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Mortimer M. Caplin, Charlottesville, Va.

Subchapter S of the Code-sections 1371 through 1377—was enacted in September 1958 to permit businesses “to select the form of business organization desired, without the necessity of taking into account major differences in tax consequences.” Under its elective provisions, no corporate tax is paid; rather, the corporation's current taxable income is included on a per share basis in the gross income of the shareholders. Generally, they report this as ordinary income, except for certain long-term capital gain which retains its character in their hands.

This new tax pattern, publicized as “partnership type tax treatment," was adopted so that subchapter S could operate in as simple a manner as possible." In practice, however, subchapter S fails to meet its limited stated purpose. S shareholders are not taxed like partners; and tax planners, who typically were limited to partnership-versus-corporation considerations, now make a tripartite analysis in determining the optimum tax results: partnership-versus-corporation-versus-subchapter S. The differences in tax consequences can be “major" and the tax-savings possibilities startling.

In addition-chiefly due to its divergence from partnership taxation-subchapter S is fast becoming an important “tax gadget." Already, it has been widely publicized as a patented cure-all for a wide variety of serious tax ailments: for family income-splitting and for "employee” fringe benefits, for accumulated earnings and for personal-service personal holding companies, for collapsible corporations and for borderline partial liquidations—in fact, for any liquidation not otherwise assured of a single capital gain.

Aside from manifesting many policy conflicts with other code sections, subchapter S is also a sophisticated and complex provision. A full understanding of its operation demands knowledge not only of its novel terminology, but also of the refinements of taxing individuals, corporations, as well as partnerships. Comparison of each of these systems of taxation must be made if subchapter S is to be used intelligently.

In short, subchapter S has a Lorelei-like quality which can easily entrap the uninitiated. It contains unexpected quirks and reflects dubious policy distinctions. If the continuance of this legislation is still warranted, far-reaching amendments should be made as rapidly as possible.



It is true that an S corporation, like a partnership, is not a taxable entity. Income taxation is imposed upon the respective participants, while the organization itself is merely required to make annual filings in the nature of information returns. But at this point the similarity ceases, for the variations between the two are myriad.

Taxable year. -A partnership may not adopt or change to a taxable year other than that of all its principal partners unless it demonstrates a business purpose to the Commissioner's satisfaction. In contrast, a new S corporation has complete freedom in selecting an initial fiscal year, permitting deferral of income tax for as much as 11 months along with many other tax-savings possibilities.

Compensation arrangements.-A partner is not an "employee" under the Internal Revenue Code; a shareholder of an S corporation could be. Consequently, only the latter could qualify for tax benefits under qualified deferred compensation plans, accident and health plans, "convenience of employer” rules, group, term life insurance, employee death benefits, as well as restricted stock options. Numerous compensation arrangements are therefore available to an S corporation but denied to a partnership.

Character of income and deductions. The partnership is true conduit: the character of receipts or deductions is determined at the partnership level and then transferred to the individual partners. An S corporation operates almost completely contrariwise; for its "taxable income” is computed at the corporate level with no carrythrough to shareholders of income or deduction characteristics, except as to net long-term capital gain. For example, while interest on the obligations of a municipality is not part of the corporation's taxable income, it would be included in corporate “earnings and profits” and could bring dividend treatment on actual distribution to shareholders. Similarly, while the S corporation's taxable income is reduced by a percentage depletion deduction, its earnings and profits would only be charged with cost depletion; and actual distributions to shareholders could result in dividends beyond the corporation's taxable income for the year. Another illustration of this noncharacterization rule is the S corporation's receipt of dividends from other corporations: for, regardless of subsequent distribution of these dividends, S shareholders would not obtain a dividends received credit, retirement income credit or $50 exclusion.

Capital gain.--The single characterization exception in subchapter S is the special recognition given to a shareholder's pro rata share of the excess of the corporation's net long-term capital gain over its net short-term capital loss. Yet, even in this instance, capital gain treatment is limited to the shareholder's share of the corporation's taxable income and does not conform to the partnership pattern in several important respects.

