II

107TH CONGRESS

1ST SESSION S. 1201

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 19, 2001

Mr. HATCH (for himself, Mr. BREAUX, Mrs. LINCOLN, Mr. ALLARD, Mr.

THOMPSON, and Mr. GRAMM) 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 Modernization Act of 2001’’.

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.

Sec. 103. Expansion of bank S corporation eligible shareholders to include

IRAs.

Sec. 104. Increase in number of eligible shareholders to 150.

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. Modifications to passive income rules.

Sec. 205. Adjustment to basis of S corporation stock for certain charitable contributions.

TITLE III—TREATMENT OF S CORPORATION SHAREHOLDERS

Sec. 301. Treatment of losses to shareholders.

Sec. 302. Transfer of suspended losses incident to divorce.

Sec. 303. Use of passive activity loss and at-risk amounts by qualified subchapter S trust income beneficiaries.

Sec. 304. Deductibility of interest expense incurred by an electing small business trust to acquire S corporation stock.

Sec. 305. Disregard of unexercised powers of appointment in determining potential current beneficiaries of ESBT.

Sec. 306. Clarification of electing small business trust distribution rules.

Sec. 307. Allowance of charitable contributions deduction for electing small

business trusts.

Sec. 308. Shareholder basis not increased by income derived from cancellation

of S corporation’s debt.

Sec. 309. Back to back loans as indebtedness.

TITLE IV—EXPANSION OF S CORPORATION ELIGIBILITY FOR

BANKS.

Sec. 401. Exclusion of investment securities income from passive income test

for bank S corporations.

Sec. 402. Treatment of qualifying director shares.

Sec. 403. Recapture of bad debt reserves.

TITLE V—QUALIFIED SUBCHAPTER S SUBSIDIARIES

Sec. 501. Relief from inadvertently invalid qualified subchapter S subsidiary

elections and terminations.
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Sec. 502. Information returns for qualified subchapter S subsidiaries.

Sec. 503. Treatment of the sale of interest in a qualified subchapter S subsidiary.

Sec. 504. Exception to application of step transaction doctrine for restructuring

in connection with making qualified subchapter S subsidiary

elections.

TITLE VI—ADDITIONAL PROVISIONS

Sec. 601. Elimination of all earnings and profits attributable to pre-1983 years.

Sec. 602. No gain or loss on deferred intercompany transactions because of

conversion to S corporation or qualified S corporation subsidiary.

Sec. 603. Treatment of charitable contribution and foreign tax credit

carryforwards.

Sec. 604. Distributions by an S corporation to an employee stock ownership

plan.

Sec. 605. Special rules of application.

1 TITLE I—ELIGIBLE SHARE2 HOLDERS OF AN S CORPORA3 TION

4 SEC. 101. MEMBERS OF FAMILY TREATED AS 1 SHARE5 HOLDER.

6 (a) IN GENERAL.—Paragraph (1) of section 1361(c)

7 (relating to special rules for applying subsection (b)) is

8 amended to read as follows:

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

10 SHAREHOLDER.—

11 ‘‘(A) IN GENERAL.—For purpose of sub12 section (b)(1)(A)—

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

14 a husband and wife (and their estates)

15 shall be treated as 1 shareholder, and

16 ‘‘(ii) in the case of a family with re17 spect to which an election is in effect
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1 under subparagraph (E), all members of

2 the family shall be treated as 1 share3 holder.

4 ‘‘(B) MEMBERS OF THE FAMILY.—For

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

6 ‘members of the family’ means the common an7 cestor, lineal descendants of the common ances8 tor and the spouses (or former spouses) of such

9 lineal descendants or common ancestor.

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

11 of this paragraph, an individual shall not be

12 considered a common ancestor if, as of the later

13 of the effective date of this paragraph or the

14 time the election under section 1362(a) is

15 made, the individual is more than 6 generations

16 removed from the youngest generation of share17 holders.

18 ‘‘(D) EFFECT OF ADOPTION, ETC.—In de19 termining whether any relationship specified in

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

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

22 ‘‘(E) ELECTION.—An election under sub23 paragraph (A)(ii)—

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

25 shareholders (including those that are fam-
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1 ily members) holding in the aggregate

2 more than one-half of the shares of stock

3 in the corporation on the day the election

4 is made,

5 ‘‘(ii) in the case of—

6 ‘‘(I) an electing small business

7 trust, shall be made by the trustee of

8 the trust, and

9 ‘‘(II) a qualified subchapter S

10 trust, shall be made by the beneficiary

11 of the trust,

12 ‘‘(iii) under regulations, shall remain

13 in effect until terminated, and

14 ‘‘(iv) shall apply only with respect to

15 1 family in any corporation.’’.

16 (b) RELIEF FROM INADVERTENT INVALID ELECTION

17 OR TERMINATION.—Section 1362(f) (relating to inad18 vertent invalid elections or terminations), as amended by

19 section 501, is amended—

20 (1) by inserting ‘‘or under section

21 1361(c)(1)(A)(ii)’’ after ‘‘section 1361(b)(3)(B)(ii)’’

22 in paragraph (1), and

23 (2) by inserting ‘‘or under section

24 1361(c)(1)(E)(iii)’’ after ‘‘section 1361(b)(3)(C)’’ in

25 paragraph (1)(B).
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1 (c) EFFECTIVE DATES.—

2 (1) SUBSECTION (a).—The amendment made

3 by subsection (a) shall apply to taxable years begin4 ning after December 31, 2001.

