REPORT ON SUBCHAPTER S

Frederic A. Nicholson

GENERAL APPROACH

Subchapter S provides special tax treatment for a corporation and its shareholders if the corporation makes an election under that subchapter. To qualify for the right to make an election, the corporation must satisfy certain requirements, among them that it have no more than 10 shareholders and no more than 1 class of stock outstanding.

If an election is made, the income of the electing corporation (referred to hereafter as an S corporation) is taxed not to the corporation but to its shareholders either as an actual dividend distribution during the taxable year or, to the extent not distributed, as a constructive dividend at the end of the corporation's taxable year. Further, the net operating loss of the S corporation is, with certain limitations, deductible directly by its shareholders. This, although far from comprehensively covering the special rules of subchapter S, describes the basic manner in which the treatment of an S corporation and its shareholders differs from that generally applied to corporations and shareholders.

The primary objective of subchapter S, as indicated in the Senate committee report, is to aid small businesses by permitting them "to select the form of business organization desired, without the necessity of taking into account major differences in tax consequence."

There are two situations in which subchapter S tends to accomplish this objective. The first is where (i) business income is in excess of the amount payable to the owners as a deductible salary were the business conducted by a corporation, and (ii) the tax bracket of the owners is such that it would be preferable to have all the income taxed directly to them. In such a case, prior to the enactment of subchapter S, the owners may have been constrained, solely for tax reasons, to conduct business as a partnership even though considerations apart from taxation militate in favor of a corporation. But with subchapter S, assuming there are less than 11 owners, et cetera, the business may be conducted by a corporation with the assurance that all income will be taxed directly to the owners.

The second situation arises when the owners of a new business anticipate that it will have expenses in excess of income during the early years of its existence. Prior to the enactment of subchapter S, the owners could not deduct the excess expenses against ordinary income if the business were transferred to a corporation. Therefore, in the first few years they may have conducted business as a partnership, although reasons apart from taxation indicate that it would be preferable to form a corporation. With subchapter S, however, the owners may transfer the business to a corporation and, assuming the corporation qualifies for the election, receive a deduction for the corporate losses pursuant to the net operating loss pass through.

But even in the above cases subchapter S does not eliminate tax considerations in determining the form in which business is to be conducted, nor does it purport to do so. The subchapter does not treat an electing corporation as a partnership; instead it applies general corporate rules with specified exceptions.

As a result, there are differences in the tax treatment of a partnership as compared with an S corporation, and these may be signifiant in determining the form in which a business is to be conducted. As illustrations: The character of all items of partnership income (such as rent, interest, etc.) is carried through to the partners, under subchapter S the corporate income, other than long-term capital gain, loses its character and is taxed to the shareholders as a dividend; partners may, under certain circumstances, make a special allocation among themselves of particular items of partnership income, the shareholders of an electing corporation have no such right; the liquidation of a partnership ordinarily is not a taxable event, the liquidation of an S corporation is subject to general corporate rules and, therefore, ordinarily will be taxable; and the dollar amount limitation on certain deductions is imposed at the partner level so that a partnership may receive a deduction in excess of the per taxpayer limitation, in subchapter S the limitation is imposed at the corporate level without regard to the number of shareholders.

It is not intended through these comments to suggest that subchapter S be amended to adopt a pure partnership approach-an approach which grants a corporation an election to be treated as a partnership for tax purposes. However feasible it might be to apply partnership rules to a new corporation-and even this is open to serious question— it should be clear that those rules will not work satisfactorily when applied to an existing corporation.

Ordinarily, an existing corporation will have accumulated earnings and profits prior to making the election. There are, of course, no provisions in subchapter K (relating to partnerships and partners) that take such a possibility into account; therefore if a partnership approach were adopted it would be necessary to provide special rules in order to prevent the use of the election as a method of eliminating earnings and profits. This could only be done by somehow integrating into subchapter K the corporate provisions relating to distributions from earnings and profits. The technical problems attendant to this should trouble the imagination of anyone familiar with the complexities presently involved in applying subchapter K to a routine partnership that has no earnings and profits.

