I
105TH CONGRESS
2D SESSION
H. R. 4285
To amend the Internal Revenue Code of 1986 to provide for S corporation
reform, and for other purposes.
IN THE HOUSE OF REPRESENTATIVES
JULY 21, 1998
Mr. SHAW (for himself, Mr. MATSUI, Mr. PORTMAN, Mr. NEAL of Massachu-
setts, Mr. CAMP, Ms. DUNN, Mr. HERGER, Mr. BUNNING, Mr. LEVIN,
Mr. THOMAS, Mr. HOUGHTON, Mr. HALL of Texas, Mr. KLECZKA, Mr.
WATKINS, and Mr. ENSIGN) introduced the following bill; which was re-
ferred 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.
Be it enacted by the Senate and House of Representa-
tives of the United States of America in Congress assembled,
SECTION 1. SHORT TITLE; AMENDMENT OF 1986 CODE;
TABLE OF CONTENTS.
(a) SHORT TITLE.—This Act may be cited as the
‘‘Subchapter S Revision Act of 1998’’.
(b) AMENDMENT OF 1986 CODE.—Except as other-
wise expressly provided, whenever in this Act an amend-
ment or repeal is expressed in terms of an amendment
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to, or repeal of, a section or other provision, the reference
shall be considered to be made to a section or other provi-
sion of the Internal Revenue Code of 1986.
(c) TABLE OF CONTENTS.—The table of contents is
as follows:
Sec. 1. Short title; amendment of 1986 Code; table of contents.
TITLE I—SUBCHAPTER S EXPANSION
Subtitle A—Eligible Shareholders of an S Corporation
Sec. 101. Members of a family treated as one shareholder.
Sec. 102. Nonresident aliens.
Subtitle B—Qualification and Eligibility Requirements of S Corporations
Sec. 111. Issuance of preferred stock permitted.
Sec. 112. Safe harbor debt expanded to include convertible debt.
Sec. 113. Repeal of excessive passive investment income as termination event.
Sec. 114. Repeal passive income capital gain category.
Sec. 115. Allowance of charitable contributions of inventory and scientific prop-
erty.
Sec. 116. C corporation rules to apply for fringe benefit purposes.
Subtitle C—Taxation of S Corporation Shareholders
Sec. 120. Treatment of losses to shareholders.
Subtitle D—Effective Date
Sec. 130. Effective Date.
TITLE II—SENSE OF THE HOUSE OF REPRESENTATIVES
RESOLUTION
Sec. 201. Sense of the House of Representatives resolution opposing the admin-
istration’s proposal to treat Subchapter S elections as taxable
liquidations of C corporations.
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TITLE I—SUBCHAPTER S
EXPANSION
Subtitle A—Eligible Shareholders
of an S Corporation
SEC. 101. MEMBERS OF FAMILY TREATED AS 1 SHARE-
HOLDER.
Paragraph (1) of section 1361(c) (relating to special
rules for applying subsection (b)) is amended to read as
follows:
‘‘(1) MEMBERS
OF
FAMILY
TREATED
AS 1
SHAREHOLDER.—
‘‘(A) IN GENERAL.—For purpose of sub-
section (b)(1)(A)—
‘‘(i) except as provided in clause (ii),
a husband and wife (and their estates)
shall be treated as 1 shareholder, and
‘‘(ii) in the case of a family with re-
spect to which an election is in effect
under subparagraph (E), all members of
the family shall be treated as 1 share-
holder.
‘‘(B) MEMBERS
OF
THE
FAMILY.—For
purpose of subparagraph (A)(ii), the term
‘members of the family’ means the lineal de-
scendants of the common ancestor and the
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spouses (or former spouses) of such lineal de-
scendants or common ancestor.
‘‘(C) COMMON ANCESTOR.—For purposes
of this paragraph, an individual shall not be
considered a common ancestor if, as of the later
of the effective date of this paragraph or the
time the election under section 1362(a) is
made, the individual is more than 6 generations
removed from the youngest generation of share-
holders.
