upon whether the purchaser is a partnership or S corporation. Liquidating payments by a partnership to a retiring partner or successor of a deceased partner will generally be treated as a purchase of the partner's share of partnership property to the extent of the fair market value of this property. Amounts paid in excess of this value will be treated as a distributive share of partnership income or as a guaranteed payment. Special provisions are made for unrealized receivables and good will of the partnership: payment for the former is never treated as a purchase of the partner's share of partnership property, while payment for the latter is not considered such a purchase unless the partnership agreement so provides. If a "purchase" is involved, payments in excess of basis of the partner's interest in the partnership usually produces capital gain, with the remaining partners receiving no deduction for the amounts paid. But if the payments constitute a "distributive share" or "guaranteed payment," the retiring or successor partner reports this as ordinary income, while the remaining partners are able to reduce their taxable income.

S shareholders must look to general corporate provisions under subchapter C for taxation of their buy-out arrangements. Under section 302 (a), the payments may qualify as a purchase with capital gain treatment for any excess over the seller's stock basis. At the same time, the broad constructive ownership rules of sections 302 (c) and 318 may convert the redemption into a dividend distribution with ordinary income consequences. Special relief may be found in section 303, treating certain redemptions of a deceased shareholder's stock as a purchase to the extent of death taxes and funeral and administration expenses. However, in some corporate purchases there also exists the possibility that the continuing shareholders will be threatened with having received constructive dividends. Of course, the existence of current or accumulated earnings and profits would always be a prerequisite to possible dividend consequences.

Death. On the death of a partner, the taxable year of the partnership does not generally close for him before the end of the partnership's regular taxable year. Exceptions to this would occur only on (a) prior termination of the partnership, (b) prior sale of the deceased partner's interest to outsiders or remaining partners, or (c) under the regulations, prior completion of liquidation of his interest. Under the general rule, therefore, his final income tax return does not include even his distributive share for the portion of the partnership year up to his death-whether or not he withdrew this during his lifetime. This portion, along with any remaining distributive share for the balance of the year, is reported in full by his estate or successor in interest in its taxable year in or with which the partnership's taxable year ends. Some tax relief is provided in the regulations by making section 691 applicable to decedent's distributive share for the short period ending with his death, and an income tax deduction is available to the recipient of this "income in respect of a decedent" equal to the portion of the estate tax paid attributable thereto.

Death of an S shareholder produces completely dissimilar tax treatment. As a separate legal entity, the corporation continues in existence but its qualification under subchapter S will end unless the estate files a consent within the 30-day period after the appointment of an executor or administrator-such period to begin not "later than 30 days following the close of the corporation's taxable year in which

the estate became a shareholder." Further, should the stock pass to a testamentary trust, the election would be lost immediately for such ownership falls outside the definition of a "small business corporation."

If the estate consents to continuing the S election, it will pay income tax on the entire year's "undistributed taxable income" based upon its proportionate shareholdings at the end of the corporation's fiscal year. This probably will result in both an estate tax and a full income tax, as predeath "undistributed taxable income" does not seem to qualify under section 691. To the extent that decedent received actual distributions out of current earnings and profits, inclusion is required in his final income tax return, with a compensating reduction in the constructive dividend taxable to the estate. In contrast, if the election were continued but the corporation sustained a net operating loss for the year, the estate could claim only a portion of the loss based upon the number of days it held stock during the corporation's taxable year. And, beginning January 1, 1960, the predeath share of the year's loss would be available as a deduction in decedent's final income tax return.

Finally, there is the "locked-in" problem of previously taxed income. As noted above, the right to nondividend distributions of this income is personal in nature and cannot be transferred even by death. Consequently, if the S corporation had accumulated earnings and profits, or if there existed a discrepancy between taxable income and current "earnings and profits," withdrawal by the estate of decedent's previously taxed income would result in ordinary dividend treatment. Organizational expenses.-Organizational expenses are often substantial. They include fees for legal services incident to organization, fees for necessary accounting services, costs of organizational meetings, and fees paid to State and local bodies. For partnerships, the Tax Court has held them to be capital expenditures and not deductible. Since 1954, however, section 248 permits corporations— which would include S corporations to elect to treat them as deferred expenses deductible ratably over a period of 60 months or more.

