There is a broad question of tax policy as to whether any special statutory provisions should be made available to entities classified as small business. Some experts feel that such legislation is itself preferential and tends to undermine the tax system. Others contend that small business is at an economic disadvantage under the present tax laws and that special provisions are necessary in order to place it in a more competitive position with larger business operations. It is noted, for example, that small business by its very nature does not have the ability to offset profits against losses from multiple ventures, that it does not have ready access to capital markets, and that the economic factors militating against small business are accentuated by tax limitations on capital losses.

The problem of small business tax provisions is not easy to resolve. While it would be convenient to ignore small business in the tax laws and to provide for rigidly uniform application of the statute irrespective of the size of the taxpayer, such uniformity may itself be superficial because of differences in the circumstances of the taxpayers. Furthermore, small business plays such a vital role in the economic system that tax policies which bear more heavily upon it or fail to recognize its peculiar needs may be inconsistent with generally desired economic goals.

Apart from the question as to whether any tax provisions should be specifically designed for small business, we should consider whether the specific provisions will be of actual and material benefit to small business. It has been stated, for example, that subchapter S will aid small business by allowing the income to be taxed to the shareholders at their individual rates instead of the 30-percent corporate rate. While some shareholders are subject to a rate of less than 30 percent, this would appear to be a rather limited situation. Most stockholders (other than owners of "tiny business" as distinguished from "small business") will be in a bracket of more than 30 percent when their salaries from the business are taken into account. If the shareholders are in a bracket of more than 30 percent, they will benefit by subjecting the corporate earnings (after salaries) to the corporate tax rate. In such a case the creation of capital which is essential to small business can be achieved most effectively by reinvestment of earnings at the minimum corporate rate. In this area, therefore, the subchapter S provisions would have only a minimal effect on small business.

On the other hand, allowing the losses of a business to be passed on to the shareholders should materially increase the flow of equity available to small business. It is well known that small business has a high loss ratio during the early years. Even where the venture is eventually successful, losses may be incurred for several years. Equity funds will be more readily available if stockholders can offset current business losses against income from other sources, such as salary, dividends, rent, etc. An example of this appears in the financing of Broadway plays. Despite the high percentage of failures, these productions can be financed because of the knowledge that such losses will be allowed as ordinary losses to individual participants. The passing through of losses to the shareholders should therefore be of material benefit to small business.

3. Pension and profit-sharing plans for small business

One of the most significant aspects of subchapter S, although not mentioned in the legislative history of the provision, is the possible increased use of pension and profit-sharing plans for owners of small business enterprises. Partners and proprietors can create such plans only for the benefit of their employees and may not include themselves. However, where subchapter S is used, the pension or profitsharing plan may include stockholder employees as well as other employees.

The extension of pension and profit-sharing plans to the self-employed has been extensively considered by the congressional tax committees in the past several years, but has not yet been adopted by the Congress. The present provisions which allow pension and profitsharing plans in the case of employees but exclude partners and sole proprietors are discriminatory against the owners of unincorporated businesses. Under existing tax rates, pension and profit-sharing plans are one of the few ways in which substantial funds can be set aside for an individual's retirement years. The nonavailability of these plans to unincorporated business has caused many to shift to corporate form even though in other respects it may be undesirable. It has also brought into existence new forms of business entities such as associations of medical practitioners which seek to acquire corporate tax status for the sole purpose of adopting a pension or profit-sharing plan.

The subchapter S election permits small business enterprises to use pension and profit-sharing plans for their owners as well as other employees while at the same time retaining many of the aspects of a partnership for tax purposes. A significant number of those electing subchapter S treatment may have done so primarily for this reason. Subchapter S thus provides a greater measure of uniformity in the tax laws by extending pension and profit-sharing plans to a broader segment of owners of business enterprises. There are some who will object to this result because of its revenue implications. However, it is difficult to justify the granting of these tax benefits to incorporated but not unincorporated business. If the benefits are not to be available to unincorporated business, they should, on logical grounds, be curtailed in the corporate area.

Similarly, the special fringe benefits which are available to "employees" but not to partners or proprietors, such as the exclusion of sick pay, tax-free reimbursement of medical expense, group life insurance, and payment of accident and health policies, are made available to shareholder-employees under the subchapter S election. 4. Tax planning

Subchapter S has been criticized by some because it increases the possible area of tax planning. This objection seems naive. It is elemental that business must adapt itself to, and take into account, the provisions of tax law. If those provisions provide equitable tax treatment under various conditions, tax planning will be minimized and there will be a saving of time and expense for all concerned. But if the tax treatment of business entities is illogical, antiquated, or disjointed so that one course of action results in a greater tax than a substantially similar course of action, taxpayers must plan their

affairs accordingly. They cannot be expected to take the course of action which results in the greater tax. Fundamentally, subchapter S merely provides a simplified method of choosing between the corporate and partnership methods of taxation. These choices have long been available in the tax law although, as noted above, the choice was made by selecting the form of business organization.

