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The Small Business Job Protection Act of 1996 (the "Act"), signed into law on August 20, 1996, makes many changes to the rules under subchapter S of the Internal Revenue Code (the "Code"). In general, these changes have increased the flexibility of S corporations by easing the eligibility and operational requirements of S corporations. The following changes are effective for taxable years beginning after December 31, 1996, unless otherwise noted (with the text of the relevant portions of the Act following the summary of changes):

S Corporation Shareholders

S corporations may have up to 75 shareholders. Act § 1301.

The maximum number of eligible shareholders in an S corporation is increased from 35 to 75.

Electing small business trusts allowed to be S corporation shareholders. Act § 1302.

Grantor trusts, voting trusts, certain testamentary trusts and "qualified subchapter S trusts" may be shareholders in an S corporation. The Act expands this list to include "electing small business trusts." To qualify as such a trust, all beneficiaries of the trust must be individuals, estates or charitable organizations holding a contingent remainder interest. However, no interest in the trust can be acquired by purchase; interests in the trust must be acquired by gift, bequest or other non- purchase means. Each beneficiary of the trust is counted as a shareholder for purposes of the 75 shareholder limit.

This provision permits greater estate planning opportunities for S corporation shareholders by allowing trusts to be funded with S corporation stock.

Certain charities and qualified retirement plans allowed to be S corporation shareholders. Act § 1316.

The Act allows organizations exempt from tax under Code section 501(c)(3) and qualified retirement plans described in Code section 401(a) (collectively, "qualified tax-exempt shareholders") to own stock in an S corporation. However, all items of income or loss of an S corporation will flow through to qualified tax-exempt shareholders as unrelated business taxable income, regardless of the source or nature of that income. For example, an exempt, section 501(c)(3) shareholder's share of S corporation interest income is taxable even where that interest would not have been taxable if realized directly by the shareholder. This provision is effective for taxable years beginning after December 31, 1997.

Financial institutions permitted to hold safe harbor debt. Act § 1304.

An S corporation may not have more than one class of stock. Under the safe harbor provisions, certain debt ("straight debt") is not treated as a second class of stock. The Act expands the definition of straight debt to include debt held by creditors, other than individuals, that are actively and regularly engaged in the business of lending money.

Basis of inherited S corporation stock is adjusted. Act § 1313.

The Act provides that any person who acquires stock in an S corporation through bequest, devise or inheritance must treat as income in respect to a decedent ("IRD") the pro rata share of any item of income of the corporation that would have been IRD if the income had been acquired directly from the decedent. The Act allows a deduction under Code section 691(c) for the estate tax attributable to an item of IRD. The stepped-up basis of the stock acquired from a decedent is reduced by that portion of the value of the stock attributable to items consisting of IRD. This provision applies with respect to decedents dying after August 20, 1996, the date of the enactment of the Act.

S Corporation Election and Terminations

Post-death qualification for testamentary trusts is expanded. Act § 1303.

The post-death holding period of S corporation stock for all testamentary trusts is expanded to 2 years (from 60 days).

The Service may validate inadvertently defective elections. Act § 1305.

The Act allows the Internal Revenue Service (the "IRS") to validate inadvertently defective S corporation elections. The IRS will have the authority to waive the effect of an invalid election caused by an entity's inadvertent failure to qualify as a small business corporation or to obtain required shareholder consents, or both. The IRS also may treat late-filed S corporation elections as timely if reasonable cause exists. This provision applies to taxable years beginning after December 31, 1982.

Certain shareholders may elect to terminate year. Act § 1306.

Under Treasury regulations to be prescribed, the Act allows an S corporation and its "affected shareholders" to elect to terminate the taxable year of the S corporation upon the termination of any shareholder's interest. After such election is made, the closing of the S corporation's books applies only to the affected shareholders. "Affected shareholders" means any shareholder whose interest is terminated and all shareholders to whom that terminating shareholder has transferred shares during the year.

Post-termination transition period is expanded and TEFRA audit procedures are repealed. Act § 1307.