5 (2) SUBSECTION (b).—The amendments made

6 by subsection (b) shall apply to elections and termi7 nations made after December 31, 2001.

8 SEC. 102. NONRESIDENT ALIENS ALLOWED TO BE SHARE9 HOLDERS.

10 (a) NONRESIDENT ALIENS ALLOWED TO BE SHARE11 HOLDERS.—

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

13 1361(b) (defining small business corporation) is

14 amended—

15 (A) by adding ‘‘and’’ at the end of sub16 paragraph (B),

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

18 (C) by redesignating subparagraph (D) as

19 subparagraph (C).

20 (2) CONFORMING AMENDMENTS.—Paragraph

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

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

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

24 ‘‘subsection (b)(1)(C)’’.
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1 (b) NONRESIDENT ALIEN SHAREHOLDER TREATED

2 AS ENGAGED IN TRADE OR BUSINESS WITHIN UNITED

3 STATES.—

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

5 (A) by striking ‘‘and’’ at the end of para6 graph (1),

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

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

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

10 paragraph:

11 ‘‘(3) a nonresident alien individual shall be con12 sidered as being engaged in a trade or business

13 within the United States if the S corporation of

14 which such individual is a shareholder is so en15 gaged.’’.

16 (2) APPLICATION OF WITHHOLDING TAX ON

17 NONRESIDENT ALIEN SHAREHOLDERS.—Section

18 1446 (relating to withholding tax on foreign part19 ners’ share of effectively connected income) is

20 amended by redesignating subsection (f) as sub21 section (g) and by inserting after subsection (e) the

22 following new subsection:

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

24 ETC.—For purposes of this section—
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1 ‘‘(1) an S corporation shall be treated as a

2 partnership,

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

4 be treated as partners of such partnership,

5 ‘‘(3) any reference to section 704 shall be treat6 ed as a reference to section 1366, and

7 ‘‘(4) no withholding tax under subsection (a)

8 shall be required in the case of any income realized

9 by such corporation and allocable to a shareholder

10 which is an electing small business trust (as defined

11 in section 1361(e)).’’.

12 (3) CONFORMING AMENDMENTS.—

13 (A) The heading of section 875 is amended

14 to read as follows:

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

16 AND TRUSTS; S CORPORATIONS.’’.

17 (B) The heading of section 1446 is amend18 ed to read as follows:

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

20 AND S CORPORATION SHAREHOLDERS’

21 SHARE OF EFFECTIVELY CONNECTED IN22 COME.’’.

23 (4) CLERICAL AMENDMENTS.—

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

25 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. 1446Withholding 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 by insert11 ing after subsection (b) the following new sub12 section:

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 (c) APPLICATION OF OTHER WITHHOLDING TAX

2 RULES ON NONRESIDENT ALIEN SHAREHOLDERS.—

3 (1) SECTION 1441.—Section 1441 (relating to

4 withholding of tax on nonresident aliens) is amended

5 by redesignating subsection (g) as subsection (h)

6 and by inserting after subsection (f) the following

7 new subsection:

8 ‘‘(g) S CORPORATION TREATED AS PARTNERSHIP,

9 ETC.—For purposes of this section—

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

11 partnership,

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

13 be treated as partners of such partnership, and

14 ‘‘(3) no deduction or withholding under sub15 section (a) shall be required in the case of any item

16 of income realized by such corporation and allocable

17 to a shareholder which is an electing small business

18 trust (as defined in section 1361(e)).’’.

19 (2) SECTION 1445.—Section 1445(e) (relating to

20 special rules relating to distributions, etc., by cor21 porations, partnerships, trusts, or estates) is amend22 ed by redesignating paragraph (6) as paragraph (7)

23 and by inserting after paragraph (5) the following

24 new paragraph:
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1 ‘‘(6) S CORPORATION TREATED AS PARTNER2 SHIP, ETC.—For purposes of this section—

3 ‘‘(A) an S corporation shall be treated as

4 a partnership, and

5 ‘‘(B) the shareholders of such corporation

6 shall be treated as partners of such partnership,

7 and

8 ‘‘(C) no deduction or withholding under

9 subsection (a) shall be required in the case of

10 any gain realized by such corporation and allo11 cable to a shareholder which is an electing small

12 business trust (as defined in section 1361(e)).’’.

13 (d) CONFORMING AMENDMENT.—Section 1361(e)(2)

14 is amended by inserting ‘‘(including a nonresident alien)’’

15 after ‘‘person’’ the first place it appears.

16 (e) EFFECTIVE DATE.—The amendments made by

17 this section shall apply to taxable years beginning after

18 December 31, 2001.

19 SEC. 103. EXPANSION OF BANK S CORPORATION ELIGIBLE

20 SHAREHOLDERS TO INCLUDE IRAS.

21 (a) IN GENERAL.—Section 1361(c)(2)(A) (relating to

22 certain trusts permitted as shareholders) is amended by

23 inserting after clause (v) the following new clause:

24 ‘‘(vi) In the case of a corporation

25 which is a bank (as defined in section
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1 581), a trust which constitutes an indi2 vidual retirement account under section

3 408(a), including one designated as a Roth

4 IRA under section 408A, but only to the

5 extent of the stock held by such trust in

6 such bank as of the date of the enactment

7 of this clause.’’.

