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taxable year. Thus, by adopting a fiscal year, an S corporation may provide

a means for the type of income deferral denied to a partnership. This discrepancy could be cured by requiring that an S corporation be on the same taxable year as its shareholders.

Subchapter S provides a more convenient method of shifting income among a family group than the partnership rules provide, if only because a minority stock interest in a minor child is less troublesome than a minority partnership interest. In addition, subchapter S, unlike the partnership rules, allows a shifting of income among a family group after the extent of the income is known. This follows because the undistributed taxable income of an S corporation is taxed to the shareholders in proportion to their interests on the last day of the corporation's taxable year; transfers of stock may be made up until the last day thereby shifting income from one person to another. In the writer's opinion, this result, although unfortunate, may be effectively prevented only at the expense of creating additional complexity out of proportion to the magnitude of the problem.

DIFFICULTIES IN OPERATING UNDER SUBCHAPTER S

The following is a brief discussion of a number of restrictions and pitfalls under subchapter S that limit its usefulness to many taxpayers.

An election may not be made by a corporation with substantial receipts from royalties, rents, interest, etc. This rule denies the election not only to investment corporations but to some that are engaged in the active conduct of a business; i.e., lending companies. It is the writer's understanding that the necessity of defining the type of income covered by this rule has created substantial administrative problems for the Treasury. Moreover, insofar as it ties in with the personal holding company provisions, the rule seems pointless since an S corporation, by hypothesis, may not be used as a means of transferring investment income to a lower tax bracket. Accordingly, there would seem to be compelling reasons for deleting this rule from subchapter S. It should be noted, however, that if it is deleted and the right to employee benefits retained, individuals may transfer investment property to an S corporation solely for the purpose of using the income for the payment of accident and health benefits, pension plans, etc. Therefore, the argument against the investment income rule is not as clear cut as it may first seem to be.

If income of an S corporation is taxed to a shareholder but is not distributed to him during the taxable year in which earned, he may have difficulty under the existing rules in withdrawing that income in a later year without receiving a dividend on the withdrawal. One method of dealing with this is to provide that distributions made during the period to which an election applies are deemed to come first from previously taxed income. This is an admitted departure from the approach of applying general corporate rules to an S corporation, but it seems justified in view of the magnitude of the problem. Moreover, since an election under subchapter S may be terminated against the wishes of the shareholders, it may be advisable to extend the

right to withdraw previously taxed income for a specified period of time after the election is terminated. But the period should be kept short in view of the administrative problems that may result from retaining this special rule long after the corporation has ceased to operate under subchapter S.

The present statute limits the right to withdraw previously taxed income to the shareholder who was taxed on that income. Although recognizing the difficulties created by this limitation, it is the writer's opinion that it should be retained. Many of the factors which must be taken into account in computing previously taxed income are within the exclusive knowledge of the shareholder to whom such income was taxed and may not be known to his successor in interest or to an agent who is auditing such successor's return. The problem would be compounded where the original stockholder transferred his shares to more than one person. In short, in the writer's opinion the complexities resulting from an extension of the rule to successors in interest outweigh any difficulties caused by the limitation.

Shareholders of an S corporation may never be certain that the coropration is validly under subchapter S. As a result of a defect in the election satement, a failure to satisfy certain rules of qualification, or a transfer of stock to an outsider occurring without the knowledge of other shareholders, the shareholders may learn at some later date that they were not under subchapter S in the earlier years. If this occurs, the shareholders who have relied on subchapter Š may be penalized. The corporation may have distributed current earnings on the assumption that one tax would be applicable; but if subchapter S is determined not to apply, there will be both a corporate tax and a tax on dividends to the shareholders. Consideration should be given to means of ameliorating the result in these cases. One possibility is to allow the shareholders to restore the dividends to the corporation and either receive a deduction in the year that the restoration is made or be given the right to exclude the dividend in the year of distribution. It is recognized, however, that the development of such a rule presents serious technical problems and, on further consideration, it may be shown to be impracticable.

ADMINISTRATIVE PROBLEMS

In assessing the overall merits of subchapter S, it is important to consider the extent of the administrative problems it has created. Of course, this may best be explained by members of the Revenue Service who must administer the subchapter. But even without their comments, several conclusions may be drawn.

Obviously, the enactment of any new body of law, and particularly one that has attracted as much attention as subchapter S, increases the volume of technical problems presented to the Revenue Service, adding to the burden on the interpretative and enforcement sections. The same may be said regarding the additional statements and forms, including the new type of return (form 1120S), that must now be filed and kept on record, as a result of subchapter S.

The difficulty is compounded by the fact that many statements have been improperly filed by persons who, apparently through the publicity it has received, have been attracted to subchapter S but who do not fully understand its detailed requirements. Regarding this the writer has been informed that in one District Director's office it was estimated that up to 20 percent of the election statements were defective on their face, with the inference that on further examination the percentage will be much higher.

Finally, the possibility that a corporation's status may shift from year to year-into and out of subchapter S-should substantially complicate the task of auditing the returns of closely held corporations and the shareholders of such corporations.

CONCLUSION

By eliminating the double tax and by allowing losses to be taken as a deduction by the shareholders, subchapter S makes it possible for some taxpayers to incorporate where previously it was not feasible to do so because of tax considerations. It does not, however, do away with all tax differences between a corporation and a partnership, nor is it realistic to expect that this can be done within our present tax structure. The subchapter offers a number of possibilities for avoidance, apparently unintended, and these should be cured by legislation. Of most importance, changes should be made in the capital gain passthrough in order to assure that it does not offer opportunities for circumventing general corporate rules. The subchapter is also in need of amendments to cure some of the pitfalls that presently confront taxpayers who wish to make the election.

