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SUBCHAPTER S-SOME POLICY QUESTIONS

Karl R. Price Subchapter S of chapter 1 of the Internal Revenue Code was enacted a year ago to permit corporations to elect to forgo the payment of income tax on condition that the shareholders report the entire corporate income on their personal returns currently, whether distributed or not. It was intended that the new subchapter should reduce the importance of the income tax as a factor in the selection by each business of the most desirable form of business organization, and also that it should aid small business.

It is too early to judge accurately, and on the basis of experience, the extent to which these ends are being achieved, and the extent to which the subchapter is producing or permitting other results which were not intended or desired. The Treasury advises that approximately 62,000 elections had been filed under the subchapter by the middle of February of this year, which is to be compared with about 971,000 corporation returns and 1,047,000 partnership returns filed during fiscal 1958. Of the 62,000 elections filed, about 57,000 were filed by corporations which had previously reported as corporations, and the balance of 5,000 were filed by new corporate successors to partnerships or individual proprietorships or simply by new corporate ventures. This information indicates that there is a fairly substantial amount of interest in the subchapter. It also suggests (from the large proportion of elections which were made by preexisting corporations) that much of this interest may possibly be in temporary qualification for a 1- or 2-year tax advantage rather than in a permanent method of reporting.

However, the past year has afforded an opportunity to study the new system which the subchapter embodies, and to arrive at some tentative analytical judgments with respect to the principal elements of that system. (1) Is the basic theory sound?

The basic theory of subchapter S is that the owners of a closely held corporation will pay their fair share of income tax if they report the corporate income directly on their personal returns, without reporting it on a corporate return.

Running counter to this theory is the view that the use of the corporate form invariably warrants the imposition of an additional tax at the corporate level. The law generally treats a corporation as an entity separate and distinct from its shareholders. Corporations are formed only where the owners desire to avail themselves of the benefits accruing from such treatment. It might be concluded that they should be prepared to accept the attendant burdens, including the burden of paying Federal income tax as a separate taxable entity.

My own view is that the basic theory is sound. I do not believe, and I do not think that the public generally believes, that an income tax price should be put on the privilege of incorporation as such. It must be remembered that we are considering the treatment only of closely held corporations, where there is a large measure of practical—if not legal--identity between the corporation and its shareholders. In this situation, the utilization of the corporate entity will not ordinarily contribute in a large degree to the taxpaying capacity of the owners of the business, and such capacity will ordinarily be enhanced in proportion to the earnings of the business to a degree that would not obtain in the case of publicly owned corporations.

Assuming that the conclusion is in favor of the basic theory, we must proceed to consider the various means to be employed and the difficulties to be overcome in its implementation. (2) When should the subchapter apply?

Subchapter S was "sold" through its title and the committee reports as a reporting system for small business corporations. Actually, there is no limitation which is specifically related to the size of the corporation. The subchapter is limited, however, to corporations whose shareholders are only individuals and estates and numbering 10 or less in the aggregate. These restrictions, and the requirement for shareholder reporting of undistributed income, undoubtedly make the subchapter either unavailable or unattractive (as a regular—as distinguished from a temporary-method of reporting) to businesses of substantial size, with perhaps a few exceptions. The exceptions are primarily those businesses which regularly distribute all or most of their income, and those which have tax losses as distinguished from business losses, i.e., attributable to intangible drilling costs or percentage depletion. So long as any such corporations are closely held, however, I see no reason why they should not be permitted to qualify regardless of size.

Two other restrictions relate to the source of the corporate income. Under one, the corporation must not derive more than 80 percent of its gross receipts from sources without the United States. I have not been able to see the need for this restrictions, provided that some special provision is made with regard to the Western Hemisphere deduction and the exemption for income from possessions. The other restriction relating to source of income denies qualification to a corporation where more than 20 percent of its gross receipts are of an investment nature. In support of this restriction it might be suggested that our sympathies are with active business enterprises. However, the line between active and passive income is often difficult to draw. I see nothing in the basic theory of the subchapter which requires that this line should be drawn. I can see that an individual should not be permitted to incorporate his investments and use the corporation as a vehicle for providing himself with tax-free fringe benefits ordinarily available only to employees. Consequently, this restriction will probably remain necessary so long as the subchapter permits stockholders to be covered by employee-fringe benefits. If the latter privilege is withdrawn, it seems to me that the investment income restriction could be eliminated. The elimination of both source-of-income restrictions would contribute materially to the simplifiication of the subchapter, and reduce the chances of unintentional disqualification.

