[Federal Register Volume 60, Number 245 (Thursday, December 21, 1995)]
[Proposed Rules]
[Pages 66237-66243]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30832]
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DEPARTMENT OF THE TREASURY
26 CFR Part 1
[PS-7-89]
RIN 1545-AM98
Treatment of Gain From the Disposition of Interest in Certain
Natural Resource Recapture Property by S Corporations and Their
Shareholders
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking.
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SUMMARY: This document contains proposed regulations under section 1254
of the Internal Revenue Code relating to the tax treatment by S
corporations and their shareholders of gain from the disposition by an
S corporation (and a former S corporation) of certain natural resource
recapture property (section 1254 property after enactment of the Tax
Reform Act of 1986 and oil, gas, or geothermal property before
enactment of the Tax Reform Act of 1986), and also rules relating to
the disposition of stock in an S corporation that holds certain natural
resource recapture property. Changes to the applicable tax law were
made by the Tax Reform Act of 1986, and the Subchapter S Revision Act
of 1982. The regulations provide the public with guidance in complying
with the changed tax laws.
DATES: Written comments and requests for a public hearing must be
received by February 20, 1996.
ADDRESSES: Send comments and requests for a public hearing to:
CC:DOM:CORP:R (PS-7-89), room 5228, Internal Revenue Service, P.O. Box
7604, Ben Franklin Station, Washington, DC 20044. In the alternative,
submissions may be hand-delivered to CC:DOM:CORP:R (PS-7-89), Room
5228, Internal Revenue Service Building, 1111 Constitution Avenue, NW.,
Washington, DC 20224.
FOR FURTHER INFORMATION CONTACT: James A. Quinn, 202-622-3060 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in this notice of proposed
rulemaking has been submitted to the Office of Management and Budget
(OMB) for review in accordance with the Paperwork Reduction Act of 1995
(44 U.S.C. 3507).
Comments on the collection of information should be sent to the
Office of Management and Budget, Attn: Desk Officer for the Department
of the Treasury, Office of Information and Regulatory Affairs,
Washington, DC 20503, with copies to the Internal Revenue Service,
Attn: IRS Reports Clearance Officer PC:FP, Washington, DC 20224.
Comments on the collection of information should be received by January
22, 1996.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid control number.
The collection of information is contained in Sec. 1.1254-4(c) of
the proposed regulations. This information is required by the Internal
Revenue Service to verify that taxpayers have reported the appropriate
amount of gain as ordinary income under section 1254 when a shareholder
sells stock in an S corporation that holds natural resource recapture
property. The likely respondents are individuals and businesses and
other for-profit institutions.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Estimated total annual reporting burden: 1,000 hours. The estimated
annual burden per respondent varies from .5 hours to 1.5 hours,
depending on individual circumstances, with an estimated average of 1
hour.
Estimated number of respondents: 1,000.
Estimated annual frequency of responses: On occasion.
Background
On June 11, 1980, proposed amendments to the Income Tax
Regulations, 26 CFR part 1, under sections 170, 301, 312, 341, 453,
751, 1254, and 1502 of the Internal Revenue Code of 1954 (Code) were
published in the Federal Register (45 FR 39512). These amendments were
proposed to conform the regulations to section 205(a), (b), (c)(1) and
(2) of the Tax Reform Act of 1976, Public Law 94-455, 90 Stat. 1533,
and section 402(c) of the Energy Tax Act of 1978, Public Law 95-618, 92
Stat. 3202, and to make certain other technical amendments to the
regulations to conform them to section 1(c) of the Act of September 12,
1966, Public Law 89-570, 80 Stat. 762, section 211(b)(6) of the Tax
Reform Act of 1969, Public Law 91-172, 83 Stat. 570, and sections
1042(c)(2), 1101(d)(2), 1901(a)(93), and 2110(a) of the Tax Reform Act
of 1976, 90 Stat. 1637, 1658, 1780, 1905. Section 1.1254-3 of the
proposed regulations provided rules relating to the sale or exchange of
stock in an electing small business corporation (hereinafter referred
to as an S corporation). Because of the substantial changes in the tax
treatment of S corporations since the proposed regulations were issued,
the proposed regulations contained in Sec. 1.1254-3 needed to be
completely revised.
This document revises and reproposes Sec. 1.1254-3 of the above-
referenced notice of proposed rulemaking as amendments to the Income
Tax Regulations, 26 CFR part 1, under section 1254 of the Code,
relating to S corporations (redesignated as Sec. 1.1254-4). These
amendments are proposed to conform the regulations to section 5(a)(37)
of the Subchapter S Revision Act of 1982, Public Law 97-354, 96 Stat.
