I
107TH CONGRESS
1ST SESSION
H. R. 2576
To amend the Internal Revenue Code of 1986 to provide for S corporation
reform, and for other purposes.
IN THE HOUSE OF REPRESENTATIVES
JULY 19, 2001
Mr. SHAW (for himself, Mr. MATSUI, and Mr. PORTMAN) 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 2001’’.
(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 beginning
after December 31, 2001.
(2) SUBSECTION (b).—The amendments made
by subsection (b) shall apply to elections and termi-
nations made after December 31, 2001.
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, 2001.
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
account is established if such sale is pursuant to an
election under section 1362(a).’’.
(d) CONFORMING AMENDMENT.—Section 512(e)(1)
is amended by inserting ‘‘1361(c)(2)(A)(vi) or’’ before
‘‘1361(c)(6)’’.
(e) EFFECTIVE DATE.—The amendments made by
this section shall apply to trusts which constitute indi-
vidual retirement accounts on the date of the enactment
of this Act.
SEC. 104. INCREASE IN NUMBER OF ELIGIBLE SHARE-
HOLDERS TO 150.
(a) IN GENERAL.—Section 1361(b)(1)(A) (defining
small business corporation) is amended by striking ‘‘75’’
and inserting ‘‘150’’.
(b) EFFECTIVE DATE.—The amendment made by
this section shall apply to taxable years beginning after
December 31, 2001.
TITLE II—QUALIFICATION AND
ELIGIBILITY REQUIREMENTS
OF S CORPORATIONS
SEC. 201. ISSUANCE OF PREFERRED STOCK PERMITTED.
(a) IN GENERAL.—Section 1361 (defining S corpora-
tion) is amended by adding at the end the following new
subsection:
‘‘(f) 
TREATMENT
OF
QUALIFIED
PREFERRED
STOCK.—
‘‘(1) IN
GENERAL.—For purposes of this
subchapter—
‘‘(A) qualified preferred stock shall not be
treated as a second class of stock, and
‘‘(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
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) So much of clause (ii) of section
354(a)(2)(C) as precedes subclause (II) is 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), by
striking the period at the end of paragraph (2) and
inserting ‘‘, and’’, and by adding at the end the fol-
lowing 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.’’.
(c) EFFECTIVE DATE.—The amendments made by
this section shall apply to taxable years beginning after
December 31, 2001.
SEC. 202. SAFE HARBOR EXPANDED TO INCLUDE CONVERT-
IBLE DEBT.
(a) IN GENERAL.—Subparagraph (B) of section
1361(c)(5) (defining straight debt) is amended by striking
clauses (ii) and (iii) and inserting the following new
clauses:
‘‘(ii) in any case 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),
‘‘(IV) an exempt organization de-
scribed in paragraph (6), or
‘‘(V) a person which is actively
and regularly engaged in the business
of lending money.’’.
(b) EFFECTIVE DATE.—The amendment made by
this section shall apply to taxable years beginning after
December 31, 2001.
SEC. 203. 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)(C)’’ and
inserting ‘‘section 1375(b)(4)’’.
(c) EFFECTIVE DATE.—The amendments made by
this section shall apply to taxable years beginning after
December 31, 2001.
SEC. 204. MODIFICATIONS TO PASSIVE INCOME RULES.
(a) INCREASED LIMIT.—
(1) IN GENERAL.—Subsection (a)(2) of section
1375 (relating to tax imposed when passive invest-
ment income of corporation having accumulated
earnings and profits exceeds 25 percent of gross re-
ceipts) is amended by striking ‘‘25 percent’’ and in-
serting ‘‘60 percent’’.
(2) CONFORMING AMENDMENTS.—
(A) Subparagraph (J) of section 26(b)(2)
is amended by striking ‘‘25 percent’’ and insert-
ing ‘‘60 percent’’.
(B) Clause (i) of section 1375(b)(1)(A) is
amended by striking ‘‘25 percent’’ and inserting
‘‘60 percent’’.
(C) The heading for section 1375 is
amended by striking ‘‘25 PERCENT’’ and in-
serting ‘‘60 PERCENT’’.