There are several other rules relating to qualification in addition to those already mentioned. One is that the corporation must not have more than one class of stock. A second, that all new shareholders must promptly consent to the election. A third, that the failure at any time during the year to meet any of the requirements heretofore stated results in a current disqualification. A fourth, that elections and voluntary revocations must be filed no later than the first month of the year to which they apply. A fifth, that a corporation whose S status has terminated for any reason may not again qualify for 5 years.

Each of these rules is aimed at simplifying the administration of the subchapter or at preventing abuses under it, and each of them undoubtedly has some justification. Considered in the aggregate, however, they raise serious problems revolving around the uncertainty in the corporation's status which will continue throughout each taxable year, the power over that status in the hands of each of the shareholders individually, and the peculiar tax advantages which may be derived from "shuttling" in and out of the subchapter.

Furthermore, in one important respect there is some doubt as to the manner in which present law will dispose of these problems in many cases; i.e., will disqualification always result from a transaction undertaken with the principal purpose of effecting disqualification? Will the answer depend on what the act is: i.e., on whether it is a transfer of one share of stock to a nonassenting spouse, or a transfer to an ineligible type of shareholder, such as a trust? Will it depend on whether the controlling shareholders are privy to the act? If the Treasury challenges disqualification under these circumstances, many disputes are sure to arise. This is an area in which guidance is owing to shareholders, both as shareholders and as taxpayers, and also to the Treasury.

There is no easy solution to these problems. We cannot even be sure that a satisfactory solution is possible, at least until we have had the benefit of observing the subchapter in operation. Nevertheless, I would tentatively suggest consideration of two distinct alternatives to present law as a means of dealing with them :

Ta) Provide that if a valid election is made, the electing corporation shall continue under the subchapter for 5 years or until the original consenting shareholders continue to own less than 50 percent of the stock, regardless of whether the corporation continues to meet the definition of "small business corporation” throughout such period, but that at the end of such period a new election may be made only if the definition is fully met at that time. As part of the election, both the corporation and the shareholders might be required to agree not to issue a second class of stock, or to form or acquire a subsidiary.

(6) Alternatively, make clear that calculated acts of disqualification will be recognized, permit voluntary revocations at any time during the year, provide that disqualifying events shall not terminate S status if cured before the end of the taxable year in which they first occurred, and permit new elections, following a termination, only after an interval somewhat longer than 5 years-perhaps 10.

Obviously, these two suggestions seek a solution in radically different directions. I believe the former suggestion to be more equitable, but that either would clarify the applicable law, would reduce unintentional terminations, and would tend to minimize the “shuttling" problem. (3) Determination of amount of income

Under preexisting law, a corporation has been required to maintain two income accounts: One, of its "taxable income,” on which its corporate tax liability is based, and another, of its “earnings and profits," which is taxable to its shareholders on distribution to them. There are many differences in the manner of computing these two accounts, e.g., municipal bond interest is includible in earnings and profits, but not in taxable income, capital losses are deductible from earnings and profits but not from taxable income, and percentage depletion is deductible from taxable income but not from earnings and profits.

Under subchapter S, the general rule is that the amount which is to be taxed to the shareholders currently, when not distributed, is the taxable income of the corporation rather than its earnings and profits. This is consonant with the aim that so far as possible the income tax should be a neutral factor in the choice of business form, since it is the taxable income, and not the earnings and profits, on which the shareholders would be taxed in the absence of a corporation. Also in furtherance of this aim, the subchapter disallows the corporate deduction for dividends received in computing the taxable income of the corporation, and the individual dividends-received credit and exclusion on the actual or constructive receipt by the shareholders of the current income of the corporation.