The Act expands the definition of the 120-day post-termination period during which former S corporations may make potentially nontaxable distributions. The Act allows a former S corporation to make such distributions to shareholders during the 120-day period beginning on the date of any IRS audit adjustment of its S period income, loss or deduction after termination of the S election. The Act also repeals the TEFRA partnership-based audit provisions.

Disallowed losses and deductions may be carried forward to post-termination period. Act § 1312.

The Act provides that losses disallowed under the at-risk rules of Code section 465 may be carried forward to the S corporation's post-termination period.

Re-election of S status for recent terminations is permitted. Act § 1317.

An S corporation that terminates its subchapter S election may not make another election to be an S corporation for five taxable years unless the IRS consents to the new election. The Act provides that for purposes of this five-year rule, any termination of a subchapter S election in a taxable year beginning before January 1, 1997 is not taken into account. Thus, any small business corporation that has terminated its S corporation within the five-year period immediately preceding August 20, 1996, the date of enactment, can re-elect subchapter S status without the IRS' consent. This provision is effective for terminations occurring in a taxable year beginning before January 1, 1997.

S Corporation Activities and Holdings

S corporations permitted to hold subsidiaries. Act § 1308.

The Act permits S corporations to own 80 percent or more of the stock of a C corporation. An S corporation, however, cannot elect to file a consolidated return with its affiliated C corporations. Dividends received by an S corporation from an 80 percent or greater owned C corporation will not be treated as passive investment income to the extent that the dividends are attributable to the earnings and profits of the C corporation derived from the active conduct of a trade or business.

The Act also permits S corporations to own a qualified subchapter S subsidiary. A qualified subchapter S subsidiary includes any domestic corporation that qualifies as an S corporation and is wholly owned by an S corporation parent which elects to treat such subsidiary as a qualified subchapter S subsidiary. A qualified subchapter S subsidiary is not treated as a separate corporation. Accordingly, the assets, liabilities and items of income, deduction, loss and credit of the subsidiary are treated as being those of the S corporation parent.

Certain financial institutions may be S corporations. Act § 1315.

The Act allows a bank to elect to be treated as an S corporation if the bank does not use the reserve method of accounting for bad debts and is otherwise eligible to make an S election.

Tax-free liquidation of C corporation into an S corporation is allowed. Act § 1310.

The Act repeals the rule that treats an S corporation in its capacity as a shareholder of another corporation as an individual. Thus, the Act clarifies that the subchapter C rules, including the tax- free liquidation provisions of Code sections 332 and 337, generally apply to the liquidation of a C corporation into an S corporation. The repeal of this rule does not change the general rule governing the computation of income of an S corporation.

S corporations may qualify for the capital gain presumption for real property subdivided for sale. Act § 1314.

S corporations will be eligible for the capital gain presumption under the rules of Code section 1237 which apply to noncorporate taxpayers subdividing real estate for sale. Under Code section 1237 a parcel of land held by a taxpayer other than a corporation generally is not treated as ordinary income property solely by reason of the land being subdivided if certain conditions are satisfied. The Act extends this provision to land owned by S corporations.

S Corporation Distributions

Treatment of distributions during loss years is amended. Act § 1309.

The Act provides that basis adjustments for distributions made by an S corporation during a taxable year are taken into account before applying the loss limitation for the year. Thus, distributions during a year reduce the adjusted basis for purposes of determining the allowable loss for the year, but the loss for a year does not reduce the adjusted basis for purposes of determining the tax status of the distributions made during that year. The Act also provides that for purposes of determining the accumulated undistributed account, the excess of losses and deductions over income for the taxable year is disregarded.

Certain earnings and profits are eliminated. Act § 1311.

The Act provides that the accumulated earnings and profits of an S corporation during its first taxable year beginning after December 31, 1995 will be reduced by any earnings and profits accumulated before January 1, 1983 and while the corporation was an S corporation. The elimination of those earnings and profits ensures that an S corporation's earnings and profits are attributable only to the taxable years during which its S election was not in effect.

Text of Subtitle C (Provisions Relating to S Corporations) of Title I (Small Business and Other Tax Provisions) of P.L. 104-188 (the Small Business Job Protection Act of 1996), signed into law on August 20, 1996.

