I

106TH CONGRESS

1ST SESSION H. R. 689

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

reform, and for other purposes.

IN THE HOUSE OF REPRESENTATIVES

FEBRUARY 10, 1999

Mr. SHAW (for himself, Mr. MATSUI, Mr. CRANE, Mr. LEVIN, Mr. THOMAS,

Mr. CARDIN, Mrs. JOHNSON of Connecticut, Mr. KLECZKA, Mr. HOUGHTON, Mr. LEWIS of Georgia, Mr. HERGER, Mrs. THURMAN, Mr.

MCCRERY, Mr. RAMSTAD, Ms. DUNN, Mr. COLLINS, Mr. PORTMAN, Mr.

ENGLISH, Mr. WATKINS, Mr. WELLER, Mr. MCCOLLUM, Ms.

MILLENDER-MCDONALD, Mr. BEREUTER, Mr. PETERSON of Pennsylvania, Mr. LEACH, Mr. DOOLEY of California, Mr. STEARNS, Mr. MANZULLO, and Mr. HALL of Texas) introduced the following bill; which was

referred to the Committee on Ways and Means

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’’.
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1 (b) AMENDMENT OF 1986 CODE.—Except as other2 wise expressly provided, whenever in this Act an amend3 ment or repeal is expressed in terms of an amendment

4 to, or repeal of, a section or other provision, the reference

5 shall be considered to be made to a section or other provi6 sion of the Internal Revenue Code of 1986.

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

8 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 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.
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1 TITLE I—ELIGIBLE SHAREHOLD2 ERS OF AN S CORPORATION

3 SEC. 101. MEMBERS OF FAMILY TREATED AS 1 SHARE4 HOLDER.

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

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

7 follows:

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

9 SHAREHOLDER.—

10 ‘‘(A) IN GENERAL.—For purpose of sub11 section (b)(1)(A)—

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

13 a husband and wife (and their estates)

14 shall be treated as 1 shareholder, and

15 ‘‘(ii) in the case of a family with re16 spect to which an election is in effect

17 under subparagraph (E), all members of

18 the family shall be treated as 1 share19 holder.

20 ‘‘(B) MEMBERS OF THE FAMILY.—For

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

22 ‘members of the family’ means the lineal de23 scendants of the common ancestor and the

24 spouses (or former spouses) of such lineal de25 scendants or common ancestor.
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1 ‘‘(C) COMMON ANCESTOR.—For purposes

2 of this paragraph, an individual shall not be

3 considered a common ancestor if, as of the later

4 of the effective date of this paragraph or the

5 time the election under section 1362(a) is

6 made, the individual is more than 6 generations

7 removed from the youngest generation of share8 holders.

9 ‘‘(D) EFFECT OF ADOPTION, ETC.—In de10 termining whether any relationship specified in

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

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

13 ‘‘(E) ELECTION.—An election under sub14 paragraph (A)(ii)—

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

16 all shareholders,

17 ‘‘(ii) shall remain in effect until termi18 nated, and

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

20 1 family in any corporation.’’.

21 SEC. 102. NONRESIDENT ALIENS ALLOWED TO BE SHARE22 HOLDERS.

23 (a) NONRESIDENT ALIENS ALLOWED TO BE SHARE24 HOLDERS.—
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1 (1) IN GENERAL.—Paragraph (1) of section

2 1361(b) (defining small business corporation) is

3 amended—

4 (A) by adding ‘‘and’’ at the end of sub5 paragraph (B),

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

7 (C) by redesignating subparagraph (D) as

8 subparagraph (C).

9 (2) CONFORMING AMENDMENTS.—Paragraph

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

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

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

13 ‘‘subsection (b)(1)(C)’’.

14 (b) NONRESIDENT ALIEN SHAREHOLDER TREATED

15 AS ENGAGED IN TRADE OR BUSINESS WITHIN UNITED

16 STATES.—

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

18 (A) by striking ‘‘and’’ at the end of para19 graph (1),

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

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

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

23 paragraph:

24 ‘‘(3) a nonresident alien individual shall be con25 sidered as being engaged in a trade or business
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1 within the United States if the S corporation of

2 which such individual is a shareholder is so en3 gaged.’’