8 (b) TREATMENT AS SHAREHOLDER.—Section

9 1361(c)(2)(B) (relating to treatment as shareholders) is

10 amended by adding at the end the following new clause:

11 ‘‘(vi) In the case of a trust described

12 in clause (vi) of subparagraph (A), the in13 dividual for whose benefit the trust was

14 created shall be treated as a shareholder.’’.

15 (c) SALE OF STOCK IN IRA RELATING TO S COR16 PORATION ELECTION EXEMPT FROM PROHIBITED

17 TRANSACTION RULES.—Section 4975(d) (relating to ex18 emptions) is amended by striking ‘‘or’’ at the end of para19 graph (14), by striking the period at the end of paragraph

20 (15) and inserting ‘‘; or’’, and by adding at the end the

21 following new paragraph:

22 ‘‘(16) a sale of stock held by a trust which con23 stitutes an individual retirement account under sec24 tion 408(a) to the individual for whose benefit such
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1 account is established if such sale is pursuant to an

2 election under section 1362(a).’’.

3 (d) CONFORMING AMENDMENT.—Section 512(e)(1)

4 is amended by inserting ‘‘1361(c)(2)(A)(vi) or’’ before

5 ‘‘1361(c)(6)’’.

6 (e) EFFECTIVE DATE.—The amendments made by

7 this section shall apply to trusts which constitute indi8 vidual retirement accounts on the date of the enactment

9 of this Act.

10 SEC. 104. INCREASE IN NUMBER OF ELIGIBLE SHARE11 HOLDERS TO 150.

12 (a) IN GENERAL.—Section 1361(b)(1)(A) (defining

13 small business corporation) is amended by striking ‘‘75’’

14 and inserting ‘‘150’’.

15 (b) EFFECTIVE DATE.—The amendment made by

16 this section shall apply to taxable years beginning after

17 December 31, 2001.

18 TITLE II—QUALIFICATION AND

19 ELIGIBILITY REQUIREMENTS

20 OF S CORPORATIONS

21 SEC. 201. ISSUANCE OF PREFERRED STOCK PERMITTED.

22 (a) IN GENERAL.—Section 1361 (defining S corpora23 tion) is amended by adding at the end the following new

24 subsection:
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1 ‘‘(f) TREATMENT OF QUALIFIED PREFERRED

2 STOCK.—

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

4 subchapter—

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

6 treated as a second class of stock, and

7 ‘‘(B) no person shall be treated as a share8 holder of the corporation by reason of holding

9 qualified preferred stock.

10 ‘‘(2) QUALIFIED PREFERRED STOCK DE11 FINED.—For purposes of this subsection, the term

12 ‘qualified preferred stock’ means stock which meets

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

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

15 treated as qualified preferred stock merely because

16 it is convertible into other stock.

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

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

19 the corporation with respect to qualified preferred

20 stock shall be includible as ordinary income of the

21 holder and deductible to the corporation as an ex22 pense in computing taxable income under section

23 1363(b) in the year such distribution is received.’’.

24 (b) CONFORMING AMENDMENTS.—
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1 (1) Paragraph (1) of section 1361(b) is amend2 ed by inserting ‘‘, except as provided in subsection

3 (f),’’ before ‘‘which does not’’.

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

5 by adding at the end the following new paragraph:

6 ‘‘(3) ALLOCATION WITH RESPECT TO QUALI7 FIED PREFERRED STOCK.—The holders of qualified

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

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

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

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

12 354(a)(2)(C) as precedes subclause (II) is amended

13 to read as follows:

14 ‘‘(ii) RECAPITALIZATION OF FAMILY15 OWNED CORPORATIONS AND S CORPORA16 TIONS.—

17 ‘‘(I) IN GENERAL.—Clause (i)

18 shall not apply in the case of a recapi19 talization under section 368(a)(I)(E)

20 of a family-owned corporation or S

21 corporation.’’.

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

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

24 striking the period at the end of paragraph (2) and
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1 inserting ‘‘, and’’, and by adding at the end the fol2 lowing new paragraph:

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

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

5 be apportioned or allocated to such income.’’.

6 (c) EFFECTIVE DATE.—The amendments made by

7 this section shall apply to taxable years beginning after

8 December 31, 2001.

9 SEC. 202. SAFE HARBOR EXPANDED TO INCLUDE CONVERT10 IBLE DEBT.

11 (a) IN GENERAL.—Subparagraph (B) of section

12 1361(c)(5) (defining straight debt) is amended by striking

13 clauses (ii) and (iii) and inserting the following new

14 clauses:

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

16 such promise include a provision under

17 which the obligation to pay may be con18 verted (directly or indirectly) into stock of

19 the corporation, such terms, taken as a

20 whole, are substantially the same as the

21 terms which could have been obtained on

22 the effective date of the promise from a

23 person which is not a related person (with24 in the meaning of section 465(b)(3)(C)) to

25 the S corporation or its shareholders, and
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1 ‘‘(iii) the creditor is—

2 ‘‘(I) an individual,

3 ‘‘(II) an estate,

4 ‘‘(III) a trust described in para5 graph (2),

6 ‘‘(IV) an exempt organization de7 scribed in paragraph (6), or

8 ‘‘(V) a person which is actively

9 and regularly engaged in the business

10 of lending money.’’.

11 (b) EFFECTIVE DATE.—The amendment made by

12 this section shall apply to taxable years beginning after

13 December 31, 2001.

14 SEC. 203. REPEAL OF EXCESSIVE PASSIVE INVESTMENT IN15 COME AS A TERMINATION EVENT.

16 (a) IN GENERAL.—Section 1362(d) (relating to ter17 mination) is amended by striking paragraph (3).