Sec. 1301. S Corporations Permitted to Have 75 Shareholders. Subparagraph (A) of section 1361(b)(1) (defining small business corporation) is amended by striking "35 shareholders" and inserting "75 shareholders".

Sec. 1302. Electing Small Business Trusts.

(a) General Rule.—Subparagraph (A) of section 1361(c)(2) (relating to certain trusts permitted as shareholders) is amended by inserting after clause (iv) the following new clause:

"(v) An electing small business trust.".

(b) Current Beneficiaries Treated as Shareholders.—Subparagraph (B) of section 1361(c)(2) is amended by adding at the end the following new clause:

"(v) In the case of a trust described in clause (v) of subparagraph (A), each potential current beneficiary of such trust shall be treated as a shareholder; except that, if for any period there is no potential current beneficiary of such trust, such trust shall be treated as the shareholder during such period."

(c) Electing Small Business Trust Defined.—Section 1361 (defining S corporation) is amended by adding at the end the following new subsection:

"(e) Electing Small Business Trust Defined.—

"(1) Electing Small Business Trust.—For purposes of this section—

"(A) In General.—Except as provided in subparagraph (B), the term 'electing small business trust' means any trust if—

"(i) such trust does not have as a beneficiary any person other than (I) an individual, (II) an estate, or (III) an organization described in paragraph (2), (3), (4), or (5) of section 170(c) which holds a contingent interest and is not a potential current beneficiary,

"(ii) no interest in such trust was acquired by purchase, and

"(iii) an election under this subsection applies to such trust.

"(B) Certain Trusts Not Eligible.—The term 'electing small business trust' shall not include—

"(i) any qualified subchapter S trust (as defined in subsection (d)(3)) if an election under subsection (d)(2) applies to any corporation the stock of which is held by such trust, and

"(ii) any trust exempt from tax under this subtitle.

"(C) Purchase.—For purposes of subparagraph (A), the term 'purchase' means any acquisition if the basis of the property acquired is determined under section 1012.

"(2) Potential Current Beneficiary.—For purposes of this section, the term 'potential current beneficiary' means, with respect to any period, any person who at any time during such period is entitled to, or at the discretion of any person may receive, a distribution from the principal or income of the trust. If a trust disposes of all of the stock which it holds in an S corporation, then, with respect to such corporation, the term 'potential current beneficiary' does not include any person who first met the requirements of the preceding sentence during the 60-day period ending on the date of such disposition.

"(3) Election.—An election under this subsection shall be made by the trustee. Any such election shall apply to the taxable year of the trust for which made and all subsequent taxable years of such trust unless revoked with the consent of the Secretary.

"(4) Cross Reference.—

"For special treatment of electing small business trusts, see section 641(d)."

(d) Taxation of Electing Small Business Trusts.—Section 641 (relating to imposition of tax on trusts) is amended by adding at the end the following new subsection:

"(d) Special Rules for Taxation of Electing Small Business Trusts.—

"(1) In General.—For purposes of this chapter—

"(A) the portion of any electing small business trust which consists of stock in 1 or more S corporations shall be treated as a separate trust, and

"(B) the amount of the tax imposed by this chapter on such separate trust shall be determined with the modifications of paragraph (2).

"(2) Modifications.—For purposes of paragraph (1), the modifications of this paragraph are the following:

"(A) Except as provided in section 1(h), the amount of the tax imposed by section 1(e) shall be determined by using the highest rate of tax set forth in section 1(e).

"(B) The exemption amount under section 55(d) shall be zero.

"(C) The only items of income, loss, deduction, or credit to be taken into account are the following:

"(i) The items required to be taken into account under section 1366.

"(ii) Any gain or loss from the disposition of stock in an S corporation.

"(iii) To the extent provided in regulations, State or local income taxes or administrative expenses to the extent allocable to items described in clauses (i) and (ii).

No deduction or credit shall be allowed for any amount not described in this paragraph, and no item described in this paragraph shall be apportioned to any beneficiary.

"(D) No amount shall be allowed under paragraph (1) or (2) of section 1211(b).