(D) The table of sections for part III of
subchapter S of chapter 1 is amended by strik-
ing ‘‘25 percent’’ in the item relating to section
1375 and inserting ‘‘60 percent’’.
(b) REPEAL
OF PASSIVE INCOME CAPITAL GAIN
CATEGORY.—
(1) IN
GENERAL.—Subsection (b) of section
1375 (relating to tax imposed when passive invest-
ment income of corporation having accumulated
earnings and profits exceeds 60 percent of gross re-
ceipts), as amended by subsection (a), is amended by
striking paragraphs (3) and (4) and inserting the
following new paragraph:
‘‘(3) 
PASSIVE
INVESTMENT
INCOME
DE-
FINED.—
‘‘(A) IN GENERAL.—Except as otherwise
provided in this paragraph, the term ‘passive
investment income’ means gross receipts de-
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(a)(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 extent such dividends are at-
tributable to the earnings and profits of such C
corporation 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.’’.
(2) 
CONFORMING
AMENDMENTS.—Section
1375(d) is amended by striking ‘‘subchapter C’’ both
places it appears and inserting ‘‘accumulated’’.
(c) EFFECTIVE DATE.—The amendments made by
this section shall apply to taxable years beginning after
December 31, 2001.
SEC. 205. ADJUSTMENT TO BASIS OF S CORPORATION
STOCK 
FOR 
CERTAIN 
CHARITABLE 
CON-
TRIBUTIONS.
(a) IN GENERAL.—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 subpara-
graph (B), by striking the period at the end of subpara-
graph (C) and inserting ‘‘, and’’, and by adding at the
end the following new subparagraph:
‘‘(D) the excess of the amount of the
shareholder’s proportionate share of any chari-
table contribution made by the S corporation
over the shareholder’s proportionate share of
the adjusted basis of the property contrib-
uted.’’.
(b) EFFECTIVE DATE.—The amendments made by
this section shall apply to taxable years beginning after
December 31, 2001.
‘‘(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
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).’’.
(c) EFFECTIVE DATE.—The amendments made by
this section shall apply to taxable years beginning after
December 31, 2001.
SEC. 302. TRANSFER OF SUSPENDED LOSSES INCIDENT TO
DIVORCE.
(a) IN GENERAL.—Section 1366(d) (relating to spe-
cial rules for losses and deductions) is amended by adding
at the end the following new paragraph:
‘‘(4) TRANSFER OF SUSPENDED LOSSES AND
DEDUCTIONS WHEN STOCK IS TRANSFERRED INCI-
DENT TO DIVORCE.—For purposes of paragraph (2),
the transfer of any shareholder’s stock in an S cor-
poration incident to a decree of divorce shall include
any loss or deduction described in such paragraph
attributable to such stock.’’.
(b) EFFECTIVE DATE.—The amendment made by
this section shall apply to transfers made after the date
of the enactment of this Act.
SEC. 303. USE OF PASSIVE ACTIVITY LOSS AND AT-RISK
AMOUNTS BY QUALIFIED SUBCHAPTER S
TRUST INCOME BENEFICIARIES.
(a) IN GENERAL.—Section 1361(d)(1) (relating to
special rule for qualified subchapter S trust) is amended—
(1) by striking ‘‘and’’ at the end of subpara-
graph (A),
(2) by striking the period at the end of sub-
paragraph (B) and inserting ‘‘, and’’, and
(3) by adding at the end the following new sub-
paragraph:
‘‘(C) for purposes of applying sections 465
and 469(g) to the beneficiary of the trust, the
disposition of the S corporation stock by the
trust shall be treated as a disposition by such
beneficiary.’’.
(b) EFFECTIVE DATE.—The amendments made by
this section shall apply to transfers made after the date
of the enactment of this Act.
SEC. 304. DEDUCTIBILITY OF INTEREST EXPENSE IN-
CURRED BY AN ELECTING SMALL BUSINESS
TRUST TO ACQUIRE S CORPORATION STOCK.