4 (2) APPLICATION OF WITHHOLDING TAX ON

5 NONRESIDENT ALIEN SHAREHOLDERS.—Section

6 1446 (relating to withholding tax on foreign part7 ners’ share of effectively connected income) is

8 amended by redesignating subsection (f) as sub9 section (g) and by inserting after subsection (e) the

10 following new subsection:

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

12 ETC.—For purposes of this section—

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

14 partnership,

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

16 be treated as partners of such partnership; and

17 ‘‘(3) any reference to section 704 shall be treat18 ed as a reference to section 1366.’’

19 (3) CONFORMING AMENDMENTS.—

20 (A) The heading of section 875 is amended

21 to read as follows:

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

23 AND TRUSTS; S CORPORATIONS.’’

24 (B) The heading of section 1446 is amend25 ed to read as follows:
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1 ‘‘SEC. 1446. WITHHOLDING TAX ON FOREIGN PARTNERS’

2 AND S CORPORATION SHAREHOLDERS’

3 SHARE OF EFFECTIVELY CONNECTED IN4 COME.’’

5 (4) CLERICAL AMENDMENTS.—

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

7 table of sections for subpart A of part II of

8 subchapter N of chapter 1 is amended to read

9 as follows:

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

10 (B) The item relating to section 1446 in

11 the table of sections for subchapter A of chap12 ter 3 is amended to read as follows:

‘‘Sec. 1446 Withholding tax of foreign partners’ and S corporate shareholders’

share of effectively connected income.’’

13 (C) PERMANENT ESTABLISHMENT OF

14 PARTNERS AND S CORPORATION SHAREHOLD15 ERS. Section 894 (relating to income affected

16 by treaty) is amended by redesignating sub17 section (c) as subsection (d) and inserting the

18 following new subsection after subsection (b):

19 ‘‘(c) PERMANENT ESTABLISHMENT OF PARTNERS

20 AND S CORPORATION SHAREHOLDERS.—If a partnership

21 or S corporation has a permanent establishment in the

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

23 the United States is a party) at any time during a taxable
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1 year of such entity, a nonresident alien individual or for2 eign corporation which is a partner in such partnership,

3 or a nonresident alien individual who is a shareholder in

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

5 establishment in the United States for purposes of such

6 treaty.’’

7 TITLE II—QUALIFICATION AND

8 ELIGIBILITY REQUIREMENTS

9 OF S CORPORATIONS

10 SEC. 201. ISSUANCE OF PREFERRED STOCK PERMITTED.

11 (a) IN GENERAL.—Section 1361 is amended by add12 ing at the end the following new subsection:

13 ‘‘(f) TREATMENT OF QUALIFIED PREFERRED

14 STOCK.—

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

16 subchapter—

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

18 treated as a second class of stock, and

19 ‘‘(B) no person shall be treated as a share20 holder of the corporation by reason of holding

21 qualified preferred stock.

22 ‘‘(2) QUALIFIED PREFERRED STOCK DE23 FINED.—For purposes of this subsection, the term

24 ‘qualified preferred stock’ means stock which meets

25 the requirements of subparagraphs (A), (B), and (C)
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1 of section 1504(a)(4). Stock shall not fail to be

2 treated as qualified preferred stock merely because

3 it is convertible into other stock.

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

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

6 the corporation with respect to qualified preferred

7 stock shall be includible as ordinary income of the

8 holder and deductible to the corporation as an ex9 pense in computing taxable income under section

10 1363(b) in the year such distribution is received.’’

11 (b) CONFORMING AMENDMENTS.—

12 (1) Paragraph (1) of section 1361(b) is amend13 ed by inserting ’’, except as provided in subsection

14 (f),’’ before ‘‘which does not’’.

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

16 by adding at the end the following new paragraph:

17 ‘‘(3) ALLOCATION WITH RESPECT TO QUALI18 FIED PREFERRED STOCK.—The holders of qualified

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

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

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

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

23 354(a)(2)(C) as precedes subclause (II) is amended

24 to read as follows:
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1 ‘‘(ii) RECAPITALIZATION OF FAMILY2 OWNED CORPORATIONS AND S CORPORA3 TIONS.—

4 ‘‘(I) IN GENERAL.—Clause (i)

5 shall not apply in the case of a recapi6 talization under section 368(a)(I)(E)

7 of a family-owned corporation or S

8 corporation.’’