Miscellaneous.-Many other discrepancies exist between the tax treatment of partners and S shareholders. Examples of unique partnership provisions are: optional adjustment to the basis of undistributed partnership property; optional adjustment to the basis of partnership property on transfer of an interest in a partnership; transferee partner's special basis under section 732(d); alternative rules for determining adjusted basis of a partner's interest; termination on sale or exchange of 50 percent or more of the total interest in partnership capital and profits, etc.

Subchapter S thus resembles the taxation of partnerships only in the remotest sense. Actually, it creates a new, hybrid, and extremely complex tax system.

COMPLEXITIES ARISING FROM "EARNINGS AND PROFITS"

One of the extreme complicating factors inherent in subchapter S is the treatment of "earnings and profits." In its basic form under subchapter C, this elusive concept has as its principal purpose the measurement of dividend distributions. However, its policing problem is much more involved under subchapter S. In the first instance,

earnings and profits serve as a ceiling in determining the normal annual taxability of S shareholders on actual and constructive dividends, and in determining the extent of the special treatment to be given to S dividends. At the same time, the definition of earnings and profits is kept flexible enough to reach additional distributions by old corporations with accumulated earnings and profits, corporations in receipt of items not includible in taxable income, and corporations incurring losses or expenditures not allowable as tax deductions.

Current earnings: "three-tier system”

Subchapter S also emphasizes the importance of distinguishing between current and accumulated earnings and profits. Thus, under section 1373 (c), "undistributed taxable income" is computed by subtracting from taxable income all money distributions out of current earnings and profits. And under section 1375 (b), only actual or constructive distributions out of current earnings are denied the dividends received credit, retirement income credit and dividends exclusion-but for this purpose, current earnings and profits are deemed to be never greater than the corporation's taxable income. In all events, amounts not allowable as deductions in computing taxable income may not, under section 1377 (b), reduce current earnings and profits.

Modification of the current account may, accordingly, have numerous tax consequences under subchapter S, and additional attention will have to be given to its precise computation. It is of importance to shareholders that current earnings and profits will be increased by the excess of percentage depletion over cost depletion and by the receipt of all income exempted by statute, such as municipal bond interest and life insurance proceeds. Also of significance is that a net capital loss will generally decrease earnings and profits, but for subchapter S purposes will not affect the current account as it is not an allowable tax deduction.

In view of this pressure on the current account, the proposed regulations establish a "three-tier system" for allocating current earnings and profits. In the first tier are actual money distributions not in exchange for stock-and current earnings and profits must first be allocated here. If there is any excess current earnings, it falls within the second tier and is allocated ratably to (a) constructive distributions of "undistributed taxable income" and (b) actual distributions in kind not in exchange for stock, which, for allocation purposes, are taken into account at fair market value. Finally, in the third tier, the remainder of such earnings is available for allocation to any distributions in exchange for stock-such as distributions under section 302 or 331.

Previously taxed income

Another complicating factor arises from distributions of previously taxed income ("PTI"). These distributions are not considered dividends and do not reduce earnings and profits. However, in what seems an unnecessary extension of the statute, the proposed regulations grant nondividend treatment only to money distributions of PTI. And, consistent with the foregoing three-tier system, these regulations recognize a PTI distribution only when money distributions exceed the corporation's current earnings and profits.

Before a shareholder receives credit for PTI, therefore, the full current earnings account must be exhausted. Under this interpretation, a shareholder could be taxed in 1 year on more than the corporation's taxable income, regardless of a large PTI account: on cash distributions equal to the taxable income of the year plus cash distributions equal to the amount by which the determination of current earnings exceeds the computation of taxable income.

Distributions in kind add further PTI problems. Such a distribution, being ineligible for nondividend treatment, would be charged in the second tier against any remaining current earnings. If there were no such excess, then the distribution in kind would be taxable as a dividend to the extent of any accumulated earnings. Thus, despite the existence of large PTI, a shareholder could again be taxed in 1 year on more than the corporation's taxable income-on cash distributions representing the taxable income of the year plus the value of distributions in kind. Discrepancies between the computation of taxable income and the determination of current earnings and profits might themselves create a current earnings reserve sufficient to convert the distribution in kind into an ordinary dividend.

