BACKGROUND AND PROPOSALS

RELATING TO S CORPORATIONS

Scheduled for a Public Hearing

Before the

SUBCOMMITTEE ON SELECT REVENUE MEASURES

of the

HOUSE COMMITTEE ON WAYS AND MEANS

on June 19, 2003

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

June 18, 2003

JCX-62-03
i

CONTENTS

Page

INTRODUCTION .......................................................................................................................... 1

I. BACKGROUND......................................................................................................................... 2

II. DATA ON SMALL BUSINESS AND S CORPORATIONS ................................................... 7

III. PROPOSALS .......................................................................................................................... 23

1. The Subchapter S Modernization Act of 2003.................................................................. 23

2. The Small Business and Financial Institutions Tax Relief Act of 2003 ........................... 26

3. The Small Business Opportunity and Growth Act of 2003 .............................................. 28
1

INTRODUCTION

The Subcommittee on Select Revenue Measures of the House Committee on Ways and 

Means has scheduled a public hearing for June 19, 2003, on S corporation tax reform. This 

document, 1 prepared by the staff of the Joint Committee on Taxation, provides background and a 

description of proposals relating to S corporations. 

 

1

 This document may be cited as follows: Joint Committee on Taxation, Background 

and Proposals Relating to S Corporations (JCX-62-03), June 18, 2003.
2

I. BACKGROUND

Present Law

In general

In general, an S corporation is not subject to corporate-level income tax on its items of 

income and loss. Instead, an S corporation passes through its items of income and loss to its 

shareholders.2 The shareholders take into account separately their shares of these items on their 

individual income tax returns. To prevent double taxation of these items when the stock is later 

disposed of, each shareholder’s basis in the stock of the S corporation is increased by the amount 

included in income (including tax-exempt income) and is decreased by the amount of any losses 

(including nondeductible losses) taken into account. A shareholder’s loss may be deducted only 

to the extent of his or her basis in the stock or debt of the corporation. To the extent a loss is not 

allowed due to this limitation, the loss generally is carried forward to the next year.

S corporation defined

A small business corporation may elect to be an S corporation with the consent of all its 

shareholders, and may terminate its election with the consent of shareholders holding more than 

50 percent of the stock. A "small business corporation" is defined as a domestic corporation 

which is not an ineligible corporation and which has (1) no more than 75 shareholders, all of 

whom are individuals (and certain trusts, estates, charities, and qualified retirement plans) who 

are citizens or residents of the United States, and (2) only one class of stock. For purposes of the 

75-shareholder limitation, a husband and wife are treated as one shareholder. An "ineligible 

corporation" means a corporation that is a financial institution using the reserve method of 

accounting for bad debts 3, an insurance company, a corporation electing the benefits of the 

Puerto Rico and possessions tax credit, a Domestic International Sales Corporation (“DISC”) or 

former DISC.

A corporation has one class of stock if all outstanding shares of stock confer identical 

rights to distribution and liquidation proceeds. Differences in voting rights are disregarded. 

Certain debt (“straight debt”) which is not convertible into stock and the interest with respect to 

which is not contingent on the profits of the issuer or similar factors is not treated as a second 

class of stock.

 

2

 The pass-through treatment of items generally follows the partnership rules; the items 

pass through to the shareholders on a pro rata basis.

3

 Because individuals generally are not allowed to deduct amounts added to reserves, this 

limitation was made applicable to S corporations.
3

Treatment of former C corporations and their shareholders

In general, an election by an existing C corporation to be treated as an S corporation is 

not a taxable event. 4 However, special rules apply to these corporations that are intended to 

prevent avoidance of otherwise applicable C corporation tax consequences.

Built-in gain tax.–A former C corporation with net built-in gain at the time the S election 

becomes effective is subject to tax, at the highest corporate tax rate, on the items of built-in gain 

when the items are disposed of by the S corporation within the 10-year period after becoming an 

S corporation. The gain, net of tax, is also taken into account by the shareholders. The tax is 

imposed on the corporation on gains that accrued while it was a C corporation because no 

corporate level tax is imposed at the time of converting to an S corporation.

Excess net passive income.–An S corporation is subject to corporate-level tax, at the 

highest corporate tax rate, on its excess net passive income if the corporation has (1) subchapter 

C earnings and profits at the close of the taxable year and (2) gross receipts more than 25 percent 

of which are passive investment income. In addition, an S corporation election is terminated 

whenever the corporation has subchapter C earnings and profits at the close of three consecutive 

taxable years and has gross receipts for each of such years more than 25 percent of which are 

passive investment income. These rules were intended to discourage the use of an S corporation 

election to avoid a shareholder level tax on earnings that had accumulated while a C corporation.

 “Excess net passive income” is the net passive income for a taxable year multiplied by a 

fraction, the numerator of which is the amount of passive investment income in excess of 25 

percent of gross receipts and the denominator of which is the passive investment income for the 

year. "Net passive income" is defined as passive investment income reduced by the allowable 

deductions that are directly connected with the production of that income. "Passive investment 

income" generally means gross receipts derived from royalties, rents, dividends, interest, 

annuities, and sales or exchanges of stock or securities (to the extent of gains). 

Distributions.–Distributions by S corporations that are former C corporations of earnings 

and profits are taxable as dividends to its shareholders. A former C corporation may distribute 

an amount up to its accumulated S corporation income (“accumulated adjustments account”) 

before distributions are taxed as dividends.