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

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

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

12 inserting ‘‘, and’’, and by adding at the end the fol13 lowing new paragraph:

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

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

16 be apportioned or allocated to such income.’’

17 SEC. 202. SAFE HARBOR EXPANDED TO INCLUDE CONVERT18 IBLE DEBT.

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

20 straight debt) is amended by adding ‘‘and’’ at the end of

21 clause (i) and by striking clauses (ii) and (iii) and insert22 ing the following:

23 ‘‘(ii) in any cases in which the terms

24 of such promise include a provision under

25 which the obligation to pay may be con-
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1 verted (directly or indirectly) into stock of

2 the corporation, such terms, taken as a

3 whole, are substantially the same as the

4 terms which could have been obtained on

5 the effective date of the promise from a

6 person which is not a related person (with7 in the meaning of section 465(b)(3)(C)) to

8 the S corporation or its shareholders, and

9 ‘‘(iii) the creditor is—

10 ‘‘(I) an individual,

11 ‘‘(II) an estate,

12 ‘‘(III) a trust described in para13 graph (2), or

14 ‘‘(IV) a person which is actively

15 and regularly engaged in the business

16 of lending money.’’

17 SEC. 203. REPEAL OF EXCESSIVE PASSIVE INVESTMENT IN18 COME AS A TERMINATION EVENT.

19 (a) IN GENERAL.—Section 1362(d) (relating to ter20 mination) is amended by striking paragraph (3).

21 (b) CONFORMING AMENDMENTS.—

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

23 ‘‘or (3)’’.
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1 (2) Clause (i) of section 1042(c)(4)(A) is

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

3 inserting ‘‘section 1375(b)(4)’’.

4 SEC. 204. REPEAL PASSIVE INCOME CAPITAL GAIN CAT5 EGORY.

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

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

8 paragraphs:

9 ‘‘(3) SUBCHAPTER C EARNINGS AND PROF10 ITS.—The term ‘subchapter C earnings and profits’

11 means earnings and profits of any corporation for

12 any taxable year with respect to which an election

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

14 prior law) was not in effect.

15 ‘‘(4) PASSIVE INVESTMENT INCOME DE16 FINED.—

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

18 provided in this paragraph, the term ‘passive

19 investment income’ means gross receipts de20 rived from royalties, rents, dividends, interest,

21 and annuities.

22 ‘‘(B) EXCEPTION FOR INTEREST ON

23 NOTES FROM SALES OF INVENTORY.—The term

24 ‘passive investment income’ shall not include in25 terest on any obligation acquired in the ordi-
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1 nary course of the corporation’s trade or busi2 ness from its sale of property described in sec3 tion 1221(1).

4 ‘‘(C) TREATMENT OF CERTAIN LENDING

5 OR FINANCE COMPANIES.—If the S corporation

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

7 the taxable year, the term ‘passive investment

8 income’ shall not include gross receipts for the

9 taxable year which are derived directly from the

10 active and regular conduct of a lending or fi11 nance business (as defined in section

12 542(d)(1)).

13 ‘‘(D) TREATMENT OF CERTAIN DIVI14 DENDS.—If an S corporation holds stock in a

15 C corporation meeting the requirements of sec16 tion 1504(a)(2), the term ‘passive investment

17 income’ shall not include dividends from such C

18 corporation to the extent such dividends are at19 tributable to the earnings and profits of such C

20 corporations derived from the active conduct of

21 a trade or business.

22 ‘‘(E) COORDINATION WITH SECTION

23 1374.—The amount of passive investment in24 come shall be determined by not taking into ac25 count any recognized built-in gain or loss of the
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1 S corporation for any taxable year in the rec2 ognition period. Terms used in the preceding

3 sentence shall have the same respective mean4 ing as when used in section 1374.’’