"(3) Treatment of Remainder of Trust and Distributions.—For purposes of determining—

"(A) the amount of the tax imposed by this chapter on the portion of any electing small business trust not treated as a separate trust under paragraph (1), and

"(B) the distributable net income of the entire trust, the items referred to in paragraph (2)(C) shall be excluded. Except as provided in the preceding sentence, this subsection shall not affect the taxation of any distribution from the trust.

"(4) Treatment of Unused Deductions where Termination of Separate Trust.—If a portion of an electing small business trust ceases to be treated as a separate trust under paragraph (1), any carryover or excess deduction of the separate trust which is referred to in section 642(h) shall be taken into account by the entire trust.

"(5) Electing Small Business Trust.—For purposes of this subsection, the term 'electing small business trust' has the meaning given such term by section 1361(e)(1).".

(e) Technical Amendment.—Paragraph (1) of section 1366(a) is amended by inserting ", or of a trust or estate which terminates," after "who dies".

Sec. 1303. Expansion of Post-Death Qualification For Certain Trusts.

Subparagraph (A) of section 1361(c)(2) (relating to certain trusts permitted as shareholders) is amended—

(1) by striking "60-day period" each place it appears in clauses (ii) and (iii) and inserting "2-year period", and

(2) by striking the last sentence in clause (ii).

Sec. 1304. Financial Institutions Permitted to Hold Safe Harbor Debt.

Clause (iii) of section 1361(c)(5)(B) (defining straight debt) is amended by striking "or a trust described in paragraph (2)" and inserting "a trust described in paragraph (2), or a person which is actively and regularly engaged in the business of lending money".

Sec. 1305. Rules Relating to Inadvertent Terminations and Invalid Elections.

(a) General Rule.—Subsection (f) of section 1362 (relating to inadvertent terminations) is amended to read as follows:

"(f) Inadvertent Invalid Elections or Terminations.—If—

"(1) an election under subsection (a) by any corporation—

"(A) was not effective for the taxable year for which made (determined without regard to subsection (b)(2)) by reason of a failure to meet the requirements of section 1361(b) or to obtain shareholder consents, or

"(B) was terminated under paragraph (2) or (3) of subsection (d),

"(2) the Secretary determines that the circumstances resulting in such ineffectiveness or termination were inadvertent,

"(3) no later than a reasonable period of time after discovery of the circumstances resulting in such ineffectiveness or termination, steps were taken—

"(A) so that the corporation is a small business corporation, or

"(B) to acquire the required shareholder consents, and

"(4) the corporation, and each person who was a shareholder in the corporation at any time during the period specified pursuant to this subsection, agrees to make such adjustments (consistent with the treatment of the corporation as an S corporation) as may be required by the Secretary with respect to such period, then, notwithstanding the circumstances resulting in such ineffectiveness or termination, such corporation shall be treated as an S corporation during the period specified by the Secretary.".

(b) Late Elections, Etc.—Subsection (b) of section 1362 is amended by adding at the end the following new paragraph:

"(5) Authority to Treat Late Elections, Etc., As Timely.—If—

"(A) an election under subsection (a) is made for any taxable year (determined without regard to paragraph (3)) after the date prescribed by this subsection for making such election for such taxable year or no such election is made for any taxable year, and

"(B) the Secretary determines that there was reasonable cause for the failure to timely make such election, the Secretary may treat such an election as timely made for such taxable year (and paragraph (3) shall not apply).".

(c) Effective Date.—The amendments made by subsections (a) and (b) shall apply with respect to elections for taxable years beginning after December 31, 1982.

Sec. 1306. Agreement To Terminate Year.

Paragraph (2) of section 1377(a) (relating to pro rata share) is amended to read as follows:

"(2) Election to Terminate Year.—

"(A) In General.—Under regulations prescribed by the Secretary, if any shareholder terminates the shareholder's interest in the corporation during the taxable year and all affected shareholders and the corporation agree to the application of this paragraph, paragraph (1) shall be applied to the affected shareholders as if the taxable year consisted of 2 taxable years the first of which ends on the date of the termination.