5. Loopholes

Subchapter S has been questioned by some as possibly opening up avenues of large-scale tax avoidance. Concern was expressed initially that subchapter S might emasculate the collapsible corporation provisions and other limitations in subchapter C. It has been stated that corporations which are subject to the collapsible corporation rules might adopt the subchapter S election, make a sale of assets at the corporate level, and distribute a capital gain to the shareholders. The net effect, it is said, would be a single capital gains tax in lieu of the double capital gains tax at the corporate and individual level.

It is not clear, however, that subchapter S may be used to circumvent the collapsible corporation rules. In the proposed regulations the Commissioner has taken the position that subchapter S election is not available to a corporation which is in process of or contemplates complete or partial liquidation. The scope of the regulation is probably far too broad, at least insofar as it applies to "partial liquidations" but it may well be sustained with respect to complete liquidations. Thus far there have been no indications of extensive use of subchapter S for this purpose. It is recognized, however, that further study needs to be given to the problem of liquidating distributions and the collapsible provisions.

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Subchapter S may also have a significant impact in areas where the subchapter C rules contain needless or arbitrary restrictions. example of this appears in connection with 337, which provides for nonrecognition of gain to the corporation in the case of a sale of corporate assets and a distribution of all assets to the shareholders within a period of 12 months. Section 337 is not available if the corporation technically happens to be a collapsible corporation, even though it might be entitled to exemption from the collapsible rules under section 341 (d).

There does not appear to be any substantial reason for denying the availability of section 337 under these circumstances. In such a case subchapter S may make possible a sale of corporate assets at the price of a single capital gains tax even though the corporation might technically fail to qualify under section 337. However, it can hardly be contended that the use of subchapter S in this instance constitutes a loophole. While in the absence of subchapter S there may have been a double capital gains tax, such a result would be unjustified and would result only from illogical limitations in section 337, rather than a clear-cut congressional policy. The fact that there is a difference between the rules under subchapter S and section 337 should not be considered as constituting a "loophole" unless the restriction in section 337 has substantial justification in the overall tax pattern. Furthermore, it is to be noted that section 337 applies only in the case of a complete liquidation of the selling corporation and is not available in the event of a partial liquidation. Subchapter S, on

the other hand, may permit a disposition of corporate property in a partial liquidation at the price of a single capital gains tax. This again suggests that the rules of section 337 may be too restrictive and warrants reexamination of that section.

Subchapter S has thus thrown into focus some of the limitations which appear in provisions under subchapter C. This does not necessarily mean that the tax treatment under subchapter S is incorrect. It does indicate a need for a closer analysis of the assumptions underlying certain of the provisions in subchapter C.

APPRAISAL AND RECOMMENDATIONS

It is difficult at this time to ascertain the full significance of the subchapter S elective treatment in the tax laws. On balance, however, it appears that the elective treatment is justified in the case of corporations with a limited number of shareholders, and a simple capital structure. If the parties wish to obtain the benefits of limited liability, there is no inherent reason why they should be required to use the corporate rather than the partnership method of taxation.

Elective treatment under subchapter S will probably be of real value to small business where operating losses are allocated to the shareholders. Subchapter S will also make available to many small unincorporated businesses the benefits of pension and profit-sharing plans and certain fringe benefits allowed corporate stockholder-employees.

Although useful as a planning tool, subchapter S does not appear to have had widespread use as a loophole device. While this aspect of the new provisions must be studied more carefully, the mere fact that there is a difference in tax treatment under subchapter S and subchapter C does not necessarily mean that the new provisions constitute a loophole. The effect of subchapter S provisions may be more equitable and sounder, from the point of view of tax policy, than certain of the provisions of subchapter C.

The following areas appear to merit detailed study in connection with the future scope of subchapter S:

(1) Several needless restrictions and limitations which resulted from the hasty drafting of subchapter S should be removed. For example, restrictions upon the withdrawals of funds upon which tax has been paid should be modified. The shareholder who has paid a tax on retained earnings should be permitted thereafter to withdraw the funds without payment of additional tax. Also, errors in drafting subchapter S, such as failure to provide for a basis increase with respect to shareholder indebtedness, should be corrected.

(2) The possible extension of the conduit rules to items other than capital gains should be considered. For example, taxexempt receipts such as insurance proceeds, tax exempt interest and depletion, might be passed on directly to the shareholders with the same characteristics as in the hands of the corporation. The overall effect would be to bring the subchapter S rules more in line with partnership taxation.

(3) The relationship of subchapter S with various specific rules of subchapter C, including the collapsible corporation provisions and section 337, should be explored.

(4) The possible use of a subchapter S corporation for the purpose of deferring income by the selection of a fiscal taxable year should be considered. This type of deferral of income has been blocked in the partnership area and comparable restrictions may be warranted in subchapter S.

(5) Extension of subchapter S elective treatment to small corporations deriving income from investments and personal holding companies should be considered. The personal holding company provisions were designed to compel the distribution of corporate investment income and subject it to individual taxation. Subchapter S might serve as a vehicle for achieving this result directly by allowing the shareholders to elect to pay the tax as if the income had been distributed currently. This would eliminate many of the difficulties that arise under the present personal holding company provisions.