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regulations. Or, if this administrative latitude is deemed objectionable, the statute might generally follow subchapter K, but set forth the chief points of divergence required to accommodate the idiosyncracies of the corporate form.

As another alternative, subchapter S might be retained as a skeleton, with major amendments to eliminate its most objectionable features. If this were to be the pattern, legislation along the following lines would seem desirable:

I. The statute should be limited to new corporations. This would avoid the difficulties now encountered in adjusting for preelection "accumulated earnings and profits." Further, if the "earnings and profits” concept is then retained at all, its definition under subchapter S should coincide with the definition of "taxable income" under section 1373 (d).

II. Consideration should be given to modifying the definition of "small business corporation.” In addition to the 10-shareholder rule, a dollar ceiling might be added comparable to section 1244(c) (2). Related to this, the statute would seem improved by deleting the prohibitions against foreign income and personal holding company income,

III. Events causing termination of an election should be reconsidered and further limited. Death, for example, need not retroactively defeat the election for the year in which death occurs despite the estate's refusal to give its consent. Transfers of small stock interests, also, might not require automatic termination if the transferee did not consent.

IV. The right to renew an election should be severely curtailed, particularly if the causes of termination are reduced. Freedom to shift back and forth between business forms creates tax-avoidance possibilities which far outweigh the advantages of providing greater flexibility.

V. The corporation's fiscal year should generally be limited to that of the principal shareholders, unless another period is supported by valid business reasons. In all events, a shareholder should be required to report his share of the corporation's full taxable income in his taxable year in which or with whích the corporation's taxable year ends.

VI. Taxable income should be allocated among shareholders based upon their proportionate shareholdings for each day of the yearsímilar to the allocation of net operating losses.

VII. Shareholders should not be considered "employees,” except possibly those holding less than 5 percent of the outstanding stock under a broad constructive ownership test.

VIII. Distributions in kind as well as in money should be charged against current earnings, and should be eligible for effecting PTI distributions when current earnings are accounted for.

IX. The nondividend status of the PTI account should be preserved despite stock transfers or termination of election, and should not be reduced by net operating losses. Further, greater latitude should be allowed in making PTI withdrawals. If only new corporations are permitted to make the S election and if "earnings and profits” are made to coincide with "taxable income," PTI problems would arise primarily on termination of election.

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X. Similar to a partner, an S shareholder should be permitted to claim any unused net operating loss in any year in which his stock or debt basis increases sufficiently to absorb his remaining share of the loss.

These are the major areas calling for modification. A more comprehensive program would involve adopting the partnership rules for (1) characterization of income and deductions, (2) capital gains and losses, (3) collapsible items, (4) dealings between shareholders and corporation, (5) current and liquidating distributions, and (6) payments to a retiring or deceased shareholder. While these additional changes are desirable, it is believed that the separately itemized proposals would eliminate most of the weaknesses, complexities and inequities of the existing statute.

The capital gain pass-through to shareholders has been cited as a principal source of abuse, but this would be minimized if subchapter S is limited to new corporations only. Proper handling of the capital gain problem would require provisions which, like the proposed regulations, test the capital nature of an asset by its character in the hands of the shareholders. It would also involve inquiry into the entire field of multiple corporations—a project worthy of full and immediate study.

SUBCHAPTER S-ITS ROLE IN THE TAX LAWS

Joseph P. Driscoll, Dallas, Tex. The 1958 Technical Amendments Act introduced a major change in the philosophy and method of taxing business entities. Under the new subchapter S, certain corporations may elect not to be taxed as corporations but to have their income and losses attributed directly to the shareholder. The election creates a new category of business

a entity which has the form of a corporation but many of the tax attributes of a partnership.

The new provisions have been subject to praise by those who see them as permitting greater flexibility in business operations and to criticism by those who view them as creating an exception to established rules in the area of corporate taxation. The purpose of this paper is to review some of the fundamental bases for the subchapter S provisions, to consider their role in constructive reform of the tax system, and to point the way toward problems which may require further examination.

LEGISLATIVE BACKGROUND Subchapter S was added to the Technical Amendments Act of 1958 by the Senate upon recommendation of the Finance Committee. Two principal reasons were given by the Finance Committee 1 for the adoption of the provisions. The committee stated, first, that the legislation would permit greater flexibility in selecting the form of business organization by minimizing differences in tax consequences. Secondly, the committee stated that the provision would benefit small business by eliminating double taxation on income derived by the shareholders, and by allowing the shareholders to deduct their share of losses incurred by the business entity. Other than these statements, there is little in the legislative history to explain the adoption of provisions which may have a fundamental impact on the structure of the tax system as applied to business organizations.

The new provisions, however, were not without precedent in the legislative process. In the 1954 revision of the tax laws Congress enacted subchapter R, which allows partnerships and proprietorships to be taxed as corporations. At that time the Congress had under consideration, but did not enact, provisions which would allow corporations to be taxed in certain respects as partnerships.