1669, and sections 411 and 413 of the Tax Reform Act of 1986, Public
Law 99-514, 100 Stat. 2225, 2227. The amendments are to be issued under
the authority contained in sections 1254(b) and 7805 of the Code.
Explanation of Provisions
These proposed regulations contain rules for applying the
provisions of section 1254 to the disposition of natural resource
recapture property by an S corporation (and a former S corporation) and
the disposition of S corporation stock.
The proposed regulations provide that the recognition of ordinary
income under section 1254 upon the disposition of natural resource
recapture property by an S corporation is generally computed at the
shareholder level. Determining the amount of ordinary income to be
recognized under section 1254 at the shareholder level is appropriate
because the determination of section 1254 costs can be affected by
shareholder elections and characteristics. See, for example, sections
59(e) and 1363(c)(2)(A). Similarly, in the case of oil and gas
properties, gain on the disposition of the property and depletion with
respect to the property are computed at the shareholder level. See
section 613A(c)(11).
The proposed regulations also contain rules relating to the
recognition of ordinary income under section 1254 upon a sale or
exchange of S corporation stock. Under section 1254(b)(2), rules
similar to the rules of section 751 are to be applied to that portion
of the excess of the amount realized over the adjusted basis of the
stock that is attributable to section 1254 costs. Pursuant to section
1254(b)(2), the proposed regulations provide that, as a general rule, a
[[Page 66239]]
shareholder must treat any gain recognized on a sale or exchange of S
corporation stock as ordinary income to the extent of the shareholder's
section 1254 costs with respect to the shares sold or exchanged.
The proposed regulations provide two exceptions to the general rule
for determining the amount treated as ordinary income under section
1254 upon a sale or exchange of stock. The first exception is that the
general rule does not apply to the extent that the shareholder
establishes that the gain is not attributable to the section 1254
costs. The portion of the gain recognized that is not attributable to
section 1254 costs is that portion of the gain recognized that exceeds
the amount of ordinary income that the shareholder would have
recognized under section 1254 (with respect to the shares sold or
exchanged) if, immediately prior to the sale or exchange of the stock,
the corporation had sold at fair market value all of the corporation's
property the disposition of which would result in the recognition by
the shareholder of ordinary income under section 1254. To establish
that a portion of the gain recognized is not attributable to a
shareholder's section 1254 costs, the shareholder must attach to the
shareholder's tax return a statement detailing the shareholder's share
of the fair market value and basis, and the shareholder's section 1254
costs, for each of the S corporation's natural resource recapture
properties held immediately before the sale or exchange of stock.
The second exception to the general rule for sales or exchanges of
stock is that, in the case of a contribution of property to the S
corporation prior to a stock sale or exchange pursuant to a plan a
principal purpose of which is to avoid the recognition of ordinary
income under section 1254, the selling or exchanging shareholder must
recognize as ordinary income under section 1254 the amount of ordinary
income the shareholder would have recognized under section 1254 (with
respect to the shares sold or exchanged) had the S corporation sold all
of its natural resource recapture property the disposition of which
would result in ordinary income under section 1254. Section 1.1254-
4(c)(3) Example 3 of the proposed regulations illustrates this
exception. The proposed regulations also provide rules for determining
an S corporation shareholder's section 1254 costs. Generally, an S
corporation shareholder's section 1254 costs with respect to any
natural resource recapture property held by the corporation include all
of the shareholder's section 1254 costs with respect to the property
while in the hands of the S corporation. In the case of a person
(acquiring shareholder) who acquires stock from another shareholder,
the proposed regulations provide that the acquiring shareholder's
section 1254 costs are zero if the acquiring shareholder's basis for
the stock transferred is determined by reference to its cost (within
the meaning of section 1012) or by reference to the fair market value
of the stock on the date of the decedent's death or on the applicable
date provided in section 2032 (relating to alternate valuation date).
However, an acquiring shareholder's section 1254 costs include any
section 1254 costs paid or incurred before the decedent's death, to the
extent that the basis of the stock is reduced under section 1014(b)(9)
(relating to adjustments to basis if the property is acquired from a
decedent prior to death). For stock that is acquired in a transfer that
is a gift, in a transfer that is part sale or exchange and part gift,
or a transfer described in section 1041, the acquiring shareholder
generally acquires the section 1254 costs of the transferor but reduces
the section 1254 costs by the amount of any gain treated as ordinary
income under section 1254 by the transferor on the transfer.