‘‘(D) EFFECT OF ADOPTION, ETC.—In de-
termining whether any relationship specified in
subparagraph (B) or (C) exists, the rules of
section 152(b)(2) shall apply.
‘‘(E) ELECTION.—An election under sub-
paragraph (A)(ii)—
‘‘(i) must be made with the consent of
all shareholders,
‘‘(ii) shall remain in effect until termi-
nated, and
‘‘(iii) shall apply only with respect to
1 family in any corporation.’’.
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SEC. 102. NONRESIDENT ALIENS ALLOWED TO BE SHARE-
HOLDERS.
(a) NONRESIDENT ALIENS ALLOWED TO BE SHARE-
HOLDERS.—
(1) IN
GENERAL.—Paragraph (1) of section
1361(b) (defining small business corporation) is
amended—
(A) by adding ‘‘and’’ at the end of sub-
paragraph (B),
(B) by striking subparagraph (C), and
(C) by redesignating subparagraph (D) as
subparagraph (C).
(2) CONFORMING
AMENDMENTS.—Paragraph
(4) and (5)(A) of section 1361(c) (relating to special
rules for applying subsection (b)) are each amended
by striking ‘‘subsection (b)(1)(D)’’ and inserting
‘‘subsection (b)(1)(C)’’.
(b) NONRESIDENT ALIEN SHAREHOLDER TREATED
AS ENGAGED IN TRADE OR BUSINESS WITHIN UNITED
STATES.—
(1) IN GENERAL.—Section 875 is amended—
(A) by striking ‘‘and’’ at the end of para-
graph (1),
(B) by striking the period at the end of
paragraph (2) and inserting ‘‘, and’’, and
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(C) by adding at the end the following new
paragraph:
‘‘(3) a nonresident alien individual shall be con-
sidered as being engaged in a trade or business
within the United States if the S corporation of
which such individual is a shareholder is so en-
gaged.’’
(2) APPLICATION
OF
WITHHOLDING
TAX
ON
NONRESIDENT
ALIEN
SHAREHOLDERS.—Section
1446 (relating to withholding tax on foreign part-
ners’ share of effectively connected income) is
amended by redesignating subsection (f) as sub-
section (g) and by inserting after subsection (e) the
following new subsection:
‘‘(f) S CORPORATION TREATED AS PARTNERSHIP,
ETC.—For purposes of this section—
‘‘(1) an S corporation shall be treated as a
partnership,
‘‘(2) the shareholders of such corporation shall
be treated as partners of such partnership; and
‘‘(3) any reference to section 704 shall be treat-
ed as a reference to section 1366.’’
(3) CONFORMING AMENDMENTS.—
(A) The heading of section 875 is amended
to read as follows:
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‘‘SEC. 875. PARTNERSHIPS; BENEFICIARIES OF ESTATES
AND TRUSTS; S CORPORATIONS.’’
(B) The heading of section 1446 is amend-
ed to read as follows:
‘‘SEC. 1446. WITHHOLDING TAX ON FOREIGN PARTNERS’
AND 
S 
CORPORATION 
SHAREHOLDERS’
SHARE OF EFFECTIVELY CONNECTED IN-
COME.’’
(4) CLERICAL AMENDMENTS.—
(A) The item relating to section 875 in the
table of sections for subpart A of part II of
subchapter N of chapter 1 is amended to read
as follows:
‘‘Sec. 875. Partnerships; beneficiaries of estates and trusts; S corporations.’’
(B) The item relating to section 1446 in
the table of sections for subchapter A of chap-
ter 3 is amended to read as follows:
‘‘Sec. 1446 Withholding tax of foreign partners’ and S corporate shareholders’
share of effectively connected income.’’
