Legislation is pending in Congress that would put S corporations on a more equal footing with C corporations. Many of the current rules date back to 1958, when the first Subchapter S legislation was enacted

At last count there were about 1.6 million S corporations in the United States. Close to half of Inc.'s list of the 500 fastest-growing private companies in 1993 were S corporations. For the most part, business owners have chosen to organize their companies as S corporations because of favorable federal and state income-tax treatment. But with the enactment of the 1993 tax law, which puts personal tax rates higher than corporate rates as of January 1, 1993, some S-corporation owners have been reevaluating whether C corporations or S corporations are the best fit for their businesses. (See "Do S Corporations Still Make Sense?" Financial Strategies, December 1993, [Article link].)

If your company is an S corporation or if you're thinking about starting a company and wondering what corporate form to choose, you should know that legislation has been introduced in Congress that would make it easier for S corporations to get financing, would provide more flexibility in corporate structure, and would enhance a company's ability to grow. Subchapter S, the original S-corporation legislation, has not been significantly reformed since 1982, and many of the S-corporation eligibility rules date back to 1958, when the legislation was first enacted.

Without question, S-corporation legislation has lagged far behind the changes in the business environment over the past 36 years. So when Tom Brock, chairman of the Small Business Committee for the Chamber of Commerce, asked me (as chairman of the American Institute of Certified Public Accountants' S Corporation Committee) and Jerry August from the American Bar Association if we'd be interested in working on an S-corporation-reform project, we jumped at the chance. That was in May 1992. Our goal was to try to get enacted into law a bill that would give S corporations some of the same benefits that C corporations have long enjoyed, to bring about a rough parity between C corporations, S corporations, and partnerships.

About 20 of us from those organizations worked on the project until the end of that year, and we then began to shop the bill on the Senate side of Congress in December. Senators David Pryor (D-Arkansas) and John Danforth (R-Missouri), both well-regarded senior members of the Finance Committee, wanted to cosponsor the bill, which was very gratifying. It took about another year and drafts going back and forth before the bill, S.R. 1690, was actually introduced, in November 1993. The bill -- it's still called the S Corporation Reform Act of 1993 -- has two primary purposes. One is to provide more flexibility for estate planning and succession. The other is to provide more opportunities for raising capital. There are a number of provisions particularly significant for company owners.

Probably the one that would provide the most flexibility deals with exempt-organization shareholders. Those are charitable organizations, nonprofits, private foundations, and employee stock ownership plans. The provision would allow S-corporation owners to give their stock to charities, which they can't do today. The advantage is this: when you give stock to a charity, you get a charitable deduction on the stock as in-kind property. Also, if the shareholder is short of cash, a stock contribution may be a good alternative. That is a very common estate-planning technique for owners of C corporations.

Under the same provision, private foundations would become eligible to own S-corporation stock. S-corporation owners who set up private foundations, as many company owners do, would now be able to fund them by donating company stock -- again, a common practice among C-corporation owners. The provision also would allow S-corporation owners to sell their businesses to employees through an ESOP, a device that's useful as an exit strategy for owners, as a way to raise capital for the company, and as a means to involve employees more fully in the company's operations. The exempt-organization provision is probably the one that would give the most flexibility to S-corporation owners from an overall tax-planning perspective.

A couple of other provisions are noteworthy. Certain types of trusts, which owners usually set up as estate-planning tools, are allowed to hold S-corporation stock. One is called a qualified S-corporation trust, which has cumbersome requirements. Currently, for example, the income of qualified S-corporation trusts must be distributed to their beneficiaries every year. That's counter to the purposes of many estate plans. Most trusts can accumulate income and distribute it to a number of beneficiaries whenever it's necessary. If the S-corporation bill passes, S-corporation-trust shareholders will have comparable flexibility for accumulating and distributing income.

There is also a provision allowing S corporations to issue preferred stock -- they now are limited to common stock. Again, we wanted to provide more flexibility for estate planning and capital formation. You can use preferred stock in a traditional estate freeze, which is when a company gives the senior generation preferred stock, which allows them to receive a fixed income stream, and gives the junior generation common stock, which appreciates as the company grows. That has been a common practice in C corporations. The preferred stock is also useful to bring in capital. Someone could in essence "lend" cash to the S corporation and take preferred stock. While there wouldn't be any appreciation associated with that preferred stock, that shareholder would receive preferred returns (over holders of common stock) on the corporation's earnings.

There are other provisions as well, but the ones I've mentioned are probably those most useful both in estate planning and in attracting capital.

How likely is the bill to pass? There is no opposition, but there are problems with getting it enacted into law. The primary problem is revenue. The bill is not revenue-neutral -- it will lose money. The question is, How much? We'll have to come up with some revenue raisers to go along with it, drop some of the most expensive provisions, or do both.

Unfortunately, some of the items most important to company owners are also some of the most expensive. The preferred-stock provision, for instance, is a costly item. One provision I haven't mentioned is the most costly: it would repeal that part of the Internal Revenue Code that treats fringe benefits that S-corporation owners receive as taxable to them.

Two items we recommended were dropped from S.R. 1690 before Senators Pryor and Danforth introduced it. One dealt with the ability to convert preferred stock to common stock, which would have been extremely important in raising money from venture capitalists, since it would have allowed them to benefit from the stock's appreciation.

The other provision that we recommended and that was dropped was to allow S corporations to own 100% of an S-corporation subsidiary. That would have been a dynamite provision that would have allowed extreme flexibility in structuring corporate operations. It would also have meant those subsidiaries' operations would be subject to a single tax. The senators did keep a provision to allow up to 100% ownership of C-corporation subsidiaries (formerly a maximum of 79%), but those subsidiaries, like all C corporations, would be subject to double taxation.

Still, we have made remarkable progress on this bill over the last year. As of mid-June, we were up to 33 cosponsors on the Senate side, of which 11 were Finance Committee members, a majority of the committee. This past spring we got Representative Peter Hoagland (D-Nebraska) to sponsor the bill in the House. As of mid-June he had 13 other cosponsors on the House Ways and Means Committee. Nineteen would give us a majority.

In mid-May Congress changed the landscape a bit. The House passed another bill, H.R. 3419, which, among other provisions, deals with Subchapter S simplification. Senators Pryor and Danforth, along with the majority cosponsors on S.R. 1690, could take segments of our S-corporation reform -- probably the ones that are closer to revenue neutral -- and attach them to H.R. 3419.

In any case, S-corporation reform is undoubtedly on Congress's radar screen this year. There's no longer a question about whether it will be considered. Whether it will be enacted into law is still uncertain, but I think it's a question of when, not if. I expect there will be an attempt to graft onto H.R. 3419 as much S-corporation reform as is possible. While S corporations still won't have the same degree of latitude that C corporations have, we could at least see some reforms enacted into law as early as this fall.

Sam Starr is a partner with Coopers & Lybrand's National Tax Office specializing in S corporations. He is also chairman of the American Institute of Certified Public Accountants' S Corporation Committee.