The proposed regulations provide rules for applying section 1254 to
the shareholders of an S corporation that incurred section 1254 costs
while it was a C corporation (former C corporation). In the case of a C
corporation that holds natural resource recapture property and that
elects to be an S corporation, each shareholder's section 1254 costs as
of the beginning of the corporation's first taxable year as an S
corporation include a pro rata share of the section 1254 costs of the
corporation as of the close of the last taxable year that the
corporation was a C corporation.
The proposed regulations also provide rules for applying section
1254 to a corporation that holds natural resource recapture property
after the termination of its S corporation election (former S
corporation). In the case of an S corporation that becomes a C
corporation, the C corporation's section 1254 costs with respect to any
natural resource recapture property held by the corporation as of the
beginning of the corporation's first taxable year as a C corporation
include the sum of its shareholders' section 1254 costs with respect to
the property as of the close of the last taxable year for which the
corporation was an S corporation. In the case of an S termination year
as defined in section 1362(e)(4), the shareholders' section 1254 costs
are determined as of the close of the S short year as defined in
section 1362(e)(1)(A).
Because certain transactions will change the allocation to the
shareholders of gain or amount realized from the natural resource
recapture property if the S corporation disposes of it subsequent to
these transactions, the proposed regulations require that section 1254
costs be reallocated to reflect the effects of these transactions.
Transactions requiring reallocation of the section 1254 costs are
transactions involving the issuance of stock by an S corporation in a
reorganization or otherwise, and transfers of natural resource
recapture property to the S corporation in exchange for stock of the S
corporation (for example, in a section 351 transaction or in a
reorganization).
The rules for former S corporations and the rules for allocating
section 1254 costs upon certain transfers require the S corporation to
determine the aggregate of its shareholders' section 1254 costs. The
proposed regulations provide rules for the S corporation to apply in
determining a shareholder's section 1254 costs with respect to natural
resource recapture property held by the S corporation. In general, the
S corporation may determine a shareholder's section 1254 costs by using
written data provided by the shareholder or by applying certain
assumptions.
These regulations are proposed to apply to dispositions of natural
resource recapture property by an S corporation (and a former S
corporation) and dispositions of S corporation stock occurring after
publication of these regulations as final regulations in the Federal
Register.
Comments and Requests for a Public Hearing
Before the adoption of these proposed regulations, consideration
will be given to any written comments that are timely submitted
(preferably an original and eight copies) to the IRS. All comments will
be available for public inspection and copying. A public hearing will
be held upon written request to the Internal Revenue Service by any
person who also submits written comments. If a public hearing is held,
notice of the time and place will be published in the Federal Register.
Special Analyses
It has been determined that this proposed regulation is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It also has been
determined that section
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553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the
Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these
regulations, and, therefore, a Regulatory Flexibility Analysis is not
required. Pursuant to section 7805(f) of the Internal Revenue Code,
this notice of proposed rulemaking will be submitted to the Chief
Counsel for Advocacy of the Small Business Administration for comment
on its impact on small business.
Drafting Information
The principal author of these regulations is James A. Quinn of the
Office of Assistant Chief Counsel (Passthroughs and Special
Industries), IRS. However, other personnel from the IRS and Treasury
Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805. * * *
Section 1.1254-4 also issued under 26 U.S.C. 1254(b). * * *
Par. 2. Section 1.1254-0 is amended by revising the entry for
Sec. 1.1254-4 to read as follows:
Sec. 1.1254-0 Table of contents for section 1254 recapture rules.
* * * * *
Sec. 1.1254-4 Special rules for S corporations and their shareholders.
(a) In general.
(b) Determination of gain treated as ordinary income under section
1254 upon a disposition of natural resource recapture property by an S
corporation.
(1) General rule.
(2) Examples.
(c) Character of gain recognized by a shareholder upon a sale or
exchange of S corporation stock.
(1) General rule.
(2) Exceptions.
(3) Examples.
(d) Section 1254 costs of a shareholder.
(e) Section 1254 costs of an acquiring shareholder after certain
acquisitions.
(1) Basis determined under section 1012.
(2) Basis determined by reason of the application of section
1014(a).
(3) Basis determined by reason of the application of section
1014(b)(9).
(4) Gifts and section 1041 transfers.
(f) Special rules for former S corporations and former C
corporations.
(1) Section 1254 costs of an S corporation that was formerly a C
corporation.
(2) Examples.
(3) Section 1254 costs of a C corporation that was formerly an S
corporation.