18 (b) CONFORMING AMENDMENTS.—

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

20 ‘‘or (3)’’.

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

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

23 inserting ‘‘section 1375(b)(4)’’.
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1 (c) EFFECTIVE DATE.—The amendments made by

2 this section shall apply to taxable years beginning after

3 December 31, 2001.

4 SEC. 204. MODIFICATIONS TO PASSIVE INCOME RULES.

5 (a) INCREASED LIMIT.—

6 (1) IN GENERAL.—Subsection (a)(2) of section

7 1375 (relating to tax imposed when passive invest8 ment income of corporation having accumulated

9 earnings and profits exceeds 25 percent of gross re10 ceipts) is amended by striking ‘‘25 percent’’ and in11 serting ‘‘60 percent’’.

12 (2) CONFORMING AMENDMENTS.—

13 (A) Subparagraph (J) of section 26(b)(2)

14 is amended by striking ‘‘25 percent’’ and insert15 ing ‘‘60 percent’’.

16 (B) Clause (i) of section 1375(b)(1)(A) is

17 amended by striking ‘‘25 percent’’ and inserting

18 ‘‘60 percent’’.

19 (C) The heading for section 1375 is

20 amended by striking ‘‘25 PERCENT’’ and in21 serting ‘‘60 PERCENT’’.

22 (D) The table of sections for part III of

23 subchapter S of chapter 1 is amended by strik24 ing ‘‘25 percent’’ in the item relating to section

25 1375 and inserting ‘‘60 percent’’.
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1 (b) REPEAL OF PASSIVE INCOME CAPITAL GAIN

2 CATEGORY.—

3 (1) IN GENERAL.—Subsection (b) of section

4 1375 (relating to tax imposed when passive invest5 ment income of corporation having accumulated

6 earnings and profits exceeds 60 percent of gross re7 ceipts), as amended by subsection (a), is amended by

8 striking paragraphs (3) and (4) and inserting the

9 following new paragraph:

10 ‘‘(3) PASSIVE INVESTMENT INCOME DE11 FINED.—

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

13 provided in this paragraph, the term ‘passive

14 investment income’ means gross receipts de15 rived from royalties, rents, dividends, interest,

16 and annuities.

17 ‘‘(B) EXCEPTION FOR INTEREST ON

18 NOTES FROM SALES OF INVENTORY.—The term

19 ‘passive investment income’ shall not include in20 terest on any obligation acquired in the ordi21 nary course of the corporation’s trade or busi22 ness from its sale of property described in sec23 tion 1221(a)(1).

24 ‘‘(C) TREATMENT OF CERTAIN LENDING

25 OR FINANCE COMPANIES.—If the S corporation
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1 meets the requirements of section 542(c)(6) for

2 the taxable year, the term ‘passive investment

3 income’ shall not include gross receipts for the

4 taxable year which are derived directly from the

5 active and regular conduct of a lending or fi6 nance business (as defined in section

7 542(d)(1)).

8 ‘‘(D) TREATMENT OF CERTAIN DIVI9 DENDS.—If an S corporation holds stock in a

10 C corporation meeting the requirements of sec11 tion 1504(a)(2), the term ‘passive investment

12 income’ shall not include dividends from such C

13 corporation to the extent such dividends are at14 tributable to the earnings and profits of such C

15 corporation derived from the active conduct of

16 a trade or business.

17 ‘‘(E) COORDINATION WITH SECTION

18 1374.—The amount of passive investment in19 come shall be determined by not taking into ac20 count any recognized built-in gain or loss of the

21 S corporation for any taxable year in the rec22 ognition period. Terms used in the preceding

23 sentence shall have the same respective mean24 ing as when used in section 1374.’’.
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1 (2) CONFORMING AMENDMENTS.—Section

2 1375(d) is amended by striking ‘‘subchapter C’’ both

3 places it appears and inserting ‘‘accumulated’’.

4 (c) EFFECTIVE DATE.—The amendments made by

5 this section shall apply to taxable years beginning after

6 December 31, 2001.

7 SEC. 205. ADJUSTMENT TO BASIS OF S CORPORATION

8 STOCK FOR CERTAIN CHARITABLE CON9 TRIBUTIONS.

10 (a) IN GENERAL.—Paragraph (1) of section 1367(a)

11 (relating to adjustments to basis of stock of shareholders,

12 etc.) is amended by striking ‘‘and’’ at the end of subpara13 graph (B), by striking the period at the end of subpara14 graph (C) and inserting ‘‘, and’’, and by adding at the

15 end the following new subparagraph:

16 ‘‘(D) the excess of the amount of the

17 shareholder’s proportionate share of any chari18 table contribution made by the S corporation

19 over the shareholder’s proportionate share of

20 the adjusted basis of the property contrib21 uted.’’.