(a) IN GENERAL.—Subparagraph (C) of section
641(c)(2) (relating to modifications) is amended by insert-
ing after clause (iii) the following new clause:
‘‘(iv) Any interest expense incurred to
acquire stock in an S corporation.’’.
(b) EFFECTIVE DATE.—The amendment made by
this section shall apply to taxable years beginning after
December 31, 2001.
SEC. 305. DISREGARD OF UNEXERCISED POWERS OF AP-
POINTMENT IN DETERMINING POTENTIAL
CURRENT BENEFICIARIES OF ESBT.
(a) IN GENERAL.—Section 1361(e)(2) (defining po-
tential current beneficiary) is amended—
(1) by inserting ‘‘(determined without regard to
any unexercised (in whole or in part) power of ap-
pointment during such period)’’ after ‘‘of the trust’’
in the first sentence, and
(2) by striking ‘‘60-day’’ in the second sentence
and inserting ‘‘1-year’’.
(b) EFFECTIVE DATE.—The amendments made by
this section shall apply to taxable years beginning after
December 31, 2001.
SEC. 306. CLARIFICATION OF ELECTING SMALL BUSINESS
TRUST DISTRIBUTION RULES.
(a) IN GENERAL.—Section 641(c)(1) (relating to spe-
cial rules for taxation of electing small business trusts)
is amended—
(1) by striking ‘‘and’’ at the end of subpara-
graph (A),
(2) by redesignating subparagraph (B) as sub-
paragraph (C), and
(3) by inserting after subparagraph (A) the fol-
lowing new subparagraph:
‘‘(B) any distribution attributable to the
portion treated as a separate trust shall be
treated separately from any distribution attrib-
utable to the portion not so treated, and’’.
(b) EFFECTIVE DATE.—The amendments made by
this section shall apply to taxable years beginning after
December 31, 1996.
SEC. 307. ALLOWANCE OF CHARITABLE CONTRIBUTIONS
DEDUCTION FOR ELECTING SMALL BUSINESS
TRUSTS.
(a) IN GENERAL.—Section 641(c)(2)(C) (relating to
modifications), as amended by section 304(a), is amended
by inserting after clause (iv) the following new clause:—
‘‘(v) Deductions described in section
642(c)(1).’’.
(b) CONFORMING AMENDMENT.—Section 512(e) (re-
lating to special rules applicable to S corporations) is
amended by redesignating subparagraph (3) as subpara-
graph (4) and by inserting after subparagraph (2) the fol-
lowing new subparagraph:
‘‘(3) AMOUNTS RECEIVED FROM AN ELECTING
SMALL
BUSINESS
TRUST.—Notwithstanding any
other provision of this part, amounts received by an
organization described in section 511(a)(2) from an
electing small business trust (as defined in section
1361(e)) shall be taken into account in computing
the unrelated business taxable income of such orga-
nization to the extent such amount is deducted by
such trust under section 641(c)(2)(C)(v).’’.
(c) EFFECTIVE DATE.—The amendments made by
this section shall apply to taxable years beginning after
December 31, 2001.
SEC. 308. SHAREHOLDER BASIS NOT INCREASED BY IN-
COME DERIVED FROM CANCELLATION OF S
CORPORATION’S DEBT.
(a) IN GENERAL.—Section 1366(a)(1) (relating to
determination of shareholder’s tax liability) is amended by
inserting ‘‘but not including income excludable from gross
income under section 108’’ after ‘‘tax-exempt income’’.
(b) EFFECTIVE DATE.—The amendment made by
this section shall apply to discharges of indebtedness oc-
curring after December 31, 2000.
SEC. 309. BACK TO BACK LOANS AS INDEBTEDNESS.
(a) IN GENERAL.—Section 1366(d) (relating to spe-
cial rules for losses and deductions) is amended by adding
at the end the following new paragraph:
‘‘(4) LOANS INCLUDED IN INDEBTEDNESS
OF AN S CORPORATION.—For purposes of sub-
section (d), the indebtedness of an S corpora-
tion to the shareholder shall include any loans
made or acquired (by purchase, gift, or dis-
tribution from another person) by a shareholder
to the S corporation, regardless of whether the
funds loaned by the shareholder to the S cor-
poration were obtained by the shareholder by
means of a recourse loan from another person
(whether related or unrelated to the share-
holder).’’.