(g) Determination of a shareholder's section 1254 costs upon
certain stock transactions.
(1) Issuance of stock.
(2) Natural resource recapture property acquired in exchange for
stock.
(3) Treatment of nonvested stock.
(4) Exception.
(5) Aggregate of S corporation shareholders' section 1254 costs
with respect to natural resource recapture property held by the S
corporation
(6) Examples.
(h) Effective date.
* * * * *
Par. 3. Section 1.1254-4 is amended by adding text to read as
follows:
Sec. 1.1254-4 Special rules for S corporations and their
shareholders.
(a) In general. This section provides rules for applying the
provisions of section 1254 to S corporations and their shareholders
upon the disposition by an S corporation (or a former S corporation) of
natural resource recapture property and upon the disposition by a
shareholder of stock of an S corporation that holds natural resource
recapture property.
(b) Determination of gain treated as ordinary income under section
1254 upon a disposition of natural resource recapture property by an S
corporation--(1) General rule. Upon a disposition of natural resource
recapture property by an S corporation, the amount of gain treated as
ordinary income under section 1254 is determined at the shareholder
level. Each shareholder must recognize as ordinary income under section
1254 the lesser of--
(i) The shareholder's section 1254 costs with respect to the
property disposed of; or
(ii) The shareholder's share of the amount, if any, by which the
amount realized on the sale, exchange, or involuntary conversion, or
the fair market value of the property upon any other disposition
(including a distribution), exceeds the adjusted basis of the property.
(2) Examples. The following examples illustrate the provisions of
paragraph (b)(1) of this section:
Example 1. Disposition of natural resource recapture property
other than oil and gas property. A and B are equal shareholders in
X, an S corporation. On January 1, 1995, X acquires for $90,000 an
undeveloped mineral property, its sole property. During 1995, X
expends and deducts $100,000 in developing the property. On January
15, 1996, X sells the property for $250,000 when X's basis in the
property is $90,000. Thus, X recognizes gain of $160,000 on the
sale. A and B's share of the $160,000 gain recognized is $80,000
each. Each shareholder has $50,000 of section 1254 costs with
respect to the property. Under these circumstances, A and B each are
required to recognize $50,000 of the $80,000 of gain on the sale of
the property as ordinary income under section 1254.
Example 2. Disposition of oil and gas property the adjusted
basis of which is allocated to the shareholders under section
613A(c)(11). C and D are equal shareholders in Y, an S corporation.
On January 1, 1995, Y acquires for $150,000 an undeveloped oil and
gas property, its sole property. During 1995, Y expends in
developing the property $40,000 in intangible drilling costs which
it elects to expense under section 263(c). On January 15, 1996, Y
sells the property for $200,000. C and D's share of the $200,000
amount realized on the sale is $100,000 each. C and D each have a
basis of $75,000 in the property and $20,000 of section 1254 costs
with respect to the property. Under these circumstances, C and D
each are required to recognize $20,000 of the $25,000 gain on the
sale of the property as ordinary income under section 1254.
(c) Character of gain recognized by a shareholder upon a sale or
exchange of S corporation stock--(1) General rule. Except as provided
in paragraph (c)(2) of this section, if an S corporation shareholder
recognizes gain upon a sale or exchange of stock in the S corporation
(determined without regard to section 1254), the gain is treated as
ordinary income under section 1254 to the extent of the shareholder's
section 1254 costs (with respect to the shares sold or exchanged).
(2) Exceptions--(i) Gain not attributable to section 1254 costs--
(A) General rule. Paragraph (c)(1) of this section does not apply to
any portion of the gain recognized on the sale or exchange of the stock
that the taxpayer establishes is not attributable to section 1254
costs. The portion of the gain recognized that is not attributable to
section 1254 costs is that portion of the gain recognized that exceeds
the amount of ordinary income that the shareholder would have
recognized under section 1254 (with respect to the shares sold or
exchanged) if, immediately prior to the sale or exchange of the stock,
the corporation had sold at fair market value all of the corporation's
property the disposition of which would result in the recognition by
the shareholder of ordinary income under section 1254.
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(B) Substantiation. To establish that a portion of the gain
recognized is not attributable to a shareholder's section 1254 costs so
as to qualify for the exception contained in paragraph (c)(2)(i)(A) of
this section, the shareholder must attach to the shareholder's tax
return a statement detailing the shareholder's share of the fair market
value and basis, and the shareholder's section 1254 costs, for each of
the S corporation's natural resource recapture properties held
immediately before the sale or exchange of stock.
