‘‘(2) ORDINARY INCOME BASIS.—For purposes

24 of this subsection, the ordinary income basis of stock

25 of an S corporation in the hands of a shareholder of
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1 such S corporation shall be an amount equal to the

2 portion of such shareholder’s basis in such stock

3 which is equal to the aggregate increases in such

4 basis under section 1367(a)(1) resulting from such

5 shareholder’s pro rata share of ordinary income of

6 such S corporation attributable to the complete liq7 uidation.’’

8 (b) SUSPENDED PASSIVE ACTIVITY LOSSES.—Para9 graph (3) of section 1371(b) is amended to read as fol10 lows:

11 ‘‘(3) TREATMENT OF S YEAR AS ELAPSED

12 YEAR; PASSIVE LOSSES.—Nothing in paragraphs (1)

13 and (2) shall prevent treating a taxable year for

14 which a corporation is an S corporation as a taxable

15 year for purposes of determining the number of tax16 able years to which an item may be carried back or

17 carried forward nor prevent the allowance of a pas18 sive activity loss deduction to the extent provided by

19 section 469(g).’’

20 TITLE IV—EFFECTIVE DATE

21 SEC. 401. EFFECTIVE DATE.

22 (a) IN GENERAL.—Except as otherwise provided in

23 this Act, and in section 1362(g) relating to elections after

24 termination, the amendments made by this Act shall apply

25 to taxable years beginning after December 31, 1999.
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1 (b) TREATMENT OF CERTAIN ELECTIONS UNDER

2 PRIOR LAW.—For purposes of section 1362(g) of the In3 ternal Revenue Code of 1986 (relating to election after

4 termination), any termination or revocation under section

5 1362(d) of such Code (as in effect on the day before enact6 ment of this Act) shall not be taken into account.

Æ