22 (b) EFFECTIVE DATE.—The amendments made by

23 this section shall apply to taxable years beginning after

24 December 31, 2001.
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1 TITLE III—TREATMENT OF S

2 CORPORATION SHAREHOLDERS

3 SEC. 301. TREATMENT OF LOSSES TO SHAREHOLDERS.

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

5 loss to shareholders in corporate liquidations) is amended

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

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

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

9 ‘‘(1) IN GENERAL.—The portion of any net loss

10 recognized by a shareholder of an S corporation (as

11 defined in section 1361(a)(1))—

12 ‘‘(A) on amounts received by such share13 holder in a distribution in complete liquidation

14 of such S corporation, or

15 ‘‘(B) on an installment obligation received

16 by such shareholder with respect to a sale or

17 exchange by the corporation during the 12-

18 month period beginning on the date a plan of

19 complete liquidation is adopted if the liquida20 tion is completed during such 12-month period,

21 which does not exceed the ordinary income basis of

22 stock of such S corporation in the hands of such

23 shareholder shall not be treated as a loss from the

24 sale or exchange of a capital asset but shall be treat25 ed as an ordinary loss.
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1 ‘‘(2) ORDINARY INCOME BASIS.—For purposes

2 of this subsection, the ordinary income basis of stock

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

4 such S corporation shall be an amount equal to the

5 portion of such shareholder’s basis in such stock

6 which is equal to the aggregate increases in such

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

8 shareholder’s pro rata share of ordinary income of

9 such S corporation attributable to the complete liq10 uidation.’’.

11 (b) SUSPENDED PASSIVE ACTIVITY LOSSES.—Para12 graph (3) of section 1371(b) is amended to read as fol13 lows:

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

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

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

17 which a corporation is an S corporation as a taxable

18 year for purposes of determining the number of tax19 able years to which an item may be carried back or

20 carried forward nor prevent the allowance of a pas21 sive activity loss deduction to the extent provided by

22 section 469(g).’’.

23 (c) EFFECTIVE DATE.—The amendments made by

24 this section shall apply to taxable years beginning after

25 December 31, 2001.
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1 SEC. 302. TRANSFER OF SUSPENDED LOSSES INCIDENT TO

2 DIVORCE.

3 (a) IN GENERAL.—Section 1366(d) (relating to spe4 cial rules for losses and deductions) is amended by adding

5 at the end the following new paragraph:

6 ‘‘(4) TRANSFER OF SUSPENDED LOSSES AND

7 DEDUCTIONS WHEN STOCK IS TRANSFERRED INCI8 DENT TO DIVORCE.—For purposes of paragraph (2),

9 the transfer of any shareholder’s stock in an S cor10 poration incident to a decree of divorce shall include

11 any loss or deduction described in such paragraph

12 attributable to such stock.’’.

13 (b) EFFECTIVE DATE.—The amendment made by

14 this section shall apply to transfers made after the date

15 of the enactment of this Act.

16 SEC. 303. USE OF PASSIVE ACTIVITY LOSS AND AT-RISK

17 AMOUNTS BY QUALIFIED SUBCHAPTER S

18 TRUST INCOME BENEFICIARIES.

19 (a) IN GENERAL.—Section 1361(d)(1) (relating to

20 special rule for qualified subchapter S trust) is amended—

21 (1) by striking ‘‘and’’ at the end of subpara22 graph (A),

23 (2) by striking the period at the end of sub24 paragraph (B) and inserting ‘‘, and’’, and

25 (3) by adding at the end the following new sub26 paragraph:
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1 ‘‘(C) for purposes of applying sections 465

2 and 469(g) to the beneficiary of the trust, the

3 disposition of the S corporation stock by the

4 trust shall be treated as a disposition by such

5 beneficiary.’’.

6 (b) EFFECTIVE DATE.—The amendments made by

7 this section shall apply to transfers made after the date

8 of the enactment of this Act.

9 SEC. 304. DEDUCTIBILITY OF INTEREST EXPENSE IN10 CURRED BY AN ELECTING SMALL BUSINESS

11 TRUST TO ACQUIRE S CORPORATION STOCK.

12 (a) IN GENERAL.—Subparagraph (C) of section

13 641(c)(2) (relating to modifications) is amended by insert14 ing after clause (iii) the following new clause:

15 ‘‘(iv) Any interest expense incurred to

16 acquire stock in an S corporation.’’.

17 (b) EFFECTIVE DATE.—The amendment made by

18 this section shall apply to taxable years beginning after

19 December 31, 2001.

20 SEC. 305. DISREGARD OF UNEXERCISED POWERS OF AP21 POINTMENT IN DETERMINING POTENTIAL

22 CURRENT BENEFICIARIES OF ESBT.

23 (a) IN GENERAL.—Section 1361(e)(2) (defining po24 tential current beneficiary) is amended—
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1 (1) by inserting ‘‘(determined without regard to

2 any unexercised (in whole or in part) power of ap3 pointment during such period)’’ after ‘‘of the trust’’

4 in the first sentence, and

5 (2) by striking ‘‘60-day’’ in the second sentence

6 and inserting ‘‘1-year’’.

7 (b) EFFECTIVE DATE.—The amendments made by

8 this section shall apply to taxable years beginning after

9 December 31, 2001.

10 SEC. 306. CLARIFICATION OF ELECTING SMALL BUSINESS

11 TRUST DISTRIBUTION RULES.

12 (a) IN GENERAL.—Section 641(c)(1) (relating to spe13 cial rules for taxation of electing small business trusts)

14 is amended—

15 (1) by striking ‘‘and’’ at the end of subpara16 graph (A),

17 (2) by redesignating subparagraph (B) as sub18 paragraph (C), and

19 (3) by inserting after subparagraph (A) the fol20 lowing new subparagraph:

21 ‘‘(B) any distribution attributable to the

22 portion treated as a separate trust shall be

23 treated separately from any distribution attrib24 utable to the portion not so treated, and’’.
27

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1 (b) EFFECTIVE DATE.—The amendments made by

2 this section shall apply to taxable years beginning after

3 December 31, 1996.

4 SEC. 307. ALLOWANCE OF CHARITABLE CONTRIBUTIONS

5 DEDUCTION FOR ELECTING SMALL BUSINESS

6 TRUSTS.

7 (a) IN GENERAL.—Section 641(c)(2)(C) (relating to

8 modifications), as amended by section 304(a), is amended

9 by inserting after clause (iv) the following new clause:—

10 ‘‘(v) Deductions described in section

11 642(c)(1).’’.