(ii) Transactions entered into as part of a plan to avoid
recognition of ordinary income under section 1254. In the case of a
contribution of property prior to a sale or exchange of stock pursuant
to a plan a principal purpose of which is to avoid recognition of
ordinary income under section 1254, paragraph (c)(1) of this section
does not apply. Instead, the amount recognized as ordinary income under
section 1254 is the amount of ordinary income the selling or exchanging
shareholder would have recognized under section 1254 (with respect to
the shares sold or exchanged) had the S corporation sold its natural
resource recapture property the disposition of which would have
resulted in the recognition of ordinary income under section 1254. The
amount recognized as ordinary income under the preceding sentence
reduces the amount realized on the sale or exchange of the stock. This
reduced amount realized is used in determining any gain or loss on the
sale or exchange.
(3) Examples. The following examples illustrate the provisions of
this paragraph (c):
Example 1. Application of general rule upon a sale of S
corporation stock. C and D are equal shareholders in Y, an S
corporation. As of January 1, 1995, Y holds two mining properties:
Blackacre, with an adjusted basis of $5,000 and a fair market value
of $35,000, and Whiteacre, with an adjusted basis of $20,000 and a
fair market value of $15,000. Y also holds securities with a basis
of $5,000 and a fair market value of $10,000. On January 1, 1995, D
sells 50 percent of D's Y stock to E for $15,000. As of the date of
the sale, D's adjusted basis in the Y stock sold is $7,500, and D
has $18,000 of section 1254 costs with respect to Blackacre and
$12,000 of section 1254 costs with respect to Whiteacre. Under this
paragraph (c), the gain recognized by D upon the sale of Y stock is
treated as ordinary income to the extent of D's section 1254 costs
with respect to the stock sold, unless D establishes that a portion
of such excess is not attributable to D's section 1254 costs.
However, because D would recognize $7,500 in ordinary income under
section 1254 with respect to the stock sold if Y sold Blackacre (the
only asset the disposition of which would result in ordinary income
to D under section 1254), the $7,500 of gain recognized by D upon
the sale of D's Y stock is attributable to D's section 1254 costs.
Therefore, upon the sale of stock to E, D recognizes $7,500 of
ordinary income under this paragraph (c).
Example 2. Sale of S corporation stock where gain is not
entirely attributable to section 1254 costs. Assume the same facts
as in Example 1, except that Blackacre has a fair market value of
$25,000, and the securities have a fair market value of $20,000.
Immediately prior to the sale of stock to E, if Y had sold Blackacre
(its only asset the disposition of which would result in the
recognition of ordinary income to D under section 1254), D would
recognize $5,000 in ordinary income with respect to the stock sold
under section 1254. D attaches a statement to D's tax return for
1995 detailing D's share of the fair market values and bases, and
D's section 1254 costs with respect to Blackacre and Whiteacre.
Therefore, upon the sale of stock to E, of the $7,500 gain
recognized by D, $5,000 is ordinary income under this paragraph (c).
Example 3. Contribution of property prior to sale of S
corporation stock as part of a plan to avoid recognition of ordinary
income under section 1254. H owns all of the stock of Z, an S
corporation. As of January 1, 1995, H has $3,000 of section 1254
costs with respect to property P, which is natural resource
recapture property and Z's only asset. Property P has an adjusted
basis of $5,000 and a fair market value of $8,000. H has a basis of
$5,000 in Z stock, which has a fair market value of $8,000. On
January 1, 1995, H contributes securities to Z which have a basis of
$7,000 and a fair market value of $4,000. On April 15, 1995, H sells
all of the Z stock to J for $12,000. On that date, H's adjusted
basis in the Z stock is also $12,000. Based on all the facts and
circumstances, the sale of stock is part of a plan (along with the
contribution by H of the securities to Z) that has a principal
purpose to avoid recognition of ordinary income under section 1254.
Consequently, under paragraph (c)(2)(ii) of this section, H must
recognize $3,000 as ordinary income under section 1254, the amount
of ordinary income that H would recognize as ordinary income under
section 1254 if property P were sold at fair market value. In
addition, H reduces the amount realized on the sale of the stock
($12,000) by $3,000. As a result, H also recognizes a $3,000 capital
loss on the sale of the stock ($9,000 amount realized less $12,000
adjusted basis).
(d) Section 1254 costs of a shareholder. An S corporation
shareholder's section 1254 costs with respect to any natural resource
recapture property held by the corporation include all of the
shareholder's section 1254 costs with respect to the property in the
hands of the S corporation. See Sec. 1.1254-1(b)(1) for the definition
of section 1254 costs.