Accordingly, unless the election is confined to new corporations, a provision such as subchapter S assuming it is to remain in the law, should retain its present form. The objective of eliminating tax differences between partnerships and small corporations must be compromised in the interest of providing rules that are workable.

ADVANTAGES OF CORPORATE TREATMENT WITHOUT DISADVANTAGES

As previously indicated, subchapter S makes a number of calculated departures from the objective of reducing tax differences between corporations and partnerships. In addition, however, the subchapter offers several opportunities for tax benefits, in all probability unin

tended, that are completely unrelated to the general objective of the section. By reason of these, many corporations that over the long run wish to be subject to general corporate rules, may elect under subchapter S for the sole purpose of circumventing restrictions otherwise applicable to corporations.

The most important opportunity in this regard is offered by the capital gain pass-through. Subchapter S provides that the longterm capital gain of an electing corporation retains its character when taxed to the shareholders. Thus, if the corporation sells a capital asset or a section 1231 asset at a gain, it may distribute to the shareholders an amount of cash equal to the gain, and the distribution will be taxed to the shareholder as capital gain. Together with the fact that the election is not confined to new corporations, the capital gain pass through offers a means of circumventing requirements of section 346, relating to partial liquidations. Moreover, the pass through may afford a method of using a corporation, either a new one or one already in existence, as a method of converting ordinary income into capital gain, a result that the collapsible corporation provisions of section 341 laboriously attempt to prevent.

Under general rules, the proceeds of a sale of part of a corporation's assets may not be passed to its shareholders at the cost of a single tax on capital gain unless it is possible first to distribute the assets to the shareholders at a capital gain and then have them make the sale. Normally, however, the distribution will be taxed as ordinary income unless it qualifies as a partial liquidation under section 346. And to qualify as such a number of requirements must be satisfied. These requirements are intended to assure that the distribution is not essentially equivalent to a dividend.

Without going into detail, it is sufficient to say that corporations often will not be able to satisfy the requirements of section 346. They may, however, accomplish the same result, at least in part, by making a subchapter S election for a single taxable year, selling the property at a gain during that year, and distributing cash equal to the gain to its shareholders. The gain on the sale is not taxed to the corporation but only to the shareholders, and at capital gain rates. (The distribution is limited to the amount of the gain, whereas in a partial liquidation the shareholders may receive the entire proceeds from the sale of the property, but this is not a serious limitation in cases where the value of the property is substantially in excess of basis.) After the taxable year during which it sells the capital assets, the corporation may once again become subject to general rules of corporate taxation simply by revoking its election under subchapter S.

The other provision of general corporate taxation that may be circumvented by the capital gain pass-through is the collapsible corporation rule in section 341. Section 341 is designed to prevent the conversion of ordinary income into capital gain through the sale of stock in a corporation that holds a substantial amount of ordinary income assets. An example of a situation against which section 341 is aimed is a follows: An individual transfers property which is an ordinary income asset in his hands to a corporation that is not in the business of selling such property. The asset is held by the corporation for a time, after which he sells his stock in the hope of obtaining capital gain on the sale. But by reason of section 341 the gain on the

sale will probably be treated as ordinary income unless it can be shown that a sale of the asset directly by the individual would have produced capital gain. In all probability, however, the desired result may be accomplished by a transfer of the property to an S corporation, which in turn makes the sale. The gain on the sale should be capital gain since the property, in the hands of the corporation, is not an inventory type asset. The capital gain is taxed directly to the shareholders who may then liquidate the corporation.

In regulations under subchapter S the Treasury has attempted to prevent this by providing that, under certain circumstances, the character of an asset held by an S corporation must be determined by reference to what its character would be were it held by the shareholders. There is, however, reason to doubt the validity of this: under general rules the character of a corporate asset is determined by reference to the activities of the corporation and not of the shareholders; there is nothing in the statute to indicate that a different result should obtain in subchapter S.