Trusts as shareholders

Generally, a trust is taxable at graduated rates on its taxable income. In computing the 

trust’s taxable income, a deduction is allowed for income distributed to its beneficiaries. In 

addition, property held by certain trusts is treated as owned directly by the grantor of the trust for 

Federal income tax purposes. The taxation of trusts holding stock in an S corporation differs 

from the taxation of trusts under these rules.

 

4

 An exception is the tax on LIFO recapture.
4

The share of income of an S corporation whose stock is held by a qualified subchapter S 

trust (“QSST”), with respect to which the beneficiary makes an election, is taxed to the 

beneficiary. A QSST generally is a trust with one individual income beneficiary for the life of 

the beneficiary. 

The share of income of an S corporation whose stock is held by an electing small 

business trust (“ESBT”) is taxed to the trust at the maximum individual rates. An ESBT 

generally is an electing trust all of whose beneficiaries are eligible S corporation shareholders. 

For purposes of determining the maximum number of shareholders, each person who is entitled 

to receive a distribution from the trust (“potential current beneficiary”) is treated as a shareholder 

during the period the person may receive a distribution from the trust.

Qualified subsidiary corporations

A corporation all of whose stock is held by an S corporation is treated as a qualified 

subchapter S subsidiary if the S corporation so elects. If an election is made, the subsidiary 

corporation is disregarded for income tax purposes and its assets, liabilities, and items of income, 

deduction, and credit are treated as assets, liabilities, and items of the parent S corporation.

Legislative History

Subchapter S of the Code was originally enacted in 1958 in order to diminish the effect of 

Federal income taxes in the organizational choice of small businesses, and to permit 

incorporation and operation of certain small businesses without the incidence of income taxation 

at both the corporate and shareholder levels.5 The provision was originally limited to domestic 

corporations with 10 or fewer shareholders.

The Subchapter S Revision Act of 1982 revised the provisions of Subchapter S to 

correspond more closely with the partnership taxation provisions, but without adopting many of 

the complexities of partnership taxation. 6 The Act was intended to remove restrictions and 

 

5

 See S. Rep. No. 1983, 85th Cong., 2d Sess. 87 (1958). According to the Report, 

noncorporate tax treatment may be preferred because: (i) owners may not wish business earnings 

to be subject to two levels of tax (once when earned and again when distributed); (ii) the average 

or marginal tax rates for the individual shareholders may be lower than that of the corporation; 

(iii) owners may wish to use losses generated by the business to offset income from other 

sources; and (iv) the owners may not wish tax to be imposed under the corporate tax base (which 

may include items not applicable to individuals).

6

 For example, the rules in sections 704(b) and (c), relating to allocations; sections 731-

737, relating to distributions; section 751, relating to “hot assets” producing ordinary income; 

and sections 734(b) and 743(b), relating to elective basis adjustments, were not adopted in order 

to retain relative simplicity.
5

“traps for the unwary” that had existed under the subchapter as enacted.7 That Act also increased 

the maximum number of shareholders to 35.

The Small Business Job Protection Act of 1996 increased the maximum number of 

shareholders to 75 and liberalized the types of persons that could be shareholders in an S 

corporation. That Act also allowed certain financial institutions to become S corporations.8

In 1996, the Internal Revenue Service (“IRS”) issued the “check-the-box” regulations 9

that allow an unincorporated entity to elect to be taxed as either a partnership or corporation. In 

recent years the growth of limited liability companies, which can provide owners with protection 

from liability and partnership tax treatment, has changed the relative importance of subchapter S. 

Limited liability companies may be organized in all 50 states and the District of Columbia. The 

IRS first ruled that a limited liability company could be treated as a partnership for Federal tax 

purposes in 1988.10

In general, the history of subchapter S illustrates that Congress desires small businesses 

to achieve the benefits of pass-through taxation similar to partnerships without the complexities 

of the partnership tax rules. Although some argue that the proliferation of limited liability 

companies and the flexibility afforded by the check-the-box regulations reduces the need for 

subchapter S, others argue that the relative simplicity of subchapter S is desirable and worth 

retaining. In addition to its relative simplicity, subchapter S allows a C corporation to elect to be 

an S corporation without the imposition of any liquidating tax that would apply if the corporation 

liquidated and a partnership or limited liability company were formed. S corporations (but not 

entities treated as partnerships) may engage in tax-free reorganizations with C corporations. 

Some business owners may prefer to conduct their business as a state law corporation, rather 

than as a partnership or limited liability company, because they are familiar with the established 

corporate law and governance structure. As additional complexity is added to the subchapter S 

rules, the merits of these arguments must be compared to the costs of maintaining two separate 

pass-through regimes for taxing business income.

The provisions of subchapter S were enacted in 1958 and substantially modified in 1982 

on the premise that all income of the S corporation (including all gains on the sale of stock) 

would be subject to a shareholder-level income tax. This underlying premise allows the rules 

 

7

 See H. Rep. 97-640, 1 (1982).

8

 See GAO/GGD-00-159, Banking Taxation, Implications of Proposed Revisions 

Governing S-Corporations on Community Banks (June 23, 2000), for discussion of issues 

relating to community banks electing subchapter S.

9

 Treas. Reg. sec. 301.7701-3. These regulations replaced the former entity classification 

regulations requiring an examination of the presence or absence certain corporate characteristics.