(e) Section 1254 costs of an acquiring shareholder after certain
acquisitions--(1) Basis determined under section 1012. If stock in an S
corporation that holds natural resource recapture property is acquired
and the acquiring shareholder's basis for the stock is determined
solely by reference to its cost (within the meaning of section 1012),
the amount of section 1254 costs with respect to the property held by
the corporation in the acquiring shareholder's hands is zero on the
acquisition date.
(2) Basis determined by reason of the application of section
1014(a). If stock in an S corporation that holds natural resource
recapture property is acquired from a decedent and the acquiring
shareholder's basis is determined, by reason of the application of
section 1014(a), solely by reference to the fair market value of the
stock on the date of the decedent's death or on the applicable date
provided in section 2032 (relating to alternate valuation date), the
amount of section 1254 costs with respect to the property held by the
corporation in the acquiring shareholder's hands is zero on the
acquisition date.
(3) Basis determined by reason of the application of section
1014(b)(9). If stock in an S corporation that holds natural resource
recapture property is acquired before the death of the decedent, the
amount of section 1254 costs with respect to the property held by the
corporation in the acquiring shareholder's hands includes the amount,
if any, of the section 1254 costs deducted by the acquiring shareholder
before the decedent's death, to the extent that the basis of the stock
(determined under section 1014(a)) is required to be reduced under
section 1014(b)(9) (relating to adjustments to basis when the property
is acquired before the death of the decedent).
(4) Gifts and section 1041 transfers. If stock is acquired in a
transfer that is a gift, in a transfer that is a part sale or exchange
and part gift, or in a transfer that is described in section 1041(a),
the amount of section 1254 costs with respect to the property held by
the corporation in the acquiring shareholder's hands immediately after
the transfer is an amount equal to--
(i) The amount of section 1254 costs with respect to the property
held by the corporation in the hands of the transferor immediately
before the transfer; minus
(ii) The amount of any gain recognized as ordinary income under
section 1254 by the transferor upon the transfer.
(f) Special rules for former S corporations and former C
corporations--(1) Section 1254 costs of an S corporation that was
formerly a C corporation. In the case of a C
[[Page 66242]]
corporation that holds natural resource recapture property and that
elects to be an S corporation, each shareholder's section 1254 costs as
of the beginning of the corporation's first taxable year as an S
corporation include a pro rata share of the section 1254 costs of the
corporation as of the close of the last taxable year that the
corporation was a C corporation.
(2) Examples. The following examples illustrate the application of
the provisions of paragraph (f)(1) of this section:
Example 1. Sale of natural resource recapture property held by
an S corporation that was formerly a C corporation--(i) Y is a C
corporation that elects to be an S corporation effective January 1,
1996. On that date, Y owns Oil Well, which is natural resource
recapture property and a capital asset. Y has section 1254 costs of
$20,000 as of the close of the last taxable year that it was a C
corporation. On January 1, 1996, Oil Well has a value of $200,000
and a basis of $100,000. Thus, under section 1374, Y's net
unrealized built-in gain is $100,000. Also on that date, Y's basis
in Oil Well is allocated to A, Y's sole shareholder, under section
613A(c)(11) and the section 1254 costs are allocated to A under
Sec. 1.1254-4(f)(1). In addition, A has a basis in A's Y stock of
$100,000.
(ii) On November 1, 1996, Y sells Oil Well for $250,000. During
1996, Y has taxable income greater than $100,000, and no other
transactions or items treated as recognized built-in gain or loss.
Under section 1374, Y has net recognized built-in gain of $100,000.
Assuming a tax rate of 35 percent on capital gain, Y has a tax of
$35,000 under section 1374. The tax of $35,000 is treated as a
capital loss under section 1366(f)(2). A has a realized gain on the
sale of $150,000 ($250,000 minus $100,000) of which $20,000 is
recognized as ordinary income under section 1254, and $130,000 is
recognized as capital gain. Consequently, A recognizes ordinary
income of $20,000 and net capital gain of $95,000 ($130,000 minus
$35,000) on the sale.
Example 2. Sale of stock followed by sale of natural resource
recapture property held by an S corporation that was formerly a C
corporation--(i) Assume the same facts as in Example 1(i). On
November 1, 1996, A sells all of A's Y stock to P for $250,000. A
has a realized gain on the sale of $150,000 ($250,000 minus
$100,000) of which $20,000 is recognized as ordinary income under
section 1254, and $130,000 is recognized as capital gain.