(b) EFFECTIVE DATE.—The amendment made by
this section shall apply to taxable years beginning after
December 31, 2001.
TITLE IV—EXPANSION OF S COR-
PORATION ELIGIBILITY FOR
BANKS
SEC. 401. EXCLUSION OF INVESTMENT SECURITIES INCOME
FROM PASSIVE INCOME TEST FOR BANK S
CORPORATIONS.
(a) IN GENERAL.—Section 1374(b)(3) (defining pas-
sive investment income) is amended by adding at the end
the following new subparagraph:
‘‘(E) EXCEPTION
FOR
BANKS; ETC.—In
the case of a bank (as defined in section 581),
a bank holding company (as defined in section
246A(c)(3)(B)(ii)), or a qualified subchapter S
subsidiary which is a bank, the term ‘passive
investment income’ shall not include—
‘‘(i) interest income earned by such
bank, bank holding company, or qualified
subchapter S subsidiary, or
‘‘(ii) dividends on assets required to
be held by such bank, bank holding com-
pany, or qualified subchapter S subsidiary
to conduct a banking business, including
stock in the Federal Reserve Bank, the
Federal Home Loan Bank, or the Federal
Agricultural Mortgage Bank or participa-
tion certificates issued by a Federal Inter-
mediate Credit Bank.’’.
(b) EFFECTIVE DATE.—The amendment made by
this section shall apply to taxable years beginning after
December 31, 1996.
SEC. 402. TREATMENT OF QUALIFYING DIRECTOR SHARES.
(a) IN GENERAL.—Section 1361 (defining S corpora-
tion), as amended by section 201(a), is amended by adding
at the end the following new subsection:
‘‘(g) 
TREATMENT
OF
QUALIFYING
DIRECTOR
SHARES.—
‘‘(1) IN
GENERAL.—For purposes of this
subchapter—
‘‘(A) qualifying director shares shall not be
treated as a second class of stock, and
‘‘(B) no person shall be treated as a share-
holder of the corporation by reason of holding
qualifying director shares.
‘‘(2) 
QUALIFYING
DIRECTOR
SHARES
DE-
FINED.—For purposes of this subsection, the term
‘qualifying director shares’ means any shares of
stock in a bank (as defined in section 581) or in a
bank holding company registered as such with the
Federal Reserve System—
‘‘(i) which are held by an individual
solely by reason of status as a director of
such bank or company or its controlled
subsidiary; and
‘‘(ii) which are subject to an agree-
ment pursuant to which the holder is re-
quired to dispose of the shares of stock
upon termination of the holder’s status as
a director at the same price as the indi-
vidual acquired such shares of stock.
‘‘(3) DISTRIBUTIONS.—A distribution (not in
part or full payment in exchange for stock) made by
the corporation with respect to qualifying director
shares 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) Section 1361(b)(1) is amended by inserting
‘‘, except as provided in subsection (f),’’ before
‘‘which does not’’.
(2) Section 1366(a) is amended by adding at
the end the following new paragraph:
‘‘(3) ALLOCATION
WITH
RESPECT
TO
QUALI-
FYING
DIRECTOR
SHARES.—The holders of quali-
fying director shares (as defined in section 1361(f))
shall not, with respect to such shares of stock, be al-
located any of the items described in paragraph
(1).’’.
(3) Section 1373(a) is amended by striking
‘‘and’’ at the end of paragraph (1), by striking the
period at the end of paragraph (2) and inserting
‘‘, and’’, 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.’’.
(c) EFFECTIVE DATE.—The amendments made by
this section shall apply to taxable years beginning after
December 31, 1996.
SEC. 403. RECAPTURE OF BAD DEBT RESERVES.
Notwithstanding section 481 of the Internal Revenue
Code of 1986, with respect to any S corporation election
made by any bank in taxable years beginning after Decem-
ber 31, 1996, such bank may recognize built-in gains from
changing its accounting method for recognizing bad debts
from the reserve method under section 585 or 593 of such
Code to the charge-off method under section 166 of such
Code either in the taxable year ending with or beginning
with such an election.