For example, if an S corporation has a $100 net gain under section 1231, long-term capital gain is available despite a shareholder's individual $100 net loss under this same section. In effect, he would pay a 50-percent tax on the $100 received from the corporation, and would be allowed a full $100 deduction for his personal section 1231 loss. Under the partnership form, these two transactions would offset each other, which seems the more desirable result.

Again, if there were $100 net long-term capital gain but $100 net operating loss, the absence of taxable income would deny capital gain reporting by S shareholders; although, in a partnership, the conduit approach would assure $100 long-term capital gain as well as $100 ordinary loss. Further, a net capital loss of an S corporation does not pass through to shareholders, but is apparently available at the corporate level for 5 years as a capital loss carryover. In a partnership, the partners immediately incorporate any net capital loss into their individual income tax returns.

Appreciated or depreciated property.Property contributed on organization of a partnership or S corporation will usually retain the basis of the transferor participant. And any discrepancies between basis and fair market value may have a sharp effect upon the amount of depreciation or, in a later sale or other taxable event, the amount of gain or loss.' In the partnership form, adjustments are allowed among the partners to compensate for this differential; but no similar provision exists under subcħapter S.

Distributive share of income, deductions, etc.—A partner's distributive share of any item of income, gain, loss, deduction, or credit may be determined by the partnership agreement—if the principal purpose is not tax avoidance. Under subchapter S, such an allocation would not be possible despite a business purpose.

Limitations in computing taxable income. There are a number of dollar or percentage items in the Code limiting the deductibility or exclusion of an item in the computation of taxable income. Examples are: $50 exclusion for dividends received; $1,000 deduction limitation for excess capital losses; $50,000 deduction limitation for so-called hobby losses; $100,000 deduction limitation for exploration expenditures; percentage limitation on charitable contributions; and percentage limitation on soil and water conservation expenditures. All of these are applicable to partnerships, with the limitations apparently imposed at the individual partner level. The effect, however, is quite different under subchapter S: thus, in the above examples, the first three would have no application to the S corporation, while the last three would be determined at the corporate level.

Income shifting and splitting:-Income shifting through family partnerships is sharply limited by statute and regulations. For example, a transfer of all or part of a partner's interest during the partnership's taxable year would require a proration of current income on a daily basis. Much greater freedom is allowed under subchapter S, particularly the provision which taxes "undistributed taxable income” for an entire year on the basis of share ownership on the last day of the corporation's taxable year. So long as a transfer of stock is bona fide, a shift of an entire year's corporate income may be accomplished on the last day of the year. The only limitation is that contained in section 1375(c), permitting the Commissioner to apportion and allocate "to reflect the value of services rendered to the corporation” by shareholders within the family group.

Furthermore, with a new S corporation's freedom to select a fiscal year overlapping that of its shareholders, income can be split for the same shareholder between 2 taxable years: with cash distributions early in the corporate year taxed to him in his year of actual receipt, and the balance of the corporation's taxable income taxed to him in his taxable year in which the corporation's fiscal period ends. Had a partnership been involved, both his guaranteed payments and his distributive share of partnership items, actually or constructively re

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ceived, would be bunched in a single taxable year-his taxable year in which the partnership year ends.

Net operating losses.-A partner's distributive share of partnership losses is allowed to the extent of the adjusted basis of his interest in the partnership at the end of the partnership year in which the loss occurred. In addition, a suspense account is established for any excess; and the partner is allowed a deduction at the end of any succeeding partnership year in which his adjusted basis increases sufficiently to offset any remaining unused loss. This flexibility is not available to the S shareholder; for his share of loss—"the sum of the portions of the corporation's daily net operating loss attributable on a pro rata basis to the shares held by him on each day of the taxable year”—is limited to his total adjusted basis for stock and for corporate indebtedness owed to him. To absorb an excess loss, the S shareholder must increase his basis pro tanto not later than the close of the corporation's loss year; otherwise this possible deduction is forefeited forever.