(C) 
PERMANENT
ESTABLISHMENT
OF
PARTNERS AND S CORPORATION SHAREHOLD-
ERS. Section 894 (relating to income affected
by treaty) is amended by redesignating sub-
section 894(c) as subsection 894(d) and insert-
ing the following new subsection after sub-
section 894(b):
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‘‘(c) PERMANENT ESTABLISHMENT
OF PARTNERS
AND S CORPORATION SHAREHOLDERS.—If a partnership
of S corporation has a permanent establishment in the
United States (within the meaning of a treaty to which
the United States is a party) at any time during a taxable
year of such entity, a nonresident alien individual or for-
eign corporation which is a partner in such partnership,
or a nonresident alien individual who is a shareholder in
such S corporation, shall be treated as having a permanent
establishment in the United States for purposes of such
treaty.’’
Subtitle B—Qualification and Eligi-
bility Requirements of S Cor-
porations
SEC. 111. ISSUANCE OF PREFERRED STOCK PERMITTED.
(a) IN GENERAL.—Section 1361 is amended by add-
ing at the end the following new subsection:
‘‘(f) 
TREATMENT
OF
QUALIFIED
PREFERRED
STOCK.—
‘‘(1) IN GENERAL.—For purposes of this sub-
chapter—
‘‘(A) qualified preferred stock shall not be
treated as a second class of stock, and
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‘‘(B) no person shall be treated as a share-
holder of the corporation by reason of holding
qualified preferred stock.
‘‘(2) 
QUALIFIED
PREFERRED
STOCK
DE-
FINED.—For purposes of this subsection, the term
‘qualified preferred stock’ means stock which meets
the requirements of subparagraphs (A), (B), and (C)
of section 1504(a)(4). Stock shall not fail to be
treated as qualified preferred stock merely because
it is convertible into other stock.
‘‘(3) DISTRIBUTIONS.—A distribution (not in
part or full payment in exchange for stock) made by
the corporation with respect to qualified preferred
stock shall be includible as ordinary income of the
holder and deductible to the corporation as an ex-
pense in computing taxable income under section
1363(b) in the year such distribution is received.’’
(b) CONFORMING AMENDMENTS.—
(1) Paragraph (1) of section 1361(b) is amend-
ed by inserting ’’, except as provided in subsection
(f),’’ before ‘‘which does not’’.
(2) Subsection (a) of section 1366 is amended
by adding at the end the following new paragraph:
‘‘(3) ALLOCATION
WITH
RESPECT
TO
QUALI-
FIED PREFERRED STOCK.—The holders of qualified
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preferred stock (as defined in section 1361 (f)) shall
not, with respect to such stock, be allocated any of
the items described in paragraph (1).’’
(3) The title to clause (ii) to subparagraph (C)
of section 354(a)(2) and part I of such clause (ii)
are amended to read as follows:
‘‘(ii) RECAPITALIZATION OF FAMILY-
OWNED
CORPORATIONS
AND
S
CORPORA-
TIONS.—
(I) IN
GENERAL.—Clause (I)
shall not apply in the case of a recapi-
talization under section 368(a)(I)(E)
of a family-owned corporation or S
corporation.’’
(4) Subsection (a) of Section 1373 is amended
by striking ‘‘and’’ at the end of paragraph (1), strik-
ing the period at the end of paragraph (2) and in-
serting ‘‘, and’’ in its place, and adding at the end
the following new paragraph:
‘‘(3) no amount of an expense deductible under
this subchapter by reason of section 1361(f)(3) shall
be apportioned or allocated to such income.’’
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SEC. 112. SAFE HARBOR EXPANDED TO INCLUDE CONVERT-
IBLE DEBT.
Subparagraph (B) of section 1361(c)(5) (defining
straight debt) is amended by adding ‘‘and’’ at the end of
clause (I) and by striking clauses (ii) and (iii) and insert-
ing the following:
‘‘(ii) in any cases in which the terms
of such promise include a provision under
which the obligation to pay may be con-
verted (directly or indirectly) into stock of
the corporation, such terms, taken as a
whole, are substantially the same as the
terms which could have been obtained on
the effective date of the promise from a
person which is not a related person (with-
in the meaning of section 465(b)(3)(C)) to
the S corporation or its shareholders, and
‘‘(iii) the creditor is—
‘‘(I) an individual,
‘‘(II) an estate,
‘‘(III) a trust described in para-
graph (2), or
‘‘(IV) a person which is actively
and regularly engaged in the business
of lending money.’’