"(B) Affected Shareholders.—For purposes of subparagraph (A), the term 'affected shareholders' means the shareholder whose interest is terminated and all shareholders to whom such shareholder has transferred shares during the taxable year. If such shareholder has transferred shares to the corporation, the term 'affected shareholders' shall include all persons who are shareholders during the taxable year.".

Sec. 1307. Expansion of Post-Termination Transition Period.

(a) In General.—Paragraph (1) of section 1377(b) (relating to post-termination transition period) is amended by striking "and" at the end of subparagraph (A), by redesignating subparagraph (B) as subparagraph (C), and by inserting after subparagraph (A) the following new subparagraph:

"(B) the 120-day period beginning on the date of any determination pursuant to an audit of the taxpayer which follows the termination of the corporation's election and which adjusts a subchapter S item of income, loss, or deduction of the corporation arising during the S period (as defined in section 1368(e)(2)), and ".

(b) Determination Defined.—Paragraph (2) of section 1377(b) is amended by striking subparagraphs (A) and (B), by redesignating subparagraph (C) as subparagraph (B), and by inserting before subparagraph (B) (as so redesignated) the following new subparagraph:

"(A) a determination as defined in section 1313(a), or".

(c) Repeal of Special Audit Provisions for Subchapter S Items.—

(1) General Rule.—Subchapter D of chapter 63 (relating to tax treatment of subchapter S items) is hereby repealed.

(2) Consistent Treatment Required.—Section 6037 (relating to return of S corporation) is amended by adding at the end the following new subsection:

"(c) Shareholder's Return Must Be Consistent with Corporate Return or Secretary Notified of Inconsistency.—

"(1) In General.—A shareholder of an S corporation shall, on such shareholder's return, treat a subchapter S item in a manner which is consistent with the treatment of such item on the corporate return.

"(2) Notification of Inconsistent Treatment.—

"(A) In General.—In the case of any subchapter S item, if—

"(i)(I) the corporation has filed a return but the shareholder's treatment on his return is (or may be) inconsistent with the treatment of the item on the corporate return, or

"(II) the corporation has not filed a return, and

"(ii) the shareholder files with the Secretary a statement identifying the inconsistency,

paragraph (1) shall not apply to such item.

"(B) Shareholder Receiving Incorrect Information.—A shareholder shall be treated as having complied with clause (ii) of subparagraph (A) with respect to a subchapter S item if the shareholder—

"(i) demonstrates to the satisfaction of the Secretary that the treatment of the subchapter S item on the shareholder's return is consistent with the treatment of the item on the schedule furnished to the shareholder by the corporation, and

"(ii) elects to have this paragraph apply with respect to that item.

"(3) Effect of Failure To Notify.—In any case—

"(A) described in subparagraph (A)(i)(I) of paragraph (2), and

"(B) in which the shareholder does not comply with subparagraph (A)(ii) of paragraph (2),

any adjustment required to make the treatment of the items by such shareholder consistent with the treatment of the items on the corporate return shall be treated as arising out of mathematical or clerical errors and assessed according to section 6213(b)(1). Paragraph (2) of section 6213(b) shall not apply to any assessment referred to in the preceding sentence.

"(4) Subchapter S Item.—For purposes of this subsection, the term 'subchapter S item' means any item of an S corporation to the extent that regulations prescribed by the Secretary provide that, for purposes of this subtitle, such item is more appropriately determined at the corporation level than at the shareholder level.

"(5) Addition to Tax for Failure to Comply with Section.—

"For addition to tax in the case of a shareholder's negligence in connection with, or disregard of, the requirements of this section, see part II of subchapter A of chapter 68.".

(3) Conforming Amendments.—

(A) Section 1366 is amended by striking subsection (g).

(B) Subsection (b) of section 6233 is amended to read as follows:

"(b) Similar Rules in Certain Cases.—If a partnership return is filed for any taxable year but it is determined that there is no entity for such taxable year, to the extent provided in regulations, rules similar to the rules of subsection (a) shall apply.".

(C) The table of subchapters for chapter 63 is amended by striking the item relating to subchapter D.