12 (b) CONFORMING AMENDMENT.—Section 512(e) (re13 lating to special rules applicable to S corporations) is

14 amended by redesignating subparagraph (3) as subpara15 graph (4) and by inserting after subparagraph (2) the fol16 lowing new subparagraph:

17 ‘‘(3) AMOUNTS RECEIVED FROM AN ELECTING

18 SMALL BUSINESS TRUST.—Notwithstanding any

19 other provision of this part, amounts received by an

20 organization described in section 511(a)(2) from an

21 electing small business trust (as defined in section

22 1361(e)) shall be taken into account in computing

23 the unrelated business taxable income of such orga24 nization to the extent such amount is deducted by

25 such trust under section 641(c)(2)(C)(v).’’.
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1 (c) EFFECTIVE DATE.—The amendments made by

2 this section shall apply to taxable years beginning after

3 December 31, 2001.

4 SEC. 308. SHAREHOLDER BASIS NOT INCREASED BY IN5 COME DERIVED FROM CANCELLATION OF S

6 CORPORATION’S DEBT.

7 (a) IN GENERAL.—Section 1366(a)(1) (relating to

8 determination of shareholder’s tax liability) is amended by

9 inserting ‘‘but not including income excludable from gross

10 income under section 108’’ after ‘‘tax-exempt income’’.

11 (b) EFFECTIVE DATE.—The amendment made by

12 this section shall apply to discharges of indebtedness oc13 curring after December 31, 2000.

14 SEC. 309. BACK TO BACK LOANS AS INDEBTEDNESS.

15 (a) IN GENERAL.—Section 1366(d) (relating to spe16 cial rules for losses and deductions) is amended by adding

17 at the end the following new paragraph:

18 ‘‘(4) LOANS INCLUDED IN INDEBTEDNESS

19 OF AN S CORPORATION.—For purposes of sub20 section (d), the indebtedness of an S corpora21 tion to the shareholder shall include any loans

22 made or acquired (by purchase, gift, or dis23 tribution from another person) by a shareholder

24 to the S corporation, regardless of whether the

25 funds loaned by the shareholder to the S cor-
29

•S 1201 IS

1 poration were obtained by the shareholder by

2 means of a recourse loan from another person

3 (whether related or unrelated to the share4 holder).’’.

5 (b) EFFECTIVE DATE.—The amendment made by

6 this section shall apply to taxable years beginning after

7 December 31, 2001.

8 TITLE IV—EXPANSION OF S COR9 PORATION ELIGIBILITY FOR

10 BANKS.

11 SEC. 401. EXCLUSION OF INVESTMENT SECURITIES INCOME

12 FROM PASSIVE INCOME TEST FOR BANK S

13 CORPORATIONS.

14 (a) IN GENERAL.—Section 1374(b)(3) (defining pas15 sive investment income) is amended by adding at the end

16 the following new subparagraph:

17 ‘‘(E) EXCEPTION FOR BANKS; ETC.—In

18 the case of a bank (as defined in section 581),

19 a bank holding company (as defined in section

20 246A(c)(3)(B)(ii)), or a qualified subchapter S

21 subsidiary which is a bank, the term ‘passive

22 investment income’ shall not include—

23 ‘‘(i) interest income earned by such

24 bank, bank holding company, or qualified

25 subchapter S subsidiary, or
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1 ‘‘(ii) dividends on assets required to

2 be held by such bank, bank holding com3 pany, or qualified subchapter S subsidiary

4 to conduct a banking business, including

5 stock in the Federal Reserve Bank, the

6 Federal Home Loan Bank, or the Federal

7 Agricultural Mortgage Bank or participa8 tion certificates issued by a Federal Inter9 mediate Credit Bank.’’.

10 (b) EFFECTIVE DATE.—The amendment made by

11 this section shall apply to taxable years beginning after

12 December 31, 1996.

13 SEC. 402. TREATMENT OF QUALIFYING DIRECTOR SHARES.

14 (a) IN GENERAL.—Section 1361 (defining S corpora15 tion), as amended by section 201(a), is amended by adding

16 at the end the following new subsection:

17 ‘‘(g) TREATMENT OF QUALIFYING DIRECTOR

18 SHARES.—

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

20 subchapter—

21 ‘‘(A) qualifying director shares shall not be

22 treated as a second class of stock, and

23 ‘‘(B) no person shall be treated as a share24 holder of the corporation by reason of holding

25 qualifying director shares.
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1 ‘‘(2) QUALIFYING DIRECTOR SHARES DE2 FINED.—For purposes of this subsection, the term

3 ‘qualifying director shares’ means any shares of

4 stock in a bank (as defined in section 581) or in a

5 bank holding company registered as such with the

6 Federal Reserve System—

7 ‘‘(i) which are held by an individual

8 solely by reason of status as a director of

9 such bank or company or its controlled

10 subsidiary; and

11 ‘‘(ii) which are subject to an agree12 ment pursuant to which the holder is re13 quired to dispose of the shares of stock

14 upon termination of the holder’s status as

15 a director at the same price as the indi16 vidual acquired such shares of stock.