A proposal for elective partnership taxation of corporations had been under examination for some time in connection with tax suggestions for small business. In a study on the taxation of small business published by the Treasury Department in 1949 % partnership

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1 Finance Committee Rept. No. 1983, July 28, 1958, 85th Cong., 2d sess., pp. 87–89. • Sec. 1361, Internal Revenue Code.

8 "Taxation of Small Business, a Treasury Tax Study,” published by the Division of Tax Research, U.S. Treasury Department, 1949.

tax treatment for certain corporations was discussed as one of several proposals intended to stimulate small business. Such treatment, it was observed, was intended to equalize the tax burden on small incorporated and unincorporated businesses. The study noted that the proposal might increase the flow of new equity capital into small corporations. While the Treasury study did not view with favor the enactment of any special provisions for small business, it is noticeable that no significant policy objections were presented to the partnership method of taxing corporate entities. It was stated that the proposal should be restricted, for administrative convenience, to corporations which had a limited number of shareholders, such as 10 or 15, and which had a simple capital structure. The Treasury staff appeared to favor a limitation in terms of the number of shareholders rather than one based on the size of corporate assets.

Subsequently, the President's Cabinet Committee on Small Business proposed several changes in the tax laws for the benefit of small business. The President in his budget message in January 1959 advocated a provision allowing small business entities to be taxed generally in the same manner as partnerships.

POLICY CONSIDERATION

1. Flexibility in choice of business entities

Prior to the enactment of subchapter S, there were two basic methods of structuring a business organization for tax purposes—the corporate and the partnership methods. The tax effects of the two methods were, and remain, different in several fundamental respects. A corporate entity is subject to the corporate rate of 30 percent on the first $25,000 of taxable income and 52 percent on the balance of its income, with distributions by the corporation being taxed a second time as dividends subject to the limited dividends-received credit or exclusion. The corporate form is for many purposes highly favored in the tax laws. It permits retention of earnings for the purpose of expansion and reinvestment without incurrence of an individual income tax. Amounts plowed back into business operations are insulated from the individual tax rates of the shareholders and subject only to more or less uniform corporate rates.

The partnership differs basically in that the entity itself is not subject to tax but its members, whether general or limited partners, are required to report currently their share of partnership income or loss. The partnership merely passes on to its members the taxable income or loss derived by the business operations. To a significant extent, the partnership is a form of individualized accounting for the owner's share of business profits. During a period of high individual rates reaching a maximum marginal rate of 91 percent, the partnership is not suitable to the accumulation of capital through reinvestment of earnings. However, the partnership form has advantages in certain situations in that the income is not subject to two layers of taxation and partnership losses may be deducted by the owners against other income.

The deciding factor in ascertaining whether a venture is subject to the corporate or the partnership method of taxation is the form of the organization, rather than its size or scope of operations. If the

venture is created as a corporation under State law or has the attributes of an association taxable as a corporation, it is subject to taxation as a corporate entity. If the venture is formed under partnership laws and does not constitute an association taxable as a corporation, it is subject to partnership tax treatment. The definition of an association taxable as a corporation depends in large part on the technical provisions of the governing instruments. Sometimes, relatively slight changes of wording may determine whether the venture is subject to taxation in one form rather than another.

The use of the corporate or partnership method of taxation has been largely a matter of choice for the parties concerned. They may incorporate the business and thereby subject themselves to corporate tax treatment; or they may adopt the partnership form and qualify for the partnership rules. Except in cases where nontax considerations dictate one form or the other, the use of the corporate or partnership method of taxation has been elective in substance. Prior to the 1958 Technical Amendments Act, this election was made by selecting the form of business organization rather than through an election procedure expressly provided for in the tax laws. Subchapter S allows the tax treatment to be determined independently of the form of the organization.

It is generally agreed that the tax consequences should be the same, or as similar as possible, regardless of the form employed. This rule is applicable to the form of business organization as well as specific business transactions. In this respect subchapter S is in accord with recognized tax principles. It enables taxpayers to select the form of the organization, whether corporate or noncorporate, primarily on the basis of business considerations rather than for tax reasons. The choice of the method of taxation is then made under applicable provisions of the tax law.

Despite the desirability of the general objective, there are technical and administrative limitations on the extent to which the partnership election may be made available to corporate enterprises. The partnership method of taxation is not practicable either for taxpayers or the Revenue Service if there are an excessive number of participants or in the case of a complex capital structure. Also, it should be

apparent that not all of the provisions of partnership taxation can readily be applied to corporations electing the partnership tax treatment. Subchapter S of necessity must be restricted to basic rules of partnership tax treatment although consideration may and should be given to extension of the conduit treatment to certain additional income items. In general the goal should be tax treatment comparable with that of partnerships to the extent administratively practical. 2. Small business aspects

Subchapter S is one of the several provisions which were included in the 1958 Technical Amendments Act as an aid to small business. Other "small business" provisions include allowance of losses up to $25,000 on small business stock * and additional first-year depreciation allowance for small business. The definition of "small business" for each of these provisions is different.

Sec. 1244, Internal Revenue Code. 6 Sec. 179, Internal Revenue Code.

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