(ii) On November 2, 1996, Y sells Oil Well for $250,000. During
1996, Y has taxable income greater than $100,000, and no other
transactions or items treated as recognized built-in gain or loss.
Under section 1374, Y has net recognized built-in gain of $100,000.
Assuming a tax rate of 35 percent on capital gain, Y has a tax of
$35,000 under section 1374. The tax of $35,000 is treated as a
capital loss under section 1366(f)(2). P has a realized gain on the
sale of $150,000 ($250,000 minus $100,000), which is recognized as
capital gain. Consequently, P recognizes net capital gain of
$115,000 ($150,000 minus $35,000) on the sale.
(3) Section 1254 costs of a C corporation that was formerly an S
corporation. In the case of an S corporation that becomes a C
corporation, the C corporation's section 1254 costs with respect to any
natural resource recapture property held by the corporation as of the
beginning of the corporation's first taxable year as a C corporation
include the sum of its shareholders' section 1254 costs with respect to
the property as of the close of the last taxable year that the
corporation was an S corporation. In the case of an S termination year
as defined in section 1362(e)(4), the shareholders' section 1254 costs
are determined as of the close of the S short year as defined in
section 1362(e)(1)(A). See paragraph (g)(5) of this section for rules
on determining the aggregate amount of the shareholders' section 1254
costs.
(g) Determination of a shareholder's section 1254 costs upon
certain stock transactions--(1) Issuance of stock. Upon an issuance of
stock (whether such stock is newly-issued or had been held as treasury
stock) by an S corporation in a reorganization or otherwise--
(i) Each recipient of shares must be allocated a pro rata share
(determined solely with respect to the shares issued in the
transaction) of the aggregate of the S corporation shareholders'
section 1254 costs with respect to natural resource recapture property
held by the S corporation immediately before the issuance (as
determined pursuant to paragraph (g)(5) of this section); and
(ii) Each pre-existing shareholder must reduce his or her section
1254 costs with respect to natural resource recapture property held by
the S corporation immediately before the issuance by an amount equal to
the pre-existing shareholder's section 1254 costs immediately before
the issuance multiplied by the percentage of stock of the corporation
issued in the transaction.
(2) Natural resource recapture property acquired in exchange for
stock. If natural resource recapture property is transferred to an S
corporation in exchange for stock of the S corporation (for example, in
a section 351 transaction, or in a reorganization described in section
368), the S corporation must allocate to its shareholders a pro rata
share of the S corporation's section 1254 costs with respect to the
property immediately after the transaction (as determined under
Sec. 1.1254-3(b)(1)).
(3) Treatment of nonvested stock. Stock issued in connection with
the performance of services that is substantially nonvested (within the
meaning of Sec. 1.83-3(b)) is treated as issued for purposes of this
section at the first time it is treated as outstanding stock of the S
corporation for purposes of section 1361.
(4) Exception. Paragraph (g)(1) of this section does not apply to
stock issued in exchange for stock of the same S corporation (as for
example, in a recapitalization described in section 368(a)(1)(E)).
(5) Aggregate of S corporation shareholders' section 1254 costs
with respect to natural resource recapture property held by the S
corporation--(i) In general. The aggregate of S corporation
shareholders' section 1254 costs is equal to the sum of each
shareholder's section 1254 costs. The S corporation must determine each
shareholder's section 1254 costs under either paragraph (g)(5)(i)(A)
(written data) or paragraph (g)(5)(i)(B) (assumptions) of this section.
The S corporation may determine the section 1254 costs of some
shareholders under paragraph (g)(5)(i)(A) of this section and of others
under paragraph (g)(5)(i)(B) of this section.
(A) Written data. An S corporation may determine a shareholder's
section 1254 costs by using written data provided by a shareholder
showing the shareholder's section 1254 costs with respect to natural
resource recapture property held by the S corporation unless the S
corporation knows or has reason to know that the written data is
inaccurate. If an S corporation does not receive written data upon
which it may rely, the S corporation must use the assumptions provided
in paragraph (g)(5)(i)(B) of this section in determining a
shareholder's section 1254 costs.
(B) Assumptions. An S corporation that does not use written data
pursuant to paragraph (g)(5)(i)(A) of this section to determine a
shareholder's section 1254 costs must use the following assumptions to
determine the shareholder's section 1254 costs.