5 SEC. 205. ALLOWANCE OF CHARITABLE CONTRIBUTIONS

6 OF INVENTORY AND SCIENTIFIC PROPERTY.

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

8 contributions of ordinary income and capital gain prop9 erty) is amended—

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

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

12 and

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

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

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

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

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

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

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

20 end of subparagraphs (C) and inserting ‘‘, and’’, and by

21 adding at the end the following new subparagraph:

22 ‘‘(D) the excess of the deductions for char23 itable contributions over the basis of the prop24 erty contributed.’’
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1 SEC. 206. C CORPORATION RULES TO APPLY FOR FRINGE

2 BENEFIT PURPOSES.

3 (a) IN GENERAL.—Section 1372 (relating to partner4 ship rules to apply for fringe benefit purposes) is repealed.

5 (b) PARTNERSHIP RULES TO APPLY FOR HEALTH

6 INSURANCE COSTS OF CERTAIN S CORPORATION SHARE7 HOLDERS.—Paragraph (5) of section 162(l) is amended

8 to read as follows:

9 ‘‘(5) TREATMENT OF CERTAIN S CORPORATION

10 SHAREHOLDERS.—

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

12 apply in the case of any 2-percent shareholder

13 of an S corporation, except that—

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

15 such shareholder’s wages (as defined in

16 section 3121) from the S corporation shall

17 be treated as such shareholder’s earned in18 come (within the meaning of section

19 401(c)(1)), and

20 ‘‘(ii) there shall be such adjustments

21 in the application of this subsection as the

22 Secretary may by regulations prescribe.

23 ‘‘(B) 2-PERCENT SHAREHOLDER DE24 FINED.—For purposes of this paragraph, the

25 term ‘2-percent shareholder’ means any person

26 who owns (or is considered as owning within
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1 the meaning of section 318) on any day during

2 the taxable year of the S corporation more than

3 2 percent of the outstanding stock of such cor4 poration or stock possessing more than 2 per5 cent of the total combined voting power of all

6 stock of such corporation.’’

7 (b) CONFORMING AMENDMENT.—The table of sec8 tions for part III of subchapter S of chapter 1 is amended

9 by striking the item relating to section 1372.

10 TITLE III—TAXATION OF S

11 CORPORATION SHAREHOLDERS

12 SEC. 301. TREATMENT OF LOSSES TO SHAREHOLDERS.

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

14 loss to shareholders in corporate liquidations) is amended

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

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

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

18 ‘‘(1) IN GENERAL.—The portion of any loss rec19 ognized by a shareholder of an S corporation (as de20 fined in section 1361(a)(1)) on amounts received by

21 such shareholder in a distribution in complete liq22 uidation of such S corporation which does not exceed

23 the ordinary income basis of stock of such S cor24 poration in the hands of such shareholder shall not
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1 be treated as a loss from the sale or exchange of a

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

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

4 of this subsection, the ordinary income basis of stock

5 of an S corporation in the hands of a shareholder of

6 such S corporation shall be an amount equal to the

7 portion of such shareholder’s basis in such stock

8 which is equal to the aggregate increases in such

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

10 shareholder’s pro rata share of ordinary income of

11 such S corporation attributable to the complete liq12 uidation.’’

13 (b) SUSPENDED PASSIVE ACTIVITY LOSSES.—Para14 graph (3) of section 1371(b) is amended to read as fol15 lows:

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

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

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

19 which a corporation is an S corporation as a taxable

20 year for purposes of determining the number of tax21 able years to which an item may be carried back or

22 carried forward nor prevent the allowance of a pas23 sive activity loss deduction to the extent provided by

24 section 469(g).’’
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1 TITLE IV—EFFECTIVE DATE

2 SEC. 401. EFFECTIVE DATE.

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

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

5 termination, the amendments made by this Act shall apply

6 to taxable years beginning after December 31, 1999.

7 (b) TREATMENT OF CERTAIN ELECTIONS UNDER

8 PRIOR LAW.—For purposes of section 1362(g) of the In9 ternal Revenue Code of 1986 (relating to election after

10 termination), any termination or revocation under section

11 1362(d) of such Code (as in effect on the day before enact12 ment of this Act) shall not be taken into account.

Æ