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

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

19 the corporation with respect to qualifying director

20 shares shall be includible as ordinary income of the

21 holder and deductible to the corporation as an ex22 pense in computing taxable income under section

23 1363(b) in the year such distribution is received.’’.

24 (b) CONFORMING AMENDMENTS.—
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1 (1) Section 1361(b)(1) is amended by inserting

2 ‘‘, except as provided in subsection (f),’’ before

3 ‘‘which does not’’.

4 (2) Section 1366(a) is amended by adding at

5 the end the following new paragraph:

6 ‘‘(3) ALLOCATION WITH RESPECT TO QUALI7 FYING DIRECTOR SHARES.—The holders of quali8 fying director shares (as defined in section 1361(f))

9 shall not, with respect to such shares of stock, be al10 located any of the items described in paragraph

11 (1).’’.

12 (3) Section 1373(a) is amended by striking

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

14 period at the end of paragraph (2) and inserting ‘‘,

15 and’’, and adding at the end the following new para16 graph:

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

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

19 be apportioned or allocated to such income.’’.

20 (c) EFFECTIVE DATE.—The amendments made by

21 this section shall apply to taxable years beginning after

22 December 31, 1996.

23 SEC. 403. RECAPTURE OF BAD DEBT RESERVES.

24 Notwithstanding section 481 of the Internal Revenue

25 Code of 1986, with respect to any S corporation election
33

•S 1201 IS

1 made by any bank in taxable years beginning after Decem2 ber 31, 1996, such bank may recognize built-in gains from

3 changing its accounting method for recognizing bad debts

4 from the reserve method under section 585 or 593 of such

5 Code to the charge-off method under section 166 of such

6 Code either in the taxable year ending with or beginning

7 with such an election.

8 TITLE V—QUALIFIED

9 SUBCHAPTER S SUBSIDIARIES

10 SEC. 501. RELIEF FROM INADVERTENTLY INVALID QUALI11 FIED SUBCHAPTER S SUBSIDIARY ELECTIONS

12 AND TERMINATIONS.

13 (a) IN GENERAL.—Section 1362(f) (relating to inad14 vertent invalid elections or terminations) is amended—

15 (1) by inserting ‘‘or under section

16 1361(b)(3)(B)(ii)’’ after ‘‘subsection (a)’’in para17 graph (1),

18 (2) by inserting ‘‘or under section

19 1361(b)(3)(C)’’ after ‘‘subsection (d)’’ in paragraph

20 (1)(B),

21 (3) by inserting ‘‘or a qualified subchapter S

22 subsidiary, as the case may be’’ after ‘‘small busi23 ness corporation’’ in paragraph (3)(A),
34

•S 1201 IS

1 (4) by inserting ‘‘or a qualified subchapter S

2 subsidiary, as the case may be’’ after ‘‘S corpora3 tion’’ in paragraph (4), and

4 (5) by inserting ‘‘or a qualified subchapter S

5 subsidiary, as the case may be’’ after ‘‘S corpora6 tion’’ in the matter following paragraph (4).

7 (b) EFFECTIVE DATE.—The amendments made by

8 this section shall apply to taxable years beginning after

9 December 31, 1996.

10 SEC. 502. INFORMATION RETURNS FOR QUALIFIED SUB11 CHAPTER S SUBSIDIARIES.

12 (a) IN GENERAL.—Section 1361(b)(3)(A) (relating

13 to treatment of certain wholly owned subsidiaries) is

14 amended by inserting ‘‘and in the case of information re15 turns required under part III of subchapter A of chapter

16 61’’ after ‘‘Secretary’’.

17 (b) EFFECTIVE DATE.—The amendment made by

18 this section shall apply to taxable years beginning after

19 December 31, 2001.

20 SEC. 503. TREATMENT OF THE SALE OF INTEREST IN A

21 QUALIFIED SUBCHAPTER S SUBSIDIARY.

22 (a) IN GENERAL.—Section 1361(b)(3) (relating to

23 treatment of certain wholly owned subsidiaries) is amend24 ed by adding at the end the following new subparagraph:
35

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1 ‘‘(E) SPECIAL RULE ON TERMINATION.—

2 The tax treatment of the disposition of the

3 stock of the qualified subchapter S subsidiary

4 shall be determined as if such disposition

5 were—

6 ‘‘(i) a sale of the undivided interest in

7 the subsidiary’s assets based on the per8 centage of the stock transferred, and

9 ‘‘(ii) followed by a deemed contribu10 tion by the S corporation and the trans11 feree in a section 351 transaction.’’.

12 (b) EFFECTIVE DATE.—The amendment made by

13 this section shall apply to taxable years beginning after

14 December 31, 1996.

15 SEC. 504. EXCEPTION TO APPLICATION OF STEP TRANS16 ACTION DOCTRINE FOR RESTRUCTURING IN

17 CONNECTION WITH MAKING QUALIFIED SUB18 CHAPTER S SUBSIDIARY ELECTIONS.

19 (a) IN GENERAL.—Section 1361(b)(3) (relating to

20 treatment of certain wholly owned subsidiaries), as amend21 ed by section 503, is amended by redesignating subpara22 graphs (C), (D), and (E), as subparagraphs (D), (E), and

23 (F), respectively, and by inserting after subparagraph (B)

24 the following new subparagraph:
36

•S 1201 IS

1 ‘‘(C) TREATMENT OF ELECTION.—The

2 election under subparagraph (B)(ii) shall be

3 treated as a liquidation of the qualified sub4 chapter S subsidiary to which section 332 ap5 plies.’’.