10 Rev. Rul. 88-76, 1988-2 C. B. 360 (regarding an organization operating under the 

Wyoming Limited Liability Company Act).
6

governing subchapter S corporations to be relatively simple (in contrast, for example, to the 

partnership tax rules of subchapter K) because of the lack of concern about “transferring” income 

to non-taxpaying persons.11

 

11 See S. Rept. 104-282, 61 (1996).
7

II. DATA ON SMALL BUSINESS AND S CORPORATIONS

Trends in Use of Business Entities, 1978-2000

Returns filed by C corporations, S corporations, partnerships, non-farm sole 

proprietors, and farming enterprises

 Figure 1 and Table 1 show data from the Internal Revenue Service's Statistics of Income 

("SOI") regarding the number of tax returns filed by different forms of business organizations 

from 1978 to 2000.12 In these data, farms are measured solely by reference to those taxpayers 

who report income (or loss) on Schedule F of Form 1040. Other taxpayers engaged in 

agricultural enterprises may use a separate entity. When this occurs, the data reported below 

report that entity among the totals of C corporations, S corporations, or partnerships.

Throughout the period 1978 to 2000, nonfarm sole proprietorships made up the vast 

majority of businesses. The S corporation is the second most numerous business form. In 2000, 

S corporations constituted 10.6 percent of all business entities. Over the past two decades S 

corporations have grown from approximately three percent of all business entities to over 10 

percent. 

 

12 These data are based upon returns filed by individuals and entities. The numbers 

reported for nonfarm sole proprietorships and for farm returns are based upon the number of 

taxpayers who file a business return as a sole proprietor (Schedule C to Form 1040) and who file 

a farm income return (Schedule F to Form 1040). One taxpayer may report more than one 

business organized as a sole proprietorship; the data reported here count only one sole 

proprietorship. On the other hand, the data for C corporations, S corporations, and partnerships 

count the number of tax returns and information returns filed by C corporations, S corporations, 

and partnerships. One taxpayer may own more than one corporation. When this occurs, unlike 

the case in sole proprietorships, the data reported here count each corporation as a separate 

entity. Thus, the data are not perfectly comparable across entity classification.
Figure 1.–Number of Different Types of Business Returns,

1978-2000

0

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

16,000,000

18,000,000

20,000,000

19781979198019811982198319841985198619871988198919901991199219931994199519961997199819992000

Year

Number of Business Entities

Nonfarm sole props

C Corps

S Corps

Partnerships

Farms (Schedule F)

8
9

Sole C S

Year Proprietorships Corporations Corporations Partnerships Farms Total

1978 8,908,289 1,898,100 478,679 1,234,157 2,704,794 15,224,019

1979 9,343,603 2,041,887 545,389 1,299,593 2,605,684 15,805,674

1980 9,730,019 2,165,149 545,389 1,379,654 2,608,430 16,428,641

1981 9,584,790 2,270,931 541,489 1,460,502 2,641,254 16,498,966

1982 10,105,515 2,361,714 564,219 1,514,212 2,689,237 17,234,897

1983 10,703,921 2,350,804 648,267 1,541,539 2,710,044 17,954,575

1984 11,262,390 2,469,404 701,339 1,643,581 2,694,420 18,771,134

1985 11,928,573 2,552,470 724,749 1,713,603 2,620,861 19,540,256

1986 12,393,700 2,602,301 826,214 1,702,952 2,524,331 20,049,498

1987 13,091,132 2,484,228 1,127,905 1,648,035 2,420,186 20,771,486

1988 13,679,302 2,305,598 1,257,191 1,654,245 2,367,527 21,263,863

1989 14,297,558 2,204,896 1,422,967 1,635,164 2,359,718 21,920,303

1990 14,782,738 2,141,558 1,575,092 1,553,529 2,321,153 22,374,070

1991 15,180,722 2,105,200 1,696,927 1,515,345 2,290,908 22,789,102

1992 15,495,419 2,083,652 1,785,371 1,484,752 2,288,218 23,137,412

1993 15,848,119 2,063,124 1,901,505 1,467,567 2,272,407 23,552,722

1994 16,153,871 2,318,614 2,023,754 1,493,963 2,242,324 24,232,526

1995 16,423,872 2,321,048 2,153,119 1,580,900 2,219,244 24,698,183

1996 16,955,023 2,326,954 2,304,416 1,654,256 2,188,025 25,428,674

1997 17,176,486 2,257,829 2,452,254 1,758,627 2,160,954 25,806,150

1998 17,398,440 2,260,757 2,588,081 1,855,348 2,091,845 26,194,471

1999 17,575,643 2,210,129 2,725,775 1,936,919 2,067,883 26,516,349

2000 17,902,791 2,184,795 2,860,478 2,057,500 2,086,789 27,092,353

Source: Internal Revenue Service, Statistics of Income, published and unpublished data.

Table 1.--Number of Different Types of Business Returns Relative to

All Business Returns, 1978-2000
10

Table 2 reports the rate of growth in the number of different types of business entities. 

The growth rate of all entities was greater for the period 1978 to 1988 than for the period 1988 to 

1998. The number of farm returns generally declined through the 22-year period. While the 

relative share of nonfarm sole proprietorships increased after 1986, the growth rate in their 

numbers did not rise from that of earlier periods and has in fact slowed in the 1990s. The 

increase in the relative share of nonfarm sole proprietorships is an artifact of the decline in the 

absolute number of partnerships and C corporations following the Tax Reform Act of 1986. The 

number of each of those forms declined each year from 1987 through 1993. At the same time, 

the number of S corporations has increased threefold between 1986 and 2000. The growth in the 

number of S corporations was most dramatic immediately following 1986; in the past few years, 

growth rates have returned to the range of pre-1986 growth rates. The number of S corporations 

also grew rapidly following the Subchapter S Revision Act of 1982.