Beyond question the opportunities of circumventing general corporate rules now offered by the capital gain pass through should be eliminated by statutory amendment. What possible justification can there be for the existence, at one point in the code, of detailed rules designed to prevent the use of corporations as a method of obtaining capital gain, when one need but turn the pages to find rules for accomplishing just that? The possibilities created by the capital gain pass-through bear absolutely no relation to the objective of the subchapter S. On the contrary, they encourage the use of the subchapter not as a method of equating the tax treatment of corporations with that of unincorporated organizations, but rather as a method of enjoying the best of both tax worlds, of moving from regular corporate treatment into subchapter S whenever it becomes desirable to sell substantial amounts of noninventory assets. The sale may be followed by a return to regular corporate treatment or by a liquidation of the corporation, depending upon the wishes of those involved. As subjective as the desire to aid small business may be, it surely should not encompass the encouragement of this type of manipulation.

To prevent these abuses there should be placed on the capital gain pass-through a limitation operative for a designated period of time after the election has been made, a period of sufficient length to assure that the election will not be made solely for the purpose of taking advantage of the pass-through. Three years would seem to be both adequate and reasonable for this purpose.

During each year of the limitation period, the pass-through of capital gains should be denied to the extent such gains exceed a fixed percentage of the corporation's gross income. This would discourage the making of the election solely for purposes of passing through capital gain, but at the same time would not penalize corporations that have some capital gain incidental to the conduct of a business. Opinions will differ, of course, as to the most appropriate place to draw the line; perhaps a denial of the pass-through to the extent capital gains exceed 25 percent of gross income would be consistent with the objective.

Apart from the capital gain pass-through, the right of an existing corporation (i.e. one that has been operating under general corporate rules) to make the election offers opportunities that are not within the stated purpose of the subchapter. For example, a corporation with a large accumulated earnings and profits account may face the threat of an additional tax under section 531 unless it distributes its future earnings as dividends. However, the threat may be avoided at the cost of a single tax to the shareholders, simply by making the subchapter S election whenever earnings and profits become dangerously high.

As a more general proposition, it seems relevant to ask how the right to move from corporate treatment into subchapter S, whenever desirable (with the possibility of shifting back to corporate treatment), can ever be reconciled with the objective of reducing tax differences between corporations and partnerships.

OPPORTUNITY OF ENJOYING BENEFITS OF NONCORPORATE TREATMENT WHILE AVOIDING DISADVANTAGES

As previously noted, subchapter S allows taxpayers the opportunity of taking advantage of corporate tax treatment while avoiding some of the disadvantages. Conversely, by eliminating any threat of double tax, the subchapter grants taxpayers the benefits of noncorporate tax treatment while avoiding some of the restrictions applicable to partnerships. The important considerations in this regard are the opportunity of taking advantage of the employee benefit rules, the opportunity of deferring income to a later taxable year, and the opportunity of shifting income among a family group. These are discussed briefly below.

A significant tax difference between corporations and partnerships is the fact that shareholders, but not partners, may participate in qualified employee benefit plans-i.e. pension plans, sick pay plans, etc. Subchapter S, by eliminating the threat of a double tax, accentuates the discrimination created by this difference. The right of shareholders of an S corporation to take advantage of the employee benefit rules should be reexamined in the light of the Simpson-Keogh bill, a bill designed to extend deferred compensation privileges to self-employed persons. Certainly, as a consequence of subchapter S, opposition to Simpson-Keogh becomes increasingly difficult to justify. As a general rule, the partnership provisions require that a partnership adopt the same taxable year as its partners. Without this there may be a deferral of income resulting from the fact that partnership income is included in a partner's return for his taxable year in which or with which the taxable year of the partnership ends. For example, if a partner were on a calendar year ending December 31, 1959, and the partnership on a fiscal year ending January 31, 1960, the income of the partnership for its year ending January 31, including 11 months of 1959, would not be included in the partner's income until he files his return for 1960. Subchapter S is similar to the partnership rule in that undistributed income of an S corporation is taxed to a shareholder for his taxable year in which or with which the taxable year of the corporation ends. However, there is no requirement that the shareholders and the corporation be on the same