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SEC. 113. REPEAL OF EXCESSIVE PASSIVE INVESTMENT IN-
COME AS A TERMINATION EVENT.
(a) IN GENERAL.—Section 1362(d) (relating to ter-
mination) is amended by striking paragraph (3).
(b) CONFORMING AMENDMENTS.—
(1) Section 1362(f)(1) is amended by striking
‘‘or (3)’’.
(2) Clause (I) of section 1042(c)(4)(A) is
amended by striking ‘‘section 1362(d)(3)(D)’’ and
inserting ‘‘section 1375(b)(5)’’.
SEC. 114. REPEAL PASSIVE INCOME CAPITAL GAIN CAT-
EGORY.
Subsection (b) of section 1375 is amended by striking
paragraphs (3) and (4) and inserting the following new
paragraphs:
‘‘(3) SUBCHAPTER
C
EARNINGS
AND
PROF-
ITS.—The term ‘subchapter C earnings and profits’
means earnings and profits of any corporation for
any taxable year with respect to which an election
under section 1362(a) (or under section 1372 of
prior law) was not in effect.
‘‘(4) 
PASSIVE
INVESTMENT
INCOME
DE-
FINED.—
‘‘(A) IN GENERAL.—Except as otherwise
provided in this paragraph, the term ‘passive
investment income’ means gross receipts de-
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rived from royalties, rents, dividends, interest,
and annuities.
‘‘(B) 
EXCEPTION
FOR
INTEREST
ON
NOTES FROM SALES OF INVENTORY.—The term
‘passive investment income’ shall not include in-
terest on any obligation acquired in the ordi-
nary course of the corporation’s trade or busi-
ness from its sale of property described in sec-
tion 1221(1).
‘‘(C) TREATMENT
OF
CERTAIN
LENDING
OR FINANCE COMPANIES.—If the S corporation
meets the requirements of section 542(c)(6) for
the taxable year, the term ‘passive investment
income’ shall not include gross receipts for the
taxable year which are derived directly from the
active and regular conduct of a lending or fi-
nance 
business 
(as 
defined 
in 
section
542(d)(1)).
‘‘(D) TREATMENT
OF
CERTAIN
DIVI-
DENDS.—If an S corporation holds stock in a
C corporation meeting the requirements of sec-
tion 1504(a)(2), the term ‘passive investment
income’ shall not include dividends from such C
corporation to the extend such dividends are at-
tributable to the earnings and profits of such C
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corporations derived from the active conduct of
a trade or business.
‘‘(E) 
COORDINATION
WITH
SECTION
1374.—The amount of passive investment in-
come shall be determined by not taking into ac-
count any recognized built-in gain or loss of the
S corporation for any taxable year in the rec-
ognition period. Terms used in the preceding
sentence shall have the same respective mean-
ing as when used in section 1374.’’
SEC. 115. ALLOWANCE OF CHARITABLE CONTRIBUTIONS
OF INVENTORY AND SCIENTIFIC PROPERTY.
(a) IN GENERAL.—Section 170(e) (relating to certain
contributions of ordinary income and capital gain prop-
erty) is amended—
(1) by striking ‘‘(other than a corporation
which is an S corporation)’’ in paragraph (3)(A),
and
(2) by striking clause (I) of paragraph (4)(D)
and by redesignating clauses (ii) and (iii) of such
paragraph as clauses (I) and (ii), respectively.
(b) STOCK BASIS ADJUSTMENT.—Paragraph (1) of
section 1367(a) (relating to adjustments to basis of stock
of shareholders, etc.) is amended by striking ‘‘and’’ at the
end of subparagraph (B), by striking the period at the
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end of subparagraphs (C) and inserting ‘‘, and’’, and by
adding at the end the following new subparagraph:
‘‘(D) the excess of the deductions for char-
itable contributions over the basis of the prop-
erty contributed.’’
SEC. 116. C CORPORATION RULES TO APPLY FOR FRINGE
BENEFIT PURPOSES.