Even assuming, however, that the major defects of subchapter S may be cured, the advisability of retaining the subchapter is open to question. Does the good it accomplishes outweigh the problems resulting from its addition to the code? In view of the avoidance possibilities it offers—some of which cannot be cured except at the cost of extreme complexity—the pitfalls that inevitably result from complex provisions, and the additional administrative burdens it has placed on the Revenue Service, can it be said that subchapter S, if restricted to its intended function and cured of its major loopholes, will be utilized sufficiently by taxpayers to justify its existence! There is, in the

, writer's opinion, a strong possibility that it will not be. The best approach, however, might be to first make appropriate statutory amendments, and then determine the extent to which the subchapter is used.

ESTATES AND TRUSTS

Norman A. Sugarman, attorney, Cleveland, Ohio

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I appreciate this opportunity to submit my views on principles that should be applicable in the treatment of estates and trusts under our concepts of Federal income taxation.

This subject, because it is generally considered to involve a highly technical area of complex legal relationships, is frequently considered separate and apart from the mainstream of tax policies and principles. Yet, I believe that we must recognize that estates and trusts are an important part of our system for ownership and devolution of property, and that tax legislation in this area should be guided by the same principles of soundness and practicality that should be generally applicable in our income tax structure.

Estates and trusts are the mechanisms developed under our system of law for the holding of property by a fiduciary for the benefit of others. These forms of ownership were developed under the law wholly apart from tax considerations. I also believe that the use of trusts is growing and, to a large, extent for reasons wholly apart from tax considerations. For example, it is no longer considered sufficient in many situations to appoint a guardian for a minor child. Today, a trust for a child or children is often used because it can provide more flexibility to meet the beneficiaries' needs; and, also, because it is recognized that 21 may be too early an age for placing any sizable amount of money in a person's hands. Thus, at least in my experience, trusts are used to protect a child's interest and provide management of property until a child has reached certain stages of maturity, such as age 25, 28, 35, or perhaps even later.

Tax considerations have, of course, also been a factor in the use of trusts. However, frequently impetus has been given to the use of trusts by reason of the necessity to comply with the tax laws, not in order to avoid the application of the tax statutes. An example is the marital deduction trust. Before the Revenue Act of 1948, it was not unusual to provide in a will for a life estate, in trust or otherwise, and a power of disposition for a widow. The Revenue Act of 1948 granted the benefit of an estate tax deduction for property left to a surviving spouse in a trust which meets certain requirements. This legislation clearly recognizes that in many situations the most practical method of passing on substantial property for the benefit of a widow is to transfer it into a trust, where the widow will be protected through financial management of the property by a fiduciary and yet will have the benefit of the income from the property. additional effect of the legislation, however, has been to encourage the creation of trusts in the particular form that will qualify for the marital deduction.

Estates, of course, are involuntarily created. Small estates are more common than large ones, and therefore it is particularly im

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portant that the tax law in this area be as fair, certain, and realistic as possible.

These facts suggest that (1) estates and trusts should be considered in connection with the principal purpose of tax policy to collect revenue and should not be set apart for unusual or more severe treatment, and (2) the need exists in this area for tax legislation which is reasonable and generally understandable just as much as it does in other areas of the law affecting individuals.

I think, therefore, that before considering specific areas of possible legislation, it would be well to review the direction of legislation in this field and evolve some principles as to the how and why of legislation affecting estates and trusts.

THE PROBLEM OF INCREASING COMPLEXITY IN THE LAW

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Review of legislation in this field will reveal the tremendous growth of statutory provisions and their increasing complexity in this fielda trend which appears to be accelerating, and yet which holds little promise of really providing clarity, certainty, or repose in the tax treatment of estates and trusts or their beneficiaries.

Specific provision for the income tax treatment of estates and trusts was first made in the Revenue Act of 1916. This was a comparatively simple provision consisting of one paragraph which provided in effect that income received by estates and trusts was to be assessed to the executor, administrator, or trustee at the rate and under the method of taxation applicable in the case of an individual, except when the income is returned for purpose of the tax by the beneficiary. This provision established the basic pattern which has been recognized in our tax laws ever since, namely that while an estate or trust is treated as a separate taxpayer, nevertheless for purposes of actual assessment of tax, the estate or 'trust is recognized as a conduit and income received by the estate or trust which passes through to the beneficiary or heir is taxed to the beneficiary or heir rather than to the estate or trust. Except for certain refinements and regroupings into subsections, this provision remained as the basic provision for the treatment of estates and trusts until the Revenue Act of 1942.

In the Revenue Act of 1924, however, some complexity was introduced by the specific treatment of the grantor of a trust as taxable (rather than the trust or the beneficiary) where the grantor retained power to revoke the trust. At the same time a provision was also added to tax the grantor of a trust where the income may be held or accumulated for future distribution to him or applied in payment of premiums upon policies of insurance on his life.3

In 1942, the treatment of estates and trusts was revised to correct certain interpretations of the statute which were considered to have opened loopholes in the law. The two principal situations covered were first, those involving the distributions of income by a trust in the case of a beneficiary entitled to payments out of income or corpus, and second, those involving situations in which the income of a trust was distributed to a beneficiary who was entitled to such distribution

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1 Revenue Act of 1916, sec. 2(b). : Revenue Act of 1924, sec. 219 (g). : Revenue Act of 1924, sec. 219(h).

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