(1) The shareholder deducted his or her share of the amount of
deductions under sections 263(c), 616, and 617 in the first year in
which the shareholder could claim a deduction for such amounts, unless
in the case of expenditures under sections 263(c) or 616 the S
corporation elected to capitalize such amounts;
(2) The shareholder was not subject to the following limitations
with respect to the shareholder's depletion allowance under section
611, except to the extent a limitation applied at the corporate
[[Page 66243]]
level: the taxable income limitation of section 613(a); the depletable
quantity limitations of section 613A(c); or the limitations of sections
613A(d)(2), (3), and (4) (exclusion of retailers and refiners).
(6) Examples. The following examples illustrate the provisions of
this paragraph (g):
Example 1. Transfer of natural resource recapture property to an
S corporation in a section 351 transaction. As of January 1, 1996, A
owns all the stock (20 shares) in X, an S corporation. X holds
property that is not natural resource recapture property that has a
fair market value of $2,000 and an adjusted basis of $2,000. On
January 1, 1996, B transfers natural resource recapture property,
Property P, to X in exchange for 80 shares of X stock in a
transaction that qualifies under section 351. Property P has a fair
market value of $8,000 and an adjusted basis of $5,000. Pursuant to
section 351, B does not recognize gain on the transaction.
Immediately prior to the transaction, B's section 1254 costs with
respect to Property P equaled $6,000. Under Sec. 1.1254-2(c)(1), B
does not recognize any gain under section 1254 on the section 351
transaction and, under Sec. 1.1254-3(b)(1), X's section 1254 costs
with respect to Property P immediately after the contribution equal
$6,000. Under paragraph (g)(2) of this section, each shareholder is
allocated a pro rata share of X's section 1254 costs. The pro rata
share of X's section 1254 costs that is allocated to A equals $1,200
(20 percent interest in X multiplied by X's $6,000 of section 1254
costs). The pro rata share of X's section 1254 costs that is
allocated to B equals $4,800 (80 percent interest in X multiplied by
X's $6,000 of section 1254 costs).
Example 2. Contribution of money in exchange for stock of an S
corporation holding natural resource recapture property. As of
January 1, 1996, A and B each own 50 percent of the stock (50 shares
each) in X, an S corporation. X holds natural resource recapture
property, Property P, which has a fair market value of $20,000 and
an adjusted basis of $14,000. A's and B's section 1254 costs with
respect to Property P are $4,000 and $1,500, respectively. On
January 1, 1996, C contributes $20,000 to X in exchange for 100
shares of X's stock. Under paragraph (g)(1)(i) of this section, X
must allocate to C a pro rata share of its shareholders' section
1254 costs. Using the assumptions set forth in paragraph
(g)(5)(i)(B) of this section, X determines that A's section 1254
costs with respect to natural resource recapture property held by X
equal $4,500. Using written data provided by B, X determines that
B's section 1254 costs with respect to Property P equal $1,500.
Thus, the aggregate of X's shareholders' section 1254 costs equals
$6,000. C's pro rata share of the $6,000 of section 1254 costs
equals $3,000 (C's 50 percent interest in X multiplied by $6,000).
Under paragraph (g)(1)(ii) of this section, A's section 1254 costs
are reduced by $2,000 (A's actual section 1254 costs ($4,000)
multiplied by 50 percent). B's section 1254 costs are reduced by
$750 (B's actual section 1254 costs ($1,500) multiplied by 50
percent).
Example 3. Merger involving an S corporation that holds natural
resource recapture property. X, an S corporation with one
shareholder, A, holds as its sole asset natural resource recapture
property that has a fair market value of $120,000 and an adjusted
basis of $40,000. A has section 1254 costs with respect to the
property of $60,000. For valid business reasons, X merges into Y, an
S corporation with one shareholder, B, in a reorganization described
in section 368(a)(1)(A). Y holds property that is not natural
resource recapture property that has a fair market value of $120,000
and basis of $120,000. Under paragraph (c) of this section, A does
not recognize ordinary income under section 1254 upon the exchange
of stock in the merger because A did not otherwise recognize gain on
the merger. Under paragraph (g)(2) of this section, Y must allocate
to A and B a pro rata share of its $60,000 of section 1254 costs.
Thus, A and B are each allocated $30,000 of section 1254 costs (50
percent interest in X, each, multiplied by $60,000).
(h) Effective date. This section applies to dispositions of natural
resource recapture property by an S corporation (and a former S
corporation) and dispositions of S corporation stock occurring after
publication of these regulations as final regulations in the Federal
Register.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-30832 Filed 12-20-95; 8:45 am]
BILLING CODE 4830-01-U