TITLE V—QUALIFIED
SUBCHAPTER S SUBSIDIARIES
SEC. 501. RELIEF FROM INADVERTENTLY INVALID QUALI-
FIED SUBCHAPTER S SUBSIDIARY ELECTIONS
AND TERMINATIONS.
(a) IN GENERAL.—Section 1362(f) (relating to inad-
vertent invalid elections or terminations) is amended—
(1) 
by 
inserting 
‘‘or 
under 
section
1361(b)(3)(B)(ii)’’ after ‘‘subsection (a)’’ in para-
graph (1),
(2) 
by 
inserting 
‘‘or 
under 
section
1361(b)(3)(C)’’ after ‘‘subsection (d)’’ in paragraph
(1)(B),
(3) by inserting ‘‘or a qualified subchapter S
subsidiary, as the case may be’’ after ‘‘small busi-
ness corporation’’ in paragraph (3)(A),
(4) by inserting ‘‘or a qualified subchapter S
subsidiary, as the case may be’’ after ‘‘S corpora-
tion’’ in paragraph (4), and
(5) by inserting ‘‘or a qualified subchapter S
subsidiary, as the case may be’’ after ‘‘S corpora-
tion’’ in the matter following paragraph (4).
(b) EFFECTIVE DATE.—The amendments made by
this section shall apply to taxable years beginning after
December 31, 1996.
SEC. 502. INFORMATION RETURNS FOR QUALIFIED SUB-
CHAPTER S SUBSIDIARIES.
(a) IN GENERAL.—Section 1361(b)(3)(A) (relating
to treatment of certain wholly owned subsidiaries) is
amended by inserting ‘‘and in the case of information re-
turns required under part III of subchapter A of chapter
61’’ after ‘‘Secretary’’.
(b) EFFECTIVE DATE.—The amendment made by
this section shall apply to taxable years beginning after
December 31, 2001.
SEC. 503. TREATMENT OF THE SALE OF INTEREST IN A
QUALIFIED SUBCHAPTER S SUBSIDIARY.
(a) IN GENERAL.—Section 1361(b)(3) (relating to
treatment of certain wholly owned subsidiaries) is amend-
ed by adding at the end the following new subparagraph:
‘‘(E) SPECIAL RULE ON TERMINATION.—
The tax treatment of the disposition of the
stock of the qualified subchapter S subsidiary
shall be determined as if such disposition
were—
‘‘(i) a sale of the undivided interest in
the subsidiary’s assets based on the per-
centage of the stock transferred, and
‘‘(ii) followed by a deemed contribu-
tion by the S corporation and the trans-
feree in a section 351 transaction.’’.
(b) EFFECTIVE DATE.—The amendment made by
this section shall apply to taxable years beginning after
December 31, 1996.
SEC. 504. EXCEPTION TO APPLICATION OF STEP TRANS-
ACTION DOCTRINE FOR RESTRUCTURING IN
CONNECTION WITH MAKING QUALIFIED SUB-
CHAPTER S SUBSIDIARY ELECTIONS.
(a) IN GENERAL.—Section 1361(b)(3) (relating to
treatment of certain wholly owned subsidiaries), as amend-
ed by section 503, is amended by redesignating subpara-
graphs (C), (D), and (E), as subparagraphs (D), (E), and
(F), respectively, and by inserting after subparagraph (B)
the following new subparagraph:
‘‘(C) TREATMENT
OF
ELECTION.—The
election under subparagraph (B)(ii) shall be
treated as a liquidation of the qualified sub-
chapter S subsidiary to which section 332 ap-
plies.’’.
(b) EFFECTIVE DATE.—The amendments made by
this section shall apply to elections effective after Decem-
ber 31, 2001.
TITLE VI—ADDITIONAL
PROVISIONS
SEC. 601. ELIMINATION OF ALL EARNINGS AND PROFITS
ATTRIBUTABLE TO PRE-1983 YEARS.