Table 2.–Average Annual Rate of Growth in Business Entities

(percent)

Business 1978-1989 1989-2000 1978-2000

Nonfarm sole proprietorship 4.4 2.1 3.2

C corporation 1.4 -0.1 0.6

S corporation 10.4 6.6 8.5

Partnerships 2.6 2.1 2.4

Farms (Schedule F) -1.2 -1.1 -1.2

Total 3.1 1.9 2.7

Source: Joint Committee on Taxation staff calculations.
11

As a consequence of the changing rates of growth of different forms of business entities, 

the distribution of different types of business has changed since 1978, with sole proprietorships 

and S corporations growing in relative shares of business entities and farms and C corporations 

declining in relative shares. Figures 2, 3, and 4, below, display the percentage distribution of 

different types of business returns for 1978, 1989, and 2000.

Figure 2.–Percentage Distribution of Different Types of

Business Returns, 1978

Nonfarm sole

props

59%

Farms (Schedule F)

18%

Partnerships

8%

S Corps

3%

C Corps

12%
12

Figure 3.–Percentage Distribution of Different Types of

Business Returns, 1989

Nonfarm sole

props

66%

Partnerships

7%

Farms (Schedule F)

11%

C Corps

10%

S Corps

6%
13

Figure 4.–Percentage Distribution of Different Types of

Business Returns, 2000

Nonfarm sole

props

65%

Partnerships

8%

Farms (Schedule F)

8%

C Corps

8%

S Corps

11%
14

The growth of limited liability companies

The use of the limited liability company (“LLC”) as an entity is a development of the past 

several years. Most LLCs filed the partnership reporting form for Federal reporting purposes 

and their numbers, assets, and gross receipts are counted among the partnership data reported in 

Tables 1 and 2 and Figures 1-4 above. Table 3 and Figure 5, below, decompose the number of 

partnerships for the period 1990 through 2000 into general partnerships, limited partnerships, and 

LLCs.13 Figure 5 documents the rapid growth of LLCs relative to other partnership forms over 

the past several years. Since 1996, LLCs have grown at a rate of 34 percent per year.

Table 3.–Number of Partnership Returns by Type, 1990-2000

Type of Partnership

Year

General

Partnerships

(thousands)

Limited

Partnerships

(thousands)

Limited Liability

Companies

(thousands)

1990 1,267 285 n.a.

1991 1,245 271 n.a.

1992 1,214 271 n.a.

1993 1,176 275 17

1994 1,163 283 48

1995 1,167 295 119

1996 1,116 311 221

1997 1,069 329 349

1998 945 343 470

1999 898 354 589

2000 872 349 719

n.a. - not available.

Source: Bill Pratt, “Partnership Returns, 2000,” SOI Bulletin, 22, Fall 2002.

 

13 The data in Table 3 may not sum to the total number of partnerships reported in Table 

1 because of rounding. Also, the IRS has excluded from this decomposition those businesses 

that checked either the “limited liability partnership” box, the “other” box, or those partnerships 

that identified themselves as foreign partnerships on Form 1065, Schedule B, line 1. See, Alan 

Zempel, “Partnership Returns, 1998,” SOI Bulletin, 20, Fall 2000 and Bill Pratt, “Partnership 

Returns, 2000,” SOI Bulletin, 22, Fall 2002.
Figure 5.–Partnership Returns by Type of Partnership, 1989-2000

0

200

400

600

800

1000

1200

1400

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Year

Thousands

General Partnership

Limited Partnership

Limited Liability

Companies

15
16

Businesses reporting net income

It is important to recognize that in any given year a substantial number of business 

enterprises report a loss. Figure 6, below, reports for 2000 the percentage of businesses by type 

of entity that reported net income.

Source: JCT staff tabulations from SOI data.

Figure 6.–Percentage of Business Entities with Net Income, 2000

65.3%

33.7%

43.0%

58.2%

52.8%

74.3%

0%

10%

20%

30%

40%

50%

60%

70%

80%

Nonfarm sole

proprietorship returns

C corporation returns S corporation returns Partnership returns Farms All business entities
17

Size distribution of C corporations, S corporations, partnerships, and non-farm sole 

proprietorships

While one may often associate small businesses with organization in the form of a sole 

proprietorship, a partnership, or an S corporation, there is not an ironclad correspondence 

between the size of the business and the form of organization. While many small businesses are 

arranged as a sole proprietorship, a partnership, or an S corporation, not all businesses organized 

in those forms are small and not all businesses organized as C corporations are large. One can 

use SOI data on assets and gross receipts to measure the size of businesses in order to sort out 

how small businesses are arrayed across the different forms of organization.

Tables 4 through 7 display 2000 SOI data on C corporations, S corporations, 

partnerships, and nonfarm sole proprietorships. For the first three forms of organization, the 

tables classify all taxpayers using that form of organization both by the size of assets and gross 

receipts. For sole proprietorships (Table 7), there is no tax data on assets, so the table uses only 

gross receipts as a classifier. When businesses are classified by asset size, one can see that there 

are a significant number of C corporations of small size. More than 850,000 corporations have 

assets under $50,000, approximately 40 percent of the total number of C corporations. For S 

corporations, approximately one half have assets under $50,000. 

