I 
108TH CONGRESS 
1ST SESSION H. R. 1896
To amend the Internal Revenue Code of 1986 to provide for S corporation 
reform, and for other purposes. 
IN THE HOUSE OF REPRESENTATIVES 
APRIL 30, 2003
Mr. SHAW (for himself, Mr. MATSUI, Mr. MCINNIS, and Mrs. JONES of Ohio) 
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.
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 Modernization Act of 2003’’. 
(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 
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—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 con-
tributions. 
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 sub-
chapter S trust income beneficiaries. 
Sec. 304. Deductibility of interest expense incurred by an electing small busi-
ness trust to acquire S corporation stock. 
Sec. 305. Disregard of unexercised powers of appointment in determining po-
tential 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.
Sec. 502. Information returns for qualified subchapter S subsidiaries. 
Sec. 503. Treatment of the sale of interest in a qualified subchapter S sub-
sidiary. 
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 sub-
sidiary. 
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.
TITLE 
I—ELIGIBLE 
SHARE-
HOLDERS OF AN S CORPORA-
TION 
SEC. 101. MEMBERS OF FAMILY TREATED AS 1 SHARE-
HOLDER. 
(a) IN GENERAL.—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
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 common an-
cestor, lineal descendants of the common ances-
tor and the spouses (or former spouses) of such 
lineal descendants 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 
shareholders (including those that are fam-
ily members) holding in the aggregate 
more than one-half of the shares of stock 
in the corporation on the day the election 
is made, 
‘‘(ii) in the case of—
‘‘(I) an electing small business 
trust, shall be made by the trustee of 
the trust, and 
‘‘(II) a qualified subchapter S 
trust, shall be made by the beneficiary 
of the trust, 
‘‘(iii) under regulations, shall remain 
in effect until terminated, and 
‘‘(iv) shall apply only with respect to 
1 family in any corporation.’’. 
(b) RELIEF FROM INADVERTENT INVALID ELECTION 
OR TERMINATION.—Section 1362(f) (relating to inad-
vertent invalid elections or terminations), as amended by 
section 501, is amended—
(1) 
by 
inserting 
‘‘or 
under 
section 
1361(c)(1)(A)(ii)’’ after ‘‘section 1361(b)(3)(B)(ii)’’ 
in paragraph (1), and 
(2) 
by 
inserting 
‘‘or 
under 
section 
1361(c)(1)(E)(iii)’’ after ‘‘section 1361(b)(3)(C)’’ in 
paragraph (1)(B).
(c) EFFECTIVE DATES.—
(1) SUBSECTION (a).—The amendment made 
by subsection (a) shall apply to taxable years begin-
ning after December 31, 2003. 
(2) SUBSECTION (b).—The amendments made 
by subsection (b) shall apply to elections and termi-
nations made after December 31, 2003. 
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 
(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, 
‘‘(3) any reference to section 704 shall be treat-
ed as a reference to section 1366, and 
‘‘(4) no withholding tax under subsection (a) 
shall be required in the case of any income realized 
by such corporation and allocable to a shareholder 
which is an electing small business trust (as defined 
in section 1361(e)).’’. 
(3) CONFORMING AMENDMENTS.—
(A) The heading of section 875 is amended 
to read as follows: 
‘‘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 on foreign partners’ and S corporation share-
holders’ share of effectively connected income.’’.
(C) 
PERMANENT
ESTABLISHMENT
OF 
PARTNERS
AND
S
CORPORATION
SHARE-
HOLDERS.—Section 894 (relating to income af-
fected by treaty) is amended by redesignating 
subsection (c) as subsection (d) and by insert-
ing after subsection (b) the following new sub-
section: 
‘‘(c) PERMANENT ESTABLISHMENT
OF PARTNERS 
AND S CORPORATION SHAREHOLDERS.—If a partnership 
or 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.’’.
(c) APPLICATION
OF OTHER WITHHOLDING TAX 
RULES ON NONRESIDENT ALIEN SHAREHOLDERS.—
(1) SECTION 1441.—Section 1441 (relating to 
withholding of tax on nonresident aliens) is amended 
by redesignating subsection (g) as subsection (h) 
and by inserting after subsection (f) the following 
new subsection: 
‘‘(g) 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) no deduction or withholding under sub-
section (a) shall be required in the case of any item 
of income realized by such corporation and allocable 
to a shareholder which is an electing small business 
trust (as defined in section 1361(e)).’’.
(2) SECTION 1445.—Section 1445(e) (relating to 
special rules relating to distributions, etc., by cor-
porations, partnerships, trusts, or estates) is amend-
ed by redesignating paragraph (6) as paragraph (7) 
and by inserting after paragraph (5) the following 
new paragraph:
‘‘(6) S CORPORATION TREATED AS PARTNER-
SHIP, ETC.—For purposes of this section—
‘‘(A) an S corporation shall be treated as 
a partnership, and 
‘‘(B) the shareholders of such corporation 
shall be treated as partners of such partnership, 
and 
‘‘(C) no deduction or withholding under 
subsection (a) shall be required in the case of 
any gain realized by such corporation and allo-
cable to a shareholder which is an electing small 
business trust (as defined in section 1361(e)).’’. 
(d) CONFORMING AMENDMENT.—Section 1361(e)(2) 
is amended by inserting ‘‘(including a nonresident alien)’’ 
after ‘‘person’’ the first place it appears. 
(e) EFFECTIVE DATE.—The amendments made by 
this section shall apply to taxable years beginning after 
December 31, 2003. 
SEC. 103. EXPANSION OF BANK S CORPORATION ELIGIBLE 
SHAREHOLDERS TO INCLUDE IRAS. 
(a) IN GENERAL.—Section 1361(c)(2)(A) (relating to 
certain trusts permitted as shareholders) is amended by 
inserting after clause (v) the following new clause: 
‘‘(vi) In the case of a corporation 
which is a bank (as defined in section
581), a trust which constitutes an indi-
vidual retirement account under section 
408(a), including one designated as a Roth 
IRA under section 408A, but only to the 
extent of the stock held by such trust in 
such bank as of the date of the enactment 
of this clause.’’. 
(b) 
TREATMENT
AS
SHAREHOLDER.—Section 
1361(c)(2)(B) (relating to treatment as shareholders) is 
amended by adding at the end the following new clause: 
‘‘(vi) In the case of a trust described 
in clause (vi) of subparagraph (A), the in-
dividual for whose benefit the trust was 
created shall be treated as a shareholder.’’. 
(c) SALE OF STOCK IN IRA RELATING TO S COR-
PORATION
ELECTION
EXEMPT
FROM
PROHIBITED 
TRANSACTION RULES.—Section 4975(d) (relating to ex-
emptions) is amended by striking ‘‘or’’ at the end of para-
graph (14), by striking the period at the end of paragraph
(15) and inserting ‘‘; or’’, and by adding at the end the 
following new paragraph: 
‘‘(16) a sale of stock held by a trust which con-
stitutes an individual retirement account under sec-
tion 408(a) to the individual for whose benefit such