(a) IN GENERAL.—Section 1372 (relating to partner-
ship rules to apply for fringe benefit purposes) is repealed.
(b) PARTNERSHIP RULES TO APPLY FOR HEALTH
INSURANCE COSTS OF CERTAIN S CORPORATION SHARE-
HOLDERS.—Paragraph (5) of section 162(1) is amended
to read as follows:
‘‘(5) TREATMENT OF CERTAIN S CORPORATION
SHAREHOLDERS.—
‘‘(A) IN GENERAL.—This subsection shall
apply in the case of any 2-percent shareholder
of an S corporation, except that—
‘‘(i) for purposes of this subsection,
such shareholder’s wages (as defined in
section 3121) from the S corporation shall
be treated as such shareholder’s earned in-
come (within the meaning of section
401(c)(1)), and
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‘‘(ii) there shall be such adjustments
in the application of this subsection as the
Secretary may by regulations prescribe.
‘‘(B) 
2-PERCENT
SHAREHOLDER
DE-
FINED.—For purposes of this paragraph, the
term ‘2-percent shareholder’ means any person
who owns (or is considered as owning within
the meaning of section 318) on any day during
the taxable year of the S corporation more than
2 percent of the outstanding stock of such cor-
poration or stock possessing more than 2 per-
cent of the total combined voting power of all
stock of such corporation.’’
(b) CONFORMING AMENDMENT.—The table of sec-
tions for part III of subchapter S of chapter 1 is amended
by striking the item relating to section 1372.
Subtitle C—Taxation of S
Corporation Shareholders
SEC. 120. TREATMENT OF LOSSES TO SHAREHOLDERS.
(a) LIQUIDATIONS.—Section 331 (relating to gain or
loss to shareholders in corporate liquidations) is amended
by redesignating subsection (c) as subsection (d) and by
inserting after subsection (b) the following new subsection:
‘‘(c) LOSS ON LIQUIDATIONS OF S CORPORATION.—
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‘‘(1) IN GENERAL.—The portion of any loss rec-
ognized by a shareholder of an S corporation (as de-
fined in section 1361(a)(1)) on amounts received by
such shareholder in a distribution in complete liq-
uidation of such S corporation which does not exceed
the ordinary income basis of stock of such S cor-
poration in the hands of such shareholder shall not
be treated as a loss from the sale or exchange of a
capital asset but shall be treated as an ordinary loss.
‘‘(2) ORDINARY INCOME BASIS.—For purposes
of this subsection, the ordinary income basis of stock
of an S corporation in the hands of a shareholder of
such S corporation shall be an amount equal to the
portion of such shareholder’s basis in such stock
which is equal to the aggregate increases in such
basis under section 1367(a)(1) resulting from such
shareholder’s pro rata share of ordinary income of
such S corporation attributable to the complete liq-
uidation.’’
(b) SUSPENDED PASSIVE ACTIVITY LOSSES.—Para-
graph (3) of section 1371(b) is amended to read as fol-
lows:
‘‘(3) TREATMENT
OF
S
YEAR
AS
ELAPSED
YEAR; PASSIVE LOSSES.—Nothing in paragraphs (1)
and (2) shall prevent treating a taxable year for
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which a corporation is an S corporation as a taxable
year for purposes of determining the number of tax-
able years to which an item may be carried back or
carried forward nor prevent the allowance of a pas-
sive activity loss deduction to the extent provided by
section 469(g).’’
Subtitle D—Effective Date
SEC. 130. EFFECTIVE DATE.
(a) IN GENERAL.—Except as otherwise provided in
this Act, and in section 1362(g) relating to elections after
termination, the amendments made by this Act shall apply
to taxable years beginning after December 31, 1998.
(b) TREATMENT OF CERTAIN ELECTIONS UNDER
PRIOR LAW.—For purposes of section 1362(g) of the In-
ternal Revenue Code of 1986 (relating to election after
termination), any termination or revocation under section
1362(d) of such Code (as in effect on the day before enact-
ment of this Act) shall not be taken into account.