The concentration of assets differs among the three entity forms. C corporations have the 

largest disparity in asset holding. Firms with over $100 million in assets, which represent 0.84 

percent of all C corporations, hold 95 percent of the assets in C corporations. By comparison, 

partnerships with $100 million or more in assets constitute 0.36 percent of all partnerships and 

these businesses own only 62.5 percent of all assets owned by partnerships. S corporations with 

$100 million or more in assets constitute only 0.05 percent of all S corporations and account for 

21 percent of all assets owned by S corporations.

When businesses are classified by gross receipts, a picture emerges that is similar to that 

seen in the asset data. There are a substantial number of quite small C corporations (more than 

450,000 corporations with gross receipts less than $25,000, nearly 23 percent of the number of C 

corporations). But across the other forms of organization there are higher percentages of 

businesses with small amounts of gross receipts. For nonfarm sole proprietorships, 67 percent 

have gross receipts under $25,000. For S corporations, 26 percent report gross receipts of 

$25,000 or less.

As with assets, the dispersion of gross receipts across the classifications is more skewed 

for C corporations and partnerships than for S corporations. C corporations with over $50 

million in gross receipts, which represent approximately 0.73 percent of all C corporations, 

collect over 80 percent of gross receipts of all C corporations. For partnerships, approximately 

the 0.2 percent of partnerships with gross receipts in excess of $50 million report 68 percent of 

all partnership gross receipts. For S corporations, 0.3 percent of S corporations with gross 

receipts in excess of $50 million report 29 percent of S corporation gross receipts. For non-farm 

sole proprietorships, fewer than 0.02 percent of such businesses report gross receipts in excess of 

$50 million, and these businesses report less than six percent of all non-farm sole proprietorship 