If there were merely an accumulated earnings account, distributions in kind would be costly while cash distributions equivalent to the PTI account would be tax free. Accordingly, S shareholders may attempt tax savings by first distributing cash and then using these funds to purchase corporate assets. A current tax on capital gain would certainly be preferable on a short-term basis to ordinary dividend treatment for distributions in kind. Of course, if no accumulated or current earnings balance existed, a straightforward distribution in kind would be more advantageous.

As a final fillip, the proposed regulations provide for a new PTI election: the S corporation, with the consent of all shareholders, may elect to treat distributions as coming from accumulated earnings and profits rather than from PTI. In other words, shareholders may decide to have money distributions in excess of current earnings taxed immediately as dividends to the extent of accumulated earnings. If the election is not made, automatic nondividend treatment will follow for the PTI balance.

Tax planning

From all of this, it becomes apparent that a great deal of planning is necessary to determine the optimum tax results for S shareholders. This is particularly true when the S corporation's fiscal year differs from the taxable year of the shareholders.

Distributions in kind, for example, at the beginning of the corporation's year may have their tax treatment completely altered by cash distributions at the year's end. If there had been no cash distribution, the distribution in kind in the shareholder's taxable year would be a second-tier distribution of current earnings, participating on a parity with undistributed taxable income. However, this would be changed by the corporation distributing its current earnings in cash at the end of its fiscal year-falling in the shareholder's taxable year succeeding his receipt of distributions in kind. The first-tier nature of this subsequent distribution would exhaust current earnings, thus stripping the prior distributions in kind of its current dividend status.

Consequently, if there were no accumulated earnings, the prior year's distribution in kind would retroactively be converted into a return of capital, with its value in excess of stock basis qualifying for capitalgain treatment.

Thus, when the taxable year of the corporation includes portions of 2 taxable years of the shareholder, his prior year's income-tax return may have to be amended to reflect a change in his tax caused by voluntary corporate action at its year's end. This could occur through distributions in kind just described, and could likewise occur through the requirement that capital gains be allocated ratably to the various distributions of current earnings.

Incentives for creating indebtedness

As noted above, a shareholder's PTI position may be jeopardized by any of the following events: (1) transfer of all his stock by death, gift, or otherwise; (2) termination of the S election for any reason; and (3) corporate net operating losses. S corporations can avoid these problems by distributing by the end of each year the full amount of their current taxable income.

If the corporation cannot spare these funds, shareholders may be called upon to return the distributions by way of loans. The resulting distribution-lendbacks may thus create a whole series of new tax problems: whether the transactions are to be telescoped or disregarded as a "sham"; whether they, in fact, constitute distributions of corporate obligations; whether they are contributions to capital rather than true loans; whether, if they initially seem to be loans, they are to be ultimately treated as "equity" under the thin incorporation doctrine.

In other words, the use of shareholder-held debt will be encouraged, and the debt-versus-equity problem will be accentuated in new proportions. The ultimate classification is extremely crucial under subchapter S; for a determination that "equity" was intended may be held to create a second class of stock, disqualifying the election in its entirety.

This special problem under subchapter S has a bearing upon the advisability of adopting a debt-equity ratio rule, similar to the proposed Code section 317 (c)-contained in section 10 of H.R. 4459. Before such legislation is approved, its adequacy in the context of subchapter S should be clearly tested.

CONCLUSION

Technically, subchapter S contains many structural weaknesses and complexities. Also, distinctions it makes are often indefensible and inequitable. Despite only 1 year's experience under these provisions, Congress would be justified in striking it from the Code as bad law, not worthy of retention even in modified form.

There may be a desire, however, for continued efforts to draft a statute which would effectively permit "small" businesses to select forms of organization "without the necessity of taking into account major differences in tax consequences." If this pressure exists, subchapter S should be brought as close to partnership taxation as is possible. One approach would be that employed by the Senate Finance Committee in H.R. 8300; i.e., treat the electing corporation as a partnership under subchapter K, subject to modifications contained in the