(a) IN GENERAL.—Subsection (a) of section 1311 of
the Small Business Job Protection Act of 1996 is amend-
ed to read as follows:
‘‘(a) IN GENERAL.—If a corporation was an electing
small business corporation under subchapter S of chapter
1 of the Internal Revenue Code of 1986 for any taxable
year beginning before January 1, 1983, the amount of
such corporation’s accumulated earnings and profits (as
of the beginning of any taxable year beginning after De-
cember 31, 1982) shall be reduced by an amount equal
to the portion (if any) of such accumulated earnings and
profits which were accumulated in any taxable year begin-
ning before January 1, 1983, for which such corporation
was an electing small business corporation under such
subchapter S.’’.
(b) EFFECTIVE DATE.—The amendment made by
this section shall apply to taxable years beginning after
December 31, 1996.
SEC. 602. NO GAIN OR LOSS ON DEFERRED INTERCOMPANY
TRANSACTIONS BECAUSE OF CONVERSION
TO S CORPORATION OR QUALIFIED S COR-
PORATION SUBSIDIARY.
With respect to taxable years beginning before, on,
or after July 12, 1995, the regulations under section 1502
of the Internal Revenue Code of 1986 shall not cause gain
or loss to be recognized by reason of an election under
section 1361(b)(3)(B) or 1362(a) of such Code.
SEC. 603. TREATMENT OF CHARITABLE CONTRIBUTION
AND 
FOREIGN 
TAX 
CREDIT
CARRYFORWARDS.
(a) 
CHARITABLE
CONTRIBUTION
CARRYFORWARDS.—The 
last 
sentence 
of 
section
1374(b)(2) (relating to net operating loss carryforwards
from C years allowed) is amended by inserting ‘‘or a chari-
table contribution carryforward under section 170(d)(2)’’
after ‘‘capital loss carryforward’’.
(b) FOREIGN TAX CREDIT CARRYFORWARDS.—The
last sentence of section 1374(b)(3)(B) (relating to busi-
ness credit carryforwards from C years allowed) is amend-
ed by inserting ‘‘and the foreign tax credit carryforward
under section 904’’ after ‘‘section 53’’.
(c) 
TREATMENT
OF
ADDITIONAL
CARRYFORWARDS.—Section 1374(b) (relating to amount
of tax) is amended by adding at the end the following new
paragraph:
‘‘(5) 
TREATMENT
OF
ADDITIONAL
CARRYFORWARDS.—The Secretary under regulations
shall provide treatment similar to the preceding
paragraphs 
of 
this 
subsection 
for 
other
carryforwards attributable to taxable years for which
an S corporation was a C corporation.’’.
(d) EFFECTIVE DATE.—The amendments made by
this section shall apply to taxable years beginning after
December 31, 2001.
SEC. 604. DISTRIBUTIONS BY AN S CORPORATION TO AN
EMPLOYEE STOCK OWNERSHIP PLAN.
(a) IN GENERAL.—Section 1368(f) (relating to dis-
tributions) is amended by adding at the end the following
new subsection:
‘‘(f) DISTRIBUTIONS BY AN S CORPORATION TO AN
EMPLOYEE STOCK OWNERSHIP PLAN.—Any distribution
described in subsection (a) to an employee stock ownership
plan (as defined in section 4975(e)(7)) shall be treated
as a dividend under section 404(k)(2)(A).’’.
(b) TECHNICAL AMENDMENT.—Section 404(a)(9)(C)
(relating to S corporations) is amended to read as follows:
‘‘(C) S CORPORATIONS.—The deduction
provided in this paragraph shall not apply to an
S corporation.’’.
(c) EFFECTIVE DATE.—The amendments made by
this section shall apply to distributions received after the
date of the enactment of this Act.
SEC. 605. SPECIAL RULES OF APPLICATION.
(a) WAIVER OF LIMITATIONS.—If refund or credit of
any overpayment of tax resulting from the application of
any amendment made by this Act is prevented at any time
before the close of the 1-year period beginning on the date
of the enactment of this Act by the operation of any law
or rule of law (including res judicata), such refund or cred-
it may nevertheless be made or allowed if claimed therefor
is filed before the close of such period.
(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.
Æ