gross receipts.
18

Table 4.--Distribution of C Corporations, 2000

Cumulative Percent

Firms classified by assets

Number of 

Returns

Total Assets 

(millions) Returns Total Assets

$0 or less 135,277 0 6.19% 0.00%

$1 to $25,000 507,207 4,561 29.41% 0.01%

$25,001 to $50,000 221,757 8,111 39.56% 0.03%

$50,001 to $100,000 272,301 19,815 52.02% 0.07%

$100,001 to $250,000 365,712 59,948 68.76% 0.20%

$250,001 to $500,000 237,187 84,392 79.62% 0.39%

$500,001 to $1,000,000 172,389 120,757 87.51% 0.66%

$1,000,001 to $10,000,000 216,080 595,066 97.40% 1.97%

$10,000,001 to $50,000,000 30,913 680,850 98.81% 3.48%

$50,000,001 to $100,000,000 7,685 546,532 99.16% 4.69%

More than $100,000,000 18,287 43,116,128 100.00% 100.00%

Total 2,184,795 45,236,160

Cumulative Percent

Firms classified by receipts

Number of 

Returns

Total Receipts 

(millions) Returns Total Receipts

$0 or less 255,181 -234 11.68% 0.00%

$1 to $2,500 53,783 54 14.14% 0.00%

$2,501 to $5,000 29,389 107 15.49% 0.00%

$5,001 to $10,000 51,460 370 17.84% 0.00%

$10,001 to $25,000 101,905 1,722 22.51% 0.01%

$25,001 to $50,000 122,695 4,546 28.12% 0.04%

$50,001 to $100,000 187,857 13,730 36.72% 0.14%

$100,001 to $250,000 342,738 57,315 52.41% 0.53%

$250,001 to $500,000 288,970 103,929 65.63% 1.24%

$500,001 to $1,000,000 261,326 185,588 77.60% 2.51%

$1,000,001 to $10,000,000 422,236 1,194,954 96.92% 10.67%

$10,000,001 to $50,000,000 51,264 1,037,132 99.27% 17.76%

More than $50,000,000 15,991 12,038,877 100.00% 100.00%

Total 2,184,795 14,638,090
19

Table 5.--Distribution of S Corporations, 2000

Cumulative Percent

Firms classified by assets

Number of 

Returns

Total Assets 

(millions) Returns Total Assets

$0 or less 193,628 0 6.77% 0.00%

$1 to $25,000 894,381 7,942 38.04% 0.44%

$25,001 to $50,000 342,041 12,551 49.99% 1.14%

$50,001 to $100,000 344,662 24,950 62.04% 2.54%

$100,001 to $250,000 440,476 70,465 77.44% 6.47%

$250,001 to $500,000 246,616 86,559 86.06% 11.31%

$500,001 to $1,000,000 168,592 119,036 91.96% 17.95%

$1,000,001 to $10,000,000 206,394 571,139 99.17% 49.85%

$10,000,001 to $50,000,000 20,408 392,270 99.89% 71.75%

$50,000,001 to $100,000,000 1,925 132,721 99.95% 79.17%

More than $100,000,000 1,355 373,079 100.00% 100.00%

Total 2,860,478 1,790,712

Cumulative Percent

Firms classified by receipts

Number of 

Returns

Total Receipts 

(millions) Returns Total Receipts

$0 or less 412,978 -668 14.44% -0.02%

$1 to $2,500 74,341 87 17.04% -0.02%

$2,501 to $5,000 44,629 162 18.60% -0.01%

$5,001 to $10,000 68,631 505 21.00% 0.00%

$10,001 to $25,000 149,215 2,514 26.21% 0.07%

$25,001 to $50,000 181,581 6,767 32.56% 0.26%

$50,001 to $100,000 288,224 21,108 42.64% 0.85%

$100,001 to $250,000 493,046 81,901 59.87% 3.15%

$250,001 to $500,000 385,896 138,249 73.36% 7.03%

$500,001 to $1,000,000 318,906 223,419 84.51% 13.30%

$1,000,001 to $10,000,000 385,675 1,071,404 97.99% 43.35%

$10,000,001 to $50,000,000 49,074 996,392 99.71% 71.31%

More than $50,000,000 8,282 1,022,833 100.00% 100.00%

Total 2,860,478 3,564,673
20

Table 6.--Distribution of Partnerships, 2000

Cumulative Percent

Firms classified by assets

Number of 

Returns

Total Assets 

(millions) Returns Total Assets

$0 or less 590,473 -60,359 28.70% -0.90%

$1 to $25,000 237,445 2,139 40.24% -0.87%

$25,001 to $50,000 105,285 3,833 45.36% -0.81%

$50,001 to $100,000 128,394 9,424 51.60% -0.67%

$100,001 to $250,000 229,487 37,424 62.75% -0.11%

$250,001 to $500,000 196,499 70,830 72.30% 0.95%

$500,001 to $1,000,000 183,006 130,504 81.20% 2.89%

$1,00,001 to $10,000,000 328,423 967,494 97.16% 17.35%

$10,000,001 to $50,000,000 44,739 912,256 99.33% 30.98%

$50,000,001 to $100,000,000 6,258 435,471 99.64% 37.48%

More than $100,000,000 7,491 4,185,127 100.00% 100.00%

Total 2,057,500 6,694,143

Cumulative Percent

Firms classified by receipts

Number of 

Returns

Total Receipts 

(millions) Returns Total Receipts

$0 or less 1,284,123 0 62.41% 0.00%

$1 to $2,500 48,643 55 64.78% 0.00%

$2,501 to $5,000 24,916 94 65.99% 0.01%

$5,001 to $10,000 30,174 218 67.45% 0.02%

$10,001 to $25,000 75,362 1,245 71.12% 0.08%

$25,001 to $50,000 78,518 2,876 74.93% 0.21%

$50,001 to $100,000 90,994 6,448 79.36% 0.52%

$100,001 to $250,000 139,217 23,043 86.12% 1.62%

$250,001 to $500,000 92,306 33,042 90.61% 3.20%

$500,001 to $1,000,000 75,179 53,731 94.26% 5.77%

$1,000,001 to $10,000,000 101,123 285,424 99.18% 19.40%

$10,000,001 to $50,000,000 12,816 270,988 99.80% 32.34%

More than $50,000,000 4,129 1,416,435 100.00% 100.00%

Total 2,057,500 2,093,599
21

Distribution of S Corporations by Industry

Table 8, below, details the distribution of S corporations by industry. Businesses 

classifying themselves as offering professional, scientific, and technology services account for 

14.9 percent of all S corporations. Construction businesses account for 12.8 percent of all S 

corporations. Retail trade and rental real estate each constitute more than 11 percent of all S 

corporations. 

Retail trade accounts for almost 24 percent of all S corporation gross receipts while 

wholesale trade accounts for 18 percent of S corporation gross receipts. Although manufacturing 

enterprises constitute five percent of S corporations, these enterprises account for approximately 

15 percent of S corporation assets and S corporation gross receipts.

Table 7.--Distribution of Non-farm Sole Proprietorships, 2000

Cumulative Percent

Firms classified by receipts

Number of 

Returns

Total Receipts 

(millions) Returns Total Receipts

$0 or less 744,458 0 4.16% 0.00%

$1 to $2,500 3,725,905 4,349 24.97% 0.43%

$2,501 to $5,000 1,920,789 6,964 35.70% 1.12%

$5,001 to $10,000 2,368,238 16,980 48.93% 2.80%

$10,001 to $25,000 3,303,747 53,464 67.38% 8.09%

$25,001 to $50,000 2,222,008 78,987 79.79% 15.91%

$50,001 to $100,000 1,620,707 115,569 88.85% 27.35%

$100,001 to $250,000 1,265,942 194,855 95.92% 46.63%

$250,001 to $500,000 453,235 156,519 98.45% 62.13%

$500,001 to $1,000,000 187,188 125,017 99.49% 74.50%

$1,000,001 to $10,000,000 88,806 174,571 99.99% 91.78%

$10,000,001 to $50,000,000 1,523 28,584 100.00% 94.61%

More than $50,000,000 245 54,478 100.00% 100.00%

Total 17,902,791 1,010,337
22

Table 8.–Distribution of S Corporations by Industry, 2000

Industry

Percent of all

S Corporations

Percent of Total

S Corporation 

Assets

Percent of Total

S Corporation 

Revenues

Professional, Scientific, and 

Technology Services 14.89 4.00 6.24

Construction 12.78 11.90 14.34

Retail Trade 11.87 12.69 23.84

Real Estate & Rental and 

Leasing 11.18 10.61 1.87

Other Services 6.11 1.46 2.19

Wholesale Trade 5.77 10.94 18.19

Accommodation & Food 

Services 5.73 3.56 3.34

Manufacturing 5.13 15.00 14.64

Health Care & Social 

Assistance 5.00 1.53 2.77

Admin, Supportive, Waste 

Management, and Remediation 

Services 4.86 1.67 3.06

Finance and Insurance 4.08 7.01 2.05

Transportation & Warehousing 3.11 2.58 2.56

Agriculture, Forestry, Fishing, 

and Hunting 2.53 2.31 1.36

Leisure, Accommodation, and 

Food Services 2.18 1.36 0.82

Information 2.17 3.41 1.49

Educational Services 0.76 0.20 0.23

Management of Companies 

(Holding Companies.) 0.74 8.06 0.32

Mining 0.62 1.41 0.51

Not Elsewhere Classified 0.36 0.04 0.03

Utilities 0.09 0.22 0.11

Wholesale & Retail Not 

Elsewhere Classified 0.04 0.02 0.02

Source: JCT staff tabulations for SOI data.
23

III. PROPOSALS

1. The Subchapter S Modernization Act of 2003

H.R.1896, the “Subchapter S Modernization Act of 2003”, introduced by Mr. Shaw, Mr. 