Sec. 1308. S Corporations Permitted to Hold Subsidiaries.

(a) In General.—Paragraph (2) of section 1361(b) (defining ineligible corporation) is amended by striking subparagraph (A) and by redesignating subparagraphs (B), (C), (D), and (E) as subparagraphs (A), (B), (C), and (D), respectively.

(b) Treatment of Certain Wholly Owned S Corporation Subsidiaries.—Section 1361(b) (defining small business corporation) is amended by adding at the end the following new paragraph:

"(3) Treatment of Certain Wholly Owned Subsidiaries.—

"(A) In General.—For purposes of this title—

"(i) a corporation which is a qualified subchapter S subsidiary shall not be treated as a separate corporation, and

"(ii) all assets, liabilities, and items of income, deduction, and credit of a qualified subchapter S subsidiary shall be treated as assets, liabilities, and such items (as the case may be) of the S corporation.

"(B) Qualified Subchapter S Subsidiary.—For purposes of this paragraph, the term 'qualified subchapter S subsidiary' means any domestic corporation which is not an ineligible corporation (as defined in paragraph (2)), if—

"(i) 100 percent of the stock of such corporation is held by the S corporation, and

"(ii) the S corporation elects to treat such corporation as a qualified subchapter S subsidiary.

"(C) Treatment of Terminations of Qualified Subchapter S Subsidiary Status.—For purposes of this title, if any corporation which was a qualified subchapter S subsidiary ceases to meet the requirements of subparagraph (B), such corporation shall be treated as a new corporation acquiring all of its assets (and assuming all of its liabilities) immediately before such cessation from the S corporation in exchange for its stock.

"(D) Election After Termination.—If a corporation's status as a qualified subchapter S subsidiary terminates, such corporation (and any successor corporation) shall not be eligible to make—

"(i) an election under subparagraph (B)(ii) to be treated as a qualified subchapter S subsidiary, or

"(ii) an election under section 1362(a) to be treated as an S corporation,

before its 5th taxable year which begins after the 1st taxable year for which such termination was effective, unless the Secretary consents to such election.".

(c) Certain Dividends Not Treated As Passive Investment Income.—Paragraph (3) of section 1362(d) is amended by adding at the end the following new subparagraph:

"(F) Treatment of Certain Dividends.—If an S corporation holds stock in a C corporation meeting the requirements of section 1504(a)(2), the term 'passive investment income' shall not include dividends from such C corporation to the extent such dividends are attributable to the earnings and profits of such C corporation derived from the active conduct of a trade or business.".

(d) Conforming Amendments.—

(1) Subsection (c) of section 1361 is amended by striking paragraph (6).

(2) Subsection (b) of section 1504 (defining includible corporation) is amended by adding at the end the following new paragraph:

"(8) An S corporation.".

Sec. 1309. Treatment of Distributions During Loss Years.

(a) Adjustments for Distributions Taken into Account Before Losses.—

(1) Subparagraph (A) of section 1366(d)(1) (relating to losses and deductions cannot exceed shareholder's basis in stock and debt) is amended by striking "paragraph (1)" and inserting "paragraphs (1) and (2)(A)".

(2) Subsection (d) of section 1368 (relating to certain adjustments taken into account) is amended by adding at the end the following new flush sentence:

"In the case of any distribution made during any taxable year, the adjusted basis of the stock shall be determined with regard to the adjustments provided in paragraph (1) of section 1367(a) for the taxable year.".

(b) Accumulated Adjustments Account.—Paragraph (1) of section 1368(e) (relating to accumulated adjustments account) is amended by adding at the end the following new subparagraph:

"(C) Net Loss for Year Disregarded.—

"(i) In General.—In applying this section to distributions made during any taxable year, the amount in the accumulated adjustments account as of the close of such taxable year shall be determined without regard to any net negative adjustment for such taxable year.

"(ii) Net Negative Adjustment.—For purposes of clause (i), the term 'net negative adjustment' means, with respect to any taxable year, the excess (if any) of—

"(I) the reductions in the account for the taxable year (other than for distributions), over

"(II) the increases in such account for such taxable year.".