In the light of these rules, it seems strange that the subchapter should require, as it does, that the shareholders be taxed on distributions out of earnings and profits of a qualified period to the extent that they exceed the taxable income of such period. For instance, if the corporation has $20,000 of taxable income plus $5,000 of municipal bond interest or percentage depletion (excess over cost depletion), and if it distributes $25,000, the shareholders are taxed on $25,000. This result seems anomalous, in that they would have been taxed on only $20,000 if the corporate form had not been employed, and by electing S the shareholders have assumed the tax burdens which flow from ignoring the corporate form. The result also seems anomalous in that the shareholders are taxed on $5,000 more than they would have been if the corporation had distributed no more than $20,000. This runs afoul of the general principle of the subchapter to tax income to the shareholders whether distributed or not. In both these respects, the theory and objective of the subchapter are distorted, apparently in order to limit the availability of tax benefits which are no more objectionable under this subchapter than elsewhere.

A result under present law which seems even less justifiable is one which follows from the same decision to tax distributions out of current earnings, even though not out of taxable income, coupled with the rule-proper in itself-that current earnings shall not be reduced by any items which do not reduce taxable income. Thus, if a qualified corporation (without any accumulated earnings) has $25,000 taxable income, $5,000 tax-exempt interest, and a $5,000 capital loss, and distributes $30,000 currently, the shareholders would be tased on the entire $30,000, although this is $5,000 in excess of either the taxable income or the earnings and profits of the corporation, and outside of subchapter S the shareholders would not have been taxed on more than $25,000, either as partners or as shareholders.

In my view, the rule should be that the shareholders should be required to include on their returns the taxable income of the corporation, no more and no less, whether distributed or not, except that they should, of course, also be taxed on distributions out of earnings accumulated prior to qualification. Earnings accrued during a qualified period which are not taxed to the shareholders because not includible in taxable income should become part of the capital account in the same manner as constructive distributions. Whether, in the event of disqualification, they should remain part of the capital account or should shift to the accumulated earnings account is not so clear, but the former alternative would probably be the simpler solution. (4) Treatment of previously taxed income

The subchapter provides that earnings and profits shall be reduced by the amount of constructive distributions, and that the aggregate of the amounts of such distributions previously included in the income of any shareholder, less the amount of losses passed through and allowed to him, shall constitute a special capital account of that particular shareholder so long as he continues as a shareholder and qualification continues. Any distributions made to him which are not out of current taxable income or current earnings are deemed to be out of this account so long as it lasts. If he ceases to be a shareholder, or if qualification terminates before the account is exhausted, the priority status of the account also terminates, but it, of course, does not revert to the status of accumulated earnings.

It seems to me that several valid criticisms can be made of this scheme for handling undistributed income. First, there is no apparent reason, in principle, why an undistributed income account should not pass from one shareholder to another, upon a transfer of the stock through which it was created, whether the transfer is by sale, gift, or will. This income has been taxed; the account represents capital in the hands of the tranferee as well as in those of the transferor; and so long as qualification continues, I see no objection to permitting a transferee to withdraw such capital just as readily as the transferor might have done.

Second, the determination of this account at the shareholder level, coupled with the requirement for basing computations on income actually reported and on losses allowable to the particular shareholder as limited by his basis, and also with the rule that distributions from this account do not reduce accumulated earnings, will make it virtually impossible in many cases for the corporation to maintain an accurate earnings and profits account.

Third, the determination of the account at the shareholder level puts tremendous pressure on qualifying corporations to distribute their entire income currently, and if actual distribution is not feasible, to pretend to distribute and borrow the funds back from the shareholders. Otherwise, this account might lose its priority over previously accumulated earnings.

I suggest that this account should be computed at the corporate level, rather than the shareholder level, and should continue to enjoy priority over previously accumulated earnings so long as qualification continues. This seems to me to be right in principle. If

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