Matsui, Mr. McInnis, and Mrs. Jones, makes the following amendments to the tax provisions 

relating to S corporations:

Eligible Shareholders of an S Corporation

• Certain family members may elect to be treated as one shareholder for purposes of 

determining the number of shareholders in an S corporation. A family includes a 

common ancestor (not more than six generations removed from the youngest 

generation of shareholders) and the lineal descendants (and spouses) of the common 

ancestor.

• Nonresident aliens are allowed to be eligible shareholders; S corporation income 

allocated to a nonresident alien shareholder is taxed under rules similar to the 

partnership rules taxing income to a foreign partner.

• An individual retirement account (“IRA”) holding stock in a bank14 on the date of 

enactment of the provision is an eligible S corporation shareholder with respect to 

that stock. Income with respect to the stock is treated as unrelated business taxable 

income.

• The sale of stock by an IRA to the individual beneficiary of the IRA is not a 

prohibited transaction if the sale is made pursuant to the corporation making a 

subchapter S election.

• The maximum number of eligible shareholders is increased from 75 to 150.

Qualification and Eligibility Requirements of S Corporations

• An S corporation may issue qualified preferred stock (i.e., nonparticipating preferred 

stock, as defined for purposes of determining members of an affiliated group of 

corporations eligible to file a consolidated return, determined without regard to voting 

rights and convertibility) that is not treated as a second class of stock. Distributions 

with respect to the stock are deductible by the S corporation and includible in the 

income of the holder.

 

14 The term “bank” is defined in section 581.
24

• Convertible debt qualifies as “straight debt” if the terms are substantially the same as 

could have been obtained by the S corporation from a person who is not a related 

party.

• Excess net passive income no longer causes a subchapter S election to terminate; 

instead the tax on excess net passive income applies.

• The tax on excess net passive income applies only if the gross receipts from passive 

investment income exceeds 60 percent (rather than 25 percent) of total gross receipts; 

capital gain is not treated as an item of passive income.

• A shareholder’s basis in S corporation stock is not reduced by the amount of 

appreciation in charitable contributions of appreciated property made by the S 

corporation.15

Treatment of S Corporation Shareholders

• A shareholder’s loss on the liquidation of an S corporation is treated as an ordinary 

loss to the extent ordinary income items increased the shareholder’s basis in the stock.

• Suspended passive activity loss deductions are allowed to an S corporation that 

converted from a C corporation under the rules generally applicable to other 

suspended loss deductions.

• Suspended S corporation losses with respect to stock held by a shareholder are 

transferred if the stock is transferred incident to a decree of divorce.

• Qualified subchapter S trust income beneficiaries treat dispositions of stock by the 

trust as dispositions by the beneficiary for purposes of the at-risk rules and the passive 

activity loss rules.

• Interest paid or incurred by an electing small business trust on indebtedness to acquire 

S corporation stock is deductible by the trust.

• Unexercised (in whole or in part) powers of appointment are disregarded in 

determining the potential current beneficiaries of an electing small business trust.

• The electing small business trust distribution rules provide that any distribution 

attributable to the portion treated as a separate trust shall be treated separately from 

any portion not so treated.

 

15 A similar provision is included in sec. 109 of H.R. 7 (107th Cong.) as passed by the 

House; in sec. 109 of S. 476 (108th Cong.) as passed by the Senate; and in the President’s Fiscal 

Year 2004 Budget Proposal.
25

• Charitable contributions made by an electing small business trust are deductible by 

the trust and are taken into account in computing the unrelated business taxable 

income of the charitable organization receiving the contribution.

• Excluded cancellation of indebtedness income does not increase the shareholder’s 

basis in its stock. 16

• For purposes of determining the shareholder’s basis in indebtedness of the S 

corporation, the indebtedness of the S corporation to the shareholder shall include 

loans made or acquired (by purchase, gift or distribution from another person) by the 

shareholder, regardless of whether the funds lent by the shareholder to the S 

corporation were obtained by the shareholder by means of a recourse loan from 

another person (whether related or unrelated to the shareholder).

Expansion of S Corporation Eligibility for Financial Institutions

• In the case of a bank or bank holding company, interest income and dividends on 

assets required to be held by the bank or bank holding company are not treated as 

passive investment income for purposes of the tax on excess net passive income.

• Qualifying director shares are not treated as a second class of stock for purposes of 

subchapter S. Qualifying director shares means shares in a bank or bank holding 

company that are held by an individual solely by reason of status as a director of the 

bank or company and which are subject to an agreement pursuant to which the holder 

is required to dispose of the shares upon termination of the holder’s status as a 

director at the same price as the individual acquired the shares. Distributions with 

respect to the shares are deductible by the corporation and includible in the income of 

the holder.

