[Federal Register Volume 59, Number 247 (Tuesday, December 27, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-31429]
[[Page Unknown]]
[Federal Register: December 27, 1994]
=======================================================================
-----------------------------------------------------------------------
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8579]
RIN 1545-AK93
S Corporation Built-In Gain Tax
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
-----------------------------------------------------------------------
SUMMARY: This document prescribes final regulations under section 1374
relating to the tax imposed on an S corporation's net recognized built-
in gain. The final regulations reflect changes to the law in the Tax
Reform Act of 1986. The final regulations generally affect only
corporations that changed from C to S status.
DATES: These regulations are effective December 27, 1994.
These regulations apply to taxable years ending on or after
December 27, 1994, but only in cases where the return for the taxable
year is filed pursuant to an S election or a section 1374(d)(8)
transaction occurring on or after December 27, 1994.
FOR FURTHER INFORMATION CONTACT: Mark S. Jennings or Lee D. Muchnikoff,
Office of Assistant Chief Counsel (Corporate), Internal Revenue
Service, 1111 Constitution Avenue NW, Washington, DC 20224 (Attention:
CC:DOM:CORP:T:R), or telephone (202) 622-7530 (not a toll free number).
SUPPLEMENTARY INFORMATION:
1. Background
Section 1374 of the Internal Revenue Code of 1986 (Code) generally
imposes a corporate-level tax on an S corporation's recognition of
income or gain to the extent the income or gain reflects unrealized
appreciation (or its equivalent) in the corporation when it converted
from C to S status. Section 1374 was amended to provide this treatment
as part of the legislation repealing the General Utilities rule. See
H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess., Vol. II, 198-207 (1986),
1986-3 C.B., Vol. 4, 198-207.
Section 1374 generally applies to an S corporation for taxable
years beginning after December 31, 1986, but only if the corporation
elects S status after December 31, 1986. Sections 1374(e) and 337(d)
provide specific authority to promulgate regulations under section
1374.
Proposed regulations under section 1374 were published in the
Federal Register on December 8, 1992 (57 FR 57971, or 1992-2 C.B. 594).
This document adds new Secs. 1.1374-0 through 1.1374-10 to 26 CFR Part
1.
2. Section 1374 and the Proposed Regulations
Section 1374(a) imposes a tax on an S corporation's net recognized
built-in gain for any taxable year beginning in the 10-year recognition
period following the S corporation's conversion from a C corporation or
acquisition of C corporation assets in a carryover basis transaction.
The proposed regulations provide that an S corporation's net recognized
built-in gain for any taxable year is the least of (1) its taxable
income determined by using the rules applying to C corporations and
considering only recognized built-in gain and recognized built-in loss
(the pre-limitation amount), (2) its taxable income determined by using
the rules applying to C corporations and considering all items except
as provided under section 1375(b)(1)(B) (the taxable income
limitation), or (3) the excess of its net unrealized built-in gain over
net recognized built-in gain for all prior taxable years in the
recognition period (the net unrealized built-in gain limitation).
Section 1374(d)(3) provides that any gain recognized on the
disposition of an asset during the recognition period is recognized
built-in gain except to the extent the S corporation establishes that
it did not hold the asset on the first day of the recognition period or
the asset appreciated after that day. Section 1374(d)(4) provides that
any loss recognized on a disposition of an asset during the recognition
period is recognized built-in loss to the extent the S corporation
establishes that it held the asset on the first day of the recognition
period and the asset depreciated before that day. The proposed
regulations provide that sections 1374(d) (3) and (4) apply only to
transactions treated as sales or exchanges under the Code.
Section 1374(d)(5)(A) provides that any item of income properly
taken into account during the recognition period but attributable to
periods before the first day of the recognition period is recognized
built-in gain. Section 1374(d)(5)(B) provides that any item of
deduction properly taken into account during the recognition period but
attributable to periods before the first day of the recognition period
is recognized built-in loss. The proposed regulations provide that an S
corporation's items of income or deduction generally are recognized
built-in gain or loss if the item would have been included in gross
income or allowed as a deduction against gross income before the
recognition period by an accrual method taxpayer (accrual method rule).
The proposed regulations provide that all rules applying to accrual
method taxpayers (whether from the Code, regulations, administrative
pronouncements, or otherwise) also apply for purposes of the accrual
method rule with two exceptions: (1) Section 461(h)(2)(C), relating to
liabilities for tort and worker's compensation for which payment
constitutes economic performance, and (2) section 469, relating to
suspended passive activity losses. The proposed regulations also
provide special rules for certain items including an S corporation's
section 481(a) adjustments, income reported under the completed
contract method, income reported under the installment method, and
distributive share of partnership items.