6 (b) EFFECTIVE DATE.—The amendments made by

7 this section shall apply to elections effective after Decem8 ber 31, 2001.

9 TITLE VI—ADDITIONAL

10 PROVISIONS

11 SEC. 601. ELIMINATION OF ALL EARNINGS AND PROFITS

12 ATTRIBUTABLE TO PRE-1983 YEARS.

13 (a) IN GENERAL.—Subsection (a) of section 1311 of

14 the Small Business Job Protection Act of 1996 is amend15 ed to read as follows:

16 ‘‘(a) IN GENERAL.—If a corporation was an electing

17 small business corporation under subchapter S of chapter

18 1 of the Internal Revenue Code of 1986 for any taxable

19 year beginning before January 1, 1983, the amount of

20 such corporation’s accumulated earnings and profits (as

21 of the beginning of any taxable year beginning after De22 cember 31, 1982) shall be reduced by an amount equal

23 to the portion (if any) of such accumulated earnings and

24 profits which were accumulated in any taxable year begin25 ning before January 1, 1983, for which such corporation
37

•S 1201 IS

1 was an electing small business corporation under such

2 subchapter S.’’.

3 (b) EFFECTIVE DATE.—The amendment made by

4 this section shall apply to taxable years beginning after

5 December 31, 1996.

6 SEC. 602. NO GAIN OR LOSS ON DEFERRED INTERCOMPANY

7 TRANSACTIONS BECAUSE OF CONVERSION

8 TO S CORPORATION OR QUALIFIED S COR9 PORATION SUBSIDIARY.

10 With respect to taxable years beginning before, on,

11 or after July 12, 1995, the regulations under section 1502

12 of the Internal Revenue Code of 1986 shall not cause gain

13 or loss to be recognized by reason of an election under

14 section 1361(b)(3)(B) or 1362(a) of such Code.

15 SEC. 603. TREATMENT OF CHARITABLE CONTRIBUTION

16 AND FOREIGN TAX CREDIT

17 CARRYFORWARDS.

18 (a) CHARITABLE CONTRIBUTION

19 CARRYFORWARDS.—The last sentence of section

20 1374(b)(2) (relating to net operating loss carryforwards

21 from C years allowed) is amended by inserting ‘‘or a chari22 table contribution carryforward under section 170(d)(2)’’

23 after ‘‘capital loss carryforward’’.

24 (b) FOREIGN TAX CREDIT CARRYFORWARDS.—The

25 last sentence of section 1374(b)(3)(B) (relating to busi-
38

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1 ness credit carryforwards from C years allowed) is amend2 ed by inserting ‘‘and the foreign tax credit carryforward

3 under section 904’’ after ‘‘section 53’’.

4 (c) TREATMENT OF ADDITIONAL

5 CARRYFORWARDS.—Section 1374(b) (relating to amount

6 of tax) is amended by adding at the end the following new

7 paragraph:

8 ‘‘(5) TREATMENT OF ADDITIONAL

9 CARRYFORWARDS.—The Secretary under regulations

10 shall provide treatment similar to the preceding

11 paragraphs of this subsection for other

12 carryforwards attributable to taxable years for which

13 an S corporation was a C corporation.’’.

14 (d) EFFECTIVE DATE.—The amendments made by

15 this section shall apply to taxable years beginning after

16 December 31, 2001.

17 SEC. 604. DISTRIBUTIONS BY AN S CORPORATION TO AN

18 EMPLOYEE STOCK OWNERSHIP PLAN.

19 (a) IN GENERAL.—Section 1368(f) (relating to dis20 tributions) is amended by adding at the end the following

21 new subsection:

22 ‘‘(f) DISTRIBUTIONS BY AN S CORPORATION TO AN

23 EMPLOYEE STOCK OWNERSHIP PLAN.—Any distribution

24 described in subsection (a) to an employee stock ownership
39

•S 1201 IS

1 plan (as defined in section 4975(e)(7)) shall be treated

2 as a dividend under section 404(k)(2)(A).’’.

3 (b) TECHNICAL AMENDMENT.—Section 404(a)(9)(C)

4 (relating to S corporations) is amended to read as follows:

5 ‘‘(C) S CORPORATIONS.—The deduction

6 provided in this paragraph shall not apply to an

7 S corporation.’’.

8 (c) EFFECTIVE DATE.—The amendments made by

9 this section shall apply to distributions received after the

10 date of the enactment of this Act.

11 SEC. 605. SPECIAL RULES OF APPLICATION.

12 (a) WAIVER OF LIMITATIONS.—If refund or credit of

13 any overpayment of tax resulting from the application of

14 any amendment made by this Act is prevented at any time

15 before the close of the 1-year period beginning on the date

16 of the enactment of this Act by the operation of any law

17 or rule of law (including res judicata), such refund or cred18 it may nevertheless be made or allowed if claimed therefor

19 is filed before the close of such period.

20 (b) TREATMENT OF CERTAIN ELECTIONS UNDER

21 PRIOR LAW.—For purposes of section 1362(g) of the In22 ternal Revenue Code of 1986 (relating to election after

23 termination), any termination or revocation under section
40

•S 1201 IS

1 1362(d) of such Code (as in effect on the day before enact2 ment of this Act) shall not be taken into account.

Æ