• Bad debt reserves of a bank may be recaptured on the making of an S corporation 

election in either the taxable year beginning with or ending with the year of the 

election.

Qualified Subchapter S Shareholders

• The IRS may validate an inadvertent invalid qualified subchapter S subsidiary 

election under the same circumstances that an inadvertent invalid subchapter S 

election may be validated.

 

16 A similar provision was enacted in section 402 of the Job Creation and Worker 

Assistance Act of 2002 (P.L. 107-147). The provision overturned the result in Gitlitz v. 

Commissioner, 531 U.S. 206 (2001).
26

• Information returns with respect to items of a qualified subchapter S subsidiary may 

be issued by the subsidiary.

• A sale of stock in a qualified subchapter S subsidiary by an S corporation is treated as 

a sale of an undivided interest in the underlying assets based on the percentage of 

stock transferred.

• The “step transaction” doctrine is not applicable to restructurings in connection with 

the making of a qualified subchapter S subsidiary election. Instead, the election is to 

be treated as a liquidation of the subsidiary under the usual rules applicable to 

corporate liquidations of subsidiaries.

Additional Provisions

• The provision, presently applicable to any corporation that was an S corporation for 

its first taxable year beginning after 1996, eliminating all earnings and profits 

accumulated in a taxable year beginning before 1983 in which the corporation was an 

electing small business corporation is extended to all corporations.

• With respect to taxable years beginning before, on, or after July 12, 1995, the 

consolidated return regulations shall not cause gain or loss to be recognized by reason 

of an election to be an S corporation or a qualified subchapter S subsidiary.

• Charitable contribution carryovers and other carryovers are deductible in computing 

the tax on built-in gains of S corporations that are former C corporations in the same 

manner as net operating loss carryovers; foreign tax credit carryovers may offset the 

tax on built-in gains.

• In the case of a distribution made by an S corporation with respect to its stock held by 

an employee stock ownership plan, use of the distributed amount to repay a loan that 

was used to acquire the stock is not a prohibited transaction.

• The provision that a former S corporation must wait five taxable years to reelect to be 

an S corporation is inoperative if the termination or revocation occurred prior to the 

enactment of the bill.

2. The Small Business and Financial Institutions Tax Relief Act of 2003

H.R. 714, the “Small Business and Financial Institutions Tax Relief Act of 2003”, 

introduced by Mr. McInnis, Mr. Ramstad, Mr. Matsui, Mr. English, Mr. Pomeroy, Mr. Foley, 

and others makes following amendments to the tax provisions relating to S corporations:
27

• An IRA holding stock in a bank on the date of enactment of the provision is an 

eligible S corporation shareholder with respect to that stock. Income with respect to 

the stock is treated as unrelated business taxable income.

• The sale of stock in a corporation by an IRA to the individual beneficiary of the IRA 

is not a prohibited transaction if the sale is made pursuant to the corporation making a 

subchapter S election.

• In the case of a bank or bank holding company, interest income and dividends on 

assets required to be held by the bank or bank holding company are not treated as 

passive investment income for purposes of applying the tax on excess net passive 

income.

• The maximum number of eligible shareholders is increased from 75 to 150. 

• Qualifying director shares are not treated as a second class of stock for purposes of 

subchapter S. Qualifying director shares means shares in a bank or bank holding 

company that are held by an individual solely by reason of status as a director of the 

bank or company and which are subject to an agreement pursuant to which the holder 

is required to dispose of the shares upon termination of the holder’s status as a 

director at the same price as the individual acquired the shares. Distributions with 

respect to the shares are deductible by the corporation and includible in the income of 

the holder.

• Bad debt reserves of a bank may be recaptured on the making of an S corporation 

election in either the taxable year ending with or beginning with the year of the 

election.

• The provision17 reducing corporate tax preferences (including interest of banks on 

debt to carry certain tax-exempt obligations) for the first three taxable years after a C 

corporation becomes an S corporation is clarified to specifically state that the 

reduction does not apply after three taxable years.

• Certain family members may elect to be treated as one shareholder for purposes of 

determining the number of shareholders. A family includes a common ancestor (not 

more than three generations removed from the youngest generation of shareholders) 

and the lineal descendants (and spouses) of the common ancestor.

• An S corporation may issue qualified preferred stock (i.e., nonparticipating preferred 

stock as defined for purposes of the consolidated return regulations, determined 

without regard to voting rights and convertibility) distributions with respect to which 

are deductible by the corporation and includible in income of the holder.

 

17 Sec. 1363(b)(4).
28

• Information returns with respect to items of a qualified subchapter S subsidiary may 

be issued by the subsidiary.

• A shareholder’s basis in S corporation stock is not reduced by the amount of 

appreciation in charitable contributions of appreciated property made by the S 

corporation.

3. The Small Business Opportunity and Growth Act of 2003

H.R. 1498, the “Small Business Opportunity and Growth Act of 2003”, introduced by 

Mr. Ramstad, Mr. Crane, Mrs. Johnson, Mr. Herger, Mr. Camp, Mr. Johnson, Mr. English, 

Mr. Weller, Mr. McInnis, Mr. Foley, Mr. Brady, and Mr. Cox, makes the following 

amendment:

• The tax on the built-in gain of an S corporation that filed its subchapter S election 

before March 27, 2003, does not apply to the extent that amounts are reinvested in the 

S corporation business, used to pay principal or interest on certain corporate debt, or 

distributed to shareholders to pay Federal, State, and local income taxes on the builtin gain.