On March 12, 2013, Dave Camp (R Mich.), Chairman of the House Ways and Means Committee, released his third tax reform discussion draft (Discussion Draft). One major focus of this draft involved the development of a unified pass-through regime (referred to in the draft as “Option 2”) designed to provide a simplified taxation regime for pass-through entities (i.e. S Corporations and Partnerships). Option 2 completely eliminated Subchapters K and S from the tax code and replaces them with a new Subchapter K globally governing flow-through entities.
The Draft’s Option 2 discusses numerous structural changes to the current tax code, such as easing ownership limitations on S Corporations. Under current law, in order to make an S Corp. election, the entity must have no more than 100 shareholders with all such shareholders being U.S. individuals. Under the proposed draft, only publicly traded corporations, financial institutions, IC-DISCs, and life insurance companies taxed under Section L would be barred from making an S Corp. election. Furthermore, nonresident alien individuals would be allowed to be shareholders in an S Corp.
Another major change under the proposed draft limits the flow-through entity’s ability to make special allocations of income and loss. Current law allows for a variety of special allocations of income and loss for partners in a partnership, while restricting the special allocations for S Corps to a per-share/per-day basis. The proposed draft breaks down income or loss into three categories, and while the income and loss can be allocated differently between the three categories, items must be consistently allocated within individual categories. This treatment would decrease a Partnership’s flexibility with regards to the allocations, while increasing the flexibility of S Corps. to do result in parity between the forms.
Another major change to the current tax law would treat distributions of appreciated property as taxable events. Currently, S Corps. treat distributions of appreciated property as taxable events, while Partnerships are permitted to distribute appreciated assets tax free. The effect of this treatment would force Partnerships and S Corps. to recognize gain at the entity level as if the property sold for its fair market value upon distribution to a shareholder/partner. Additionally, if the fair market value of the property distributed exceeds the distributee taxpayer’s outside basis in the entity, the taxpayer must recognize gain in the amount that exceeds the outside basis as if the taxpayer sold their entity interest or stock.