(c) Conforming Amendments.—Subparagraph (A) of section 1368(e)(1) is amended—

(1) by striking "as provided in subparagraph (B)" and inserting "as otherwise provided in this paragraph", and

(2) by striking "section 1367(b)(2)(A)" and inserting "section 1367(a)(2)".

Sec. 1310. Treatment of S Corporations Under Subchapter C.

Subsection (a) of section 1371 (relating to application of subchapter C rules) is amended to read as follows:

"(a) Application of Subchapter C Rules.—Except as otherwise provided in this title, and except to the extent inconsistent with this subchapter, subchapter C shall apply to an S corporation and its shareholders.".

Sec. 1311. Elimination of Certain Earnings and Profits.

(a) In General.—If—

(1) a corporation was an electing small business corporation under subchapter S of chapter 1 of the Internal Revenue Code of 1986 for any taxable year beginning before January 1, 1983, and

(2) such corporation is an S corporation under subchapter S of chapter 1 of such Code for its first taxable year beginning after December 31, 1996,

the amount of such corporation's accumulated earnings and profits (as of the beginning of such first taxable year) shall be reduced by an amount equal to the portion (if any) of such accumulated earnings and profits which were accumulated in any taxable year beginning before January 1, 1983, for which such corporation was an electing small business corporation under such subchapter S.

(b) Conforming Amendments.—

(1) Paragraph (3) of section 1362(d), as amended by section 1308, is amended—

(A) by striking "SUBCHAPTER C" in the paragraph heading and inserting "ACCUMULATED",

(B) by striking "subchapter C" in subparagraph (A)(i)(I) and inserting "accumulated", and

(C) by striking subparagraph (B) and redesignating the following subparagraphs accordingly.

(2)(A) Subsection (a) of section 1375 is amended by striking "subchapter C" in paragraph (1) and inserting "accumulated".

(B) Paragraph (3) of section 1375(b) is amended to read as follows:

"(3) Passive Investment Income, Etc.—The terms 'passive investment income' and 'gross receipts' have the same respective meanings as when used in paragraph (3) of section 1362(d).".

(C) The section heading for section 1375 is amended by striking "subchapter C" and inserting "accumulated".

(D) The table of sections for part III of subchapter S of chapter 1 is amended by striking "subchapter C" in the item relating to section 1375 and inserting "accumulated".

(3) Clause (i) of section 1042(c)(4)(A) is amended by striking "section 1362(d)(3)(D)" and inserting "section 1362(d)(3)(C)".

Sec. 1312. Carryover of Disallowed Losses and Deductions Under At-Risk Rules Allowed.

Paragraph (3) of section 1366(d) (relating to carryover of disallowed losses and deductions to post-termination transition period) is amended by adding at the end the following new subparagraph:

"(D) At-Risk Limitations.—To the extent that any increase in adjusted basis described in subparagraph (B) would have increased the shareholder's amount at risk under section 465 if such increase had occurred on the day preceding the commencement of the post-termination transition period, rules similar to the rules described in subparagraphs (A) through (C) shall apply to any losses disallowed by reason of section 465(a).".

Sec. 1313. Adjustments to Basis of Inherited S Stock to Reflect Certain Items of Income.

(a) In General.—Subsection (b) of section 1367 (relating to adjustments to basis of stock of shareholders, etc.) is amended by adding at the end the following new paragraph:

"(4) Adjustments in Case of Inherited Stock.—

(A) In General.—If any person acquires stock in an S corporation by reason of the death of a decedent or by bequest, devise, or inheritance, section 691 shall be applied with respect to any item of income of the S corporation in the same manner as if the decedent had held directly his pro rata share of such item.

"(B) Adjustments to Basis.—The basis determined under section 1014 of any stock in an S corporation shall be reduced by the portion of the value of the stock which is attributable to items constituting income in respect of the decedent.".

(b) Effective Date.—The amendment made by subsection (a) shall apply in the case of decedents dying after the date of the enact-ment of this Act.

Sec. 1314. S Corporations Eligible for Rules Applicable to Real Property Subdivided for Sale by Noncorporate Taxpayers.

