by Ken Rankin

Washington - Representatives of the American Institute of CPAs crossed swords with Bush administration officials during last month’s congressional hearings on legislation to make Subchapter S corporations more attractive to small businesses.

Testifying on behalf of the AICPA’s Tax Executive Committee, PricewaterhouseCoopers partner Robert A. Zarzar urged the House Ways and Means Subcommittee on Select Revenue Measures to take action to “recognize and remove the anti-competitive limitations on the growth of existing S corporations.”

Both Zarzar and Ernst & Young’s Laura M. MacDonough, who represented the institute’s S Corporation Taxation Technical Resource Panel, endorsed a series of tax code reforms contained in several pending bills designed to remove barriers to the formation of S corps.

Among other things, those bills would double the number of permissible shareholders in an S corporation from 75 to 150 - a change that the American Institute of CPAs representatives characterized as “good public policy.”

Those same provisions, however, received a drubbing from Bush administration witnesses, including Deputy Assistant Treasury Secretary Greg Jenner.

“Treasury cannot support such a dramatic increase, which we believe would run counter to the goal of maintaining Subchapter S as the simplest of systems for businesses with more than one owner,” he told the subcommittee. “Increasing the number of shareholders will, inevitably, bring increased pressure to liberalize other facets of Subchapter S, which will, in turn, increase the complexity of the provisions.”

At issue in the hearings were three separate bills to reform the rules governing Subchapter S corporations, including a proposal from Rep. Clay Shaw, R-Fla., that would increase the number of stockholders allowed to S corps, authorize these companies to treat family members as one stockholder, and permit S corps to issue preferred stock.

Enacted in 1958, Subchapter S was designed to provide small businesses that were organized as state law corporations with a single-layer tax system similar to that enjoyed by partnerships, but with the liability protection afforded corporations. Major reforms in 1982 and 1996 eased the restrictions on S corporation eligibility while moving the tax treatment of S corporations closer to that of partnerships.

The 1996 reforms increased the maximum number of S corporation shareholders from 35 to 75, allowed S corps to own subsidiaries, and exempted these entities from the unified audit and litigation procedures.

Both the 1982 and 1996 reforms triggered an increase in the popularity of these corporations, and the number of non-farm businesses that were taxed as S corporations rose from less than 4 percent to more than 11 percent.

But even so, the vast majority of small businesses have elected not to incorporate as Subchapter S corporations. As of 2000, 79 percent of non-farm businesses with gross receipts under $250,000 were operating as sole proprietorships, 13 percent were organized as C corporations, and only 8 percent were set up as S corps.

Even critics of the current reform proposals predict that, without changes in the tax code, fledgling entrepreneurs will have even less interest in organizing new businesses as S corporations.

“The relative attractiveness of S corporations will, in all likelihood, have diminished somewhat as a result of the recently enacted jobs and growth bill,” which reduced the federal tax on dividends to 15 percent - a change that negates one of the key advantages that S corps hold over traditional C corporations - Jenner told the subcommittee.

The Treasury Department representative also conceded that “eligibility restrictions” have reduced the appeal of S corps for small companies.

Even so, Jenner told Congress that “an S corporation is perhaps the only organizational form available to small multi-member businesses that offers relative simplicity. Consequently, we hesitate to support proposals that would add additional complexity to Subchapter S.”

Other witnesses at the House hearings offered a different view of the need for S corp reform.

Testifying on behalf of the U.S. Chamber of Commerce, former Internal Revenue Service director Donald Alexander told Congress that the reforms under consideration by the subcommittee “would provide the boost, at a critical time, that thousands of small businesses in America need to continue the growth of American entrepreneurship and competitiveness.”

“The rules adopted in 1958 when S corporations were created, and as subsequently amended, are out of sync with modern economic realities,” he told Congress. “The S corporation reforms we propose would address the troubling gap between the antiquated laws established over 40 years ago and the operating and capital needs of S corporations today.”

For their part, the AICPA witnesses echoed Alexander’s concerns.

In addition to supporting increases in the number of shareholders permitted to S corporations, they endorsed provisions that would allow nonresident aliens to become S corp shareholders.

Additionally, Zarzar and MacDonough urged Congress to go beyond the pending legislation and enact additional S corp reforms that would eliminate the “last-in-first out” recapture tax on S corporations - a barrier that they described as “the most significant hurdle faced by a corporation desiring to elect S corporation status.”

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