Inside sales of appreciated property.-A taxable sale of appreciated property by an organizer may bring different results depending on whether the purchaser is a partnership or an S corporation. Partnership provisions are more restrictive here; for, under section 707, capital gain is denied the partner (a) if the property is not a capital asset in the hands of the transferee-partnership and (b) if the selling partner, under a broad constructive ownership test, owns more than 80 percent of the capital or profits interests of the partnership. Yet, the S shareholder, under the limited coverage of section 1239, would lose capital gain treatment only if (a) the property was depreciable in the hands of the corporation and (b) the selling shareholder, “his spouse, and his minor children and minor grandchildren” together owned more than 80 percent in value of the outstanding stock.

Distribution in kind.Distributions in kind present few problems to a partner, except for "collapsible" items, i.e., unrealized receivables and substantially appreciated inventory. Generally, no taxable event is involved: in current distributions, the partner takes over the partnership's tax basis; in liquidation, the partner allocates the basis of his interest in the partnership among the distributed assets in proportion to their adjusted bases to the partnership. Subchapter S has an entirely different approach.

Asset distributions are received by an S shareholder at fair market value, and taxation may result under a number of common circumstances. In current distributions, for example, the existence of current or accumulated earnings and profits may bring ordinary dividend treatment to the shareholder. This could follow under the proposed regulations even though his previously taxed income account was greater than the value of the property distribution. Or, it could result from a stock redemption essentially equivalent to a dividend. The best the shareholder could hope for would be capital gain on the excess of the distributed property's value over his stock basis, which would be the automatic rule if there were no earnings and profits. In liquidation, the S shareholder would similarly realize capital gain on the excess value of the property over his stock basis-unless election was made for special treatment under section 333.

Previously taxed income. In the partnership form, no special difficulties arise in withdrawing previously taxed income—whether the

distribution be in cash or other property, or whether the withdrawing party be the originally taxed partner, his donee, executor, or outside purchaser of his interest. Generally, gain will be recognized only to the extent that a money distribution exceeds the adjusted basis of the then partner's interest, and this will usually be treated as capital gain. In contrast, distribution of previously taxed income of an S corporation is surrounded by many qualifications and complexities:

(1) Its benefits are not transferable, and it is treated as a nondividend distribution only if made to the person who paid the tax on the original income. Neither the donee, estate of the shareholder, nor any purchaser of his stock, could take advantage of his previously taxed income account. The transferor-shareholder, however, may regain his preferred position by again becoming a shareholder while the S corporation is subject to the same election.

(2) Under the proposed regulations, it is regarded as a nondividend distribution only if made in cash; for a distribution of property other than money or a distribution in exchange for stock, or a constructive distribution under section 1373(b) is never a distribution of previously taxed income.”

(3) The amount available for nondividend distribution must be reduced not only by prior nondividend distributions but also by net operating losses allowable to shareholders for prior taxable years.

(4) If the subchapter S election is terminated for any reasonwhether by disqualification, voluntary revocation, or nonconsent by new shareholders following death or otherwise—any undis

tributed previously taxed income forever loses its special status. Of course, the nondividend treatment of previously taxed income has significance only if the S corporation has accumulated earnings and profits or current earnings in excess of taxable income. Otherwise, distributions could still be tax free under section 302 (C) (2).

Collapsible items.—There is no coordination between the partnership provisions and subchapter S on collapsible items. Nor, for that matter, is there coordination between section 341 for collapsible corporations and the use of subchapter S to avoid this penalty treatment, although the proposed regulations seek to narrow the gap.

Following the distribution of a partnership inventory item, for example, the distributee partner will realize ordinary gain or loss if he disposes of the property within 5 years. There is no such automatic rule for an S shareholder. Again, on a partner's sale or exchange of his partnership interest, or upon certain disproportionate distributions to him, an allocation is required under objective standards for unrealized receivable and substantially appreciated inventory, with partial ordinary income treatment. In contrast, an S shareholder would have to run the gamut of section 341, with all-or-none ordinary income dependent upon the intention of shareholders and other intricacies of that involved provision. Further, there is no similarity of definition of a collapsible item under section 751 for partnerships and section 341 for corporations, and totally different tax consequences could occur dependent upon the type organization involved.

Buy-out arrangements.-On buy-out of the venturer's interest after death or retirement, contrasting tax results may follow dependent

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