(a) In General.—Subsection (a) of section 1237 (relating to real property subdivided for sale) is amended by striking "other than a corporation" in the material preceding paragraph (1) and in-serting "other than a C corporation".

(b) Conforming Amendment.—Subparagraph (A) of section 1237(a)(2) is amended by inserting "an S corporation which included the taxpayer as a shareholder," after "controlled by the taxpayer,".

Sec. 1315. Financial Institutions.

Subparagraph (A) of section 1361(b)(2) (defining ineligible cor-poration), as redesignated by section 1308(a), is amended to read as follows:

"(A) a financial institution which uses the reserve method of accounting for bad debts described in section 585,".

Sec. 1316. Certain Exempt Organizations Allowed To Be Shareholders.

(a) Eligibility to Be Shareholders.—

(1) In General.—Subparagraph (B) of section 1361(b)(1) (defining small business corporation) is amended to read as follows:

(B) have as a shareholder a person (other than an estate, a trust described in subsection (c)(2), or an organization described in subsection (c)(7)) who is not an individual,".

(2) Eligible Exempt Organizations.—Section 1361(c) (relating to special rules for applying subsection (b)) is amended by adding at the end the following new paragraph:

"(7) Certain Exempt Organizations Permitted As Shareholders.— For purposes of subsection (b)(1)(B), an organization which is—

(A) described in section 401(a) or 501(c)(3), and

"(B) exempt from taxation under section 501(a), may be a shareholder in an S corporation.".

(b) Contributions of S Corporation Stock.—Section 170(e)(1) (relating to certain contributions of ordinary income and capital gain property) is amended by adding at the end the following new sentence: "For purposes of applying this paragraph in the case of a charitable contribution of stock in an S corporation, rules similar to the rules of section 751 shall apply in determining whether gain on such stock would have been long-term capital gain if such stock were sold by the taxpayer.".

(c) Treatment of Income.—Section 512 (relating to unrelated business taxable income), as amended by section 1113, is amended by adding at the end the following new subsection:

"(e) Special Rules Applicable to S Corporations.—

"(1) In General.—If an organization described in section 1361(c)(7) holds stock in an S corporation—

"(A) such interest shall be treated as an interest in an unrelated trade or business; and

"(B) notwithstanding any other provision of this part—

"(i) all items of income, loss, or deduction taken into account under section 1366(a), and

"(ii) any gain or loss on the disposition of the stock in the S corporation shall be taken into account in computing the unrelated business taxable income of such organization.

"(2) Basis Reduction.—Except as provided in regulations, for purposes of paragraph (1), the basis of any stock acquired by purchase (within the meaning of section 1012) shall be reduced by the amount of any dividends received by the organization with respect to the stock.".

(d) Certain Benefits Not Applicable to S Corporations.—

(1) Contribution to ESOPs.—Paragraph (9) of section 404(a) (relating to certain contributions to employee ownership plans) is amended by inserting at the end the following new subparagraph:

(C) S Corporations.—This paragraph shall not apply to an S corporation.".

(2) Dividends on Employer Securities.—Paragraph (1) of section 404(k) (relating to deduction for dividends on certain employer securities) is amended by striking "a corporation" and inserting "a C corporation".

(3) Exchange Treatment.—Subparagraph (A) of section 1042(c)(1) (defining qualified securities) is amended by striking "domestic corporation" and inserting "domestic C corporation".

(e) Conforming Amendment.—Clause (i) of section 1361(e)(1)(A), as added by section 1302, is amended by striking "which holds a contingent interest and is not a potential current beneficiary".

(f) Effective Date.—The amendments made by this section shall apply to taxable years beginning after December 31, 1997.

Sec. 1317. Effective Date.

(a) In General.—Except as otherwise provided in this subtitle, the amendments made by this subtitle shall apply to taxable years beginning after December 31, 1996.

(b) Treatment of Certain Elections Under Prior Law.— For purposes of section 1362(g) of the Internal Revenue Code of 1986 (relating to election after termination), any termination under section 1362(d) of such Code in a taxable year beginning before January 1, 1997, shall not be taken into account.

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