Section 1374(d)(1) provides that an S corporation's net unrealized
built-in gain is the amount by which the fair market value of all its
assets exceeds the aggregate adjusted bases of all its assets as of the
beginning of the recognition period. Section 1374(d)(5)(C) provides
that an S corporation's net unrealized built-in gain is properly
adjusted for items of income and deduction that would be recognized
built-in gain or loss if taken into account during the recognition
period. The proposed regulations provide that the S corporation's net
unrealized built-in gain is determined by reference to a hypothetical
sale of all the assets of the corporation immediately before the
beginning of the recognition period to a buyer that assumed all the
corporation's liabilities.
Section 1374(b)(2) provides that an S corporation's net operating
loss carryforwards and capital loss carryforwards arising in years for
which the corporation was a C corporation are allowed as deductions
against net recognized built-in gain. The proposed regulations provide
that no other loss carryforwards may be used as a deduction against net
recognized built-in gain. Section 1374(b)(3) provides that an S
corporation's special fuels credit for the year, and business credit
carryforwards and minimum tax credit arising in years for which the
corporation was a C corporation, are allowed as credits against the
section 1374 tax. The proposed regulations provide that no other
credits or credit carryforwards may be used as a credit against the
section 1374 tax. The loss carryforwards, credits, and credit
carryforwards allowed to reduce the section 1374 tax are collectively
referred to as the section 1374 attributes in the final regulations.
3. Public Comments and the Final Regulations
The IRS received written and oral comments from the public on the
proposed regulations both in connection with the public hearing held on
April 28, 1993, and otherwise. The issues raised by these comments are
discussed below.
A. Accounting Methods
Commentators request guidance about the accounting methods an S
corporation should use in determining its pre-limitation amount and
taxable income limitation. The commentators suggest that an S
corporation should be allowed to use any accounting method it could use
if it were a C corporation. The final regulations do not adopt this
suggestion because section 1374 applies only to items an S corporation
actually takes into account during the recognition period. It does not
apply to items the corporation would have taken into account under a
hypothetical method of accounting. Accordingly, the final regulations
require the S corporation to use the accounting methods it actually
uses as an S corporation to make these taxable income determinations.
B. Recognition Period
Commentators request confirmation that the recognition period is
the 10 calendar year period (and not the 10 taxable year period)
beginning on the first day the corporation is an S corporation or the
day the S corporation acquires C corporation assets in a carryover
basis transaction. The final regulations confirm the commentators'
interpretation of the Code.
Commentators also request guidance on determining an S
corporation's net recognized built-in gain where the recognition period
ends during a taxable year (for example, because a corporation
converting from C to S status was on a fiscal year as a C corporation
and changed to a calendar year as an S corporation or because an S
corporation acquired C corporation assets in a carryover basis
transaction during a taxable year). The final regulations provide that
the pre-limitation amount for the year is determined by a closing of
the books at the end of the recognition period.
C. Accrual Method Rule and Section 267(a)(2) or 404(a)(5)
One commentator argues that the proposed regulations should not use
the accrual method rule to determine if, and the extent to which, an
item of income or deduction is included in net recognized built-in
gain. Instead, this commentator argues that the approach the proposed
regulations use to determine if, and the extent to which, an item of
income or deduction is included in net unrealized built-in gain (that
is, by valuation using a hypothetical sale of all the S corporation's
assets to a buyer that assumes all the S corporation's liabilities)
should also be used to determine if, and the extent to which, an item
of income or deduction is included in net recognized built-in gain.
The Treasury and the IRS believe that separately valuing each item
of income and deduction for net recognized built-in gain purposes would
be unduly burdensome both for taxpayers and for the IRS. Using a
valuation approach for determining net unrealized built-in gain is not
unduly burdensome because net unrealized built-in gain can be
determined by valuing the S corporation's business using an aggregate
approach where particular items of income and deduction are not valued
individually. In addition, many S corporations subject to section 1374
will not need to know their net unrealized built-in gain because they
will not approach their net unrealized built-in gain limitation in the
recognition period. However, most S corporations subject to section
1374 will have items of income and deduction taken into account in the
recognition period where a determination must be made if, and the
extent to which, the item is included in net recognized built-in gain.
Accordingly, the final regulations do not adopt the commentator's
suggestion and generally retain the accrual method rule in the proposed
regulations.
Some commentators argue that the accrual method rule in the
proposed regulations wrongly applies sections 267(a)(2), relating to
accrued amounts payable to related persons, and 404(a)(5), relating to
accrued amounts payable as deferred compensation, to determine whether
an item of deduction should be treated as a recognized built-in loss.
In general, those sections defer a deduction for an accrual method
taxpayer that owes a payment to a cash method taxpayer until the
payment is made. The commentators cite the following statement in the
section 1374 legislative history in support of their position:
As an example of these built-in gain and loss provisions, in the
case of a cash basis personal service corporation that converts to S
status and that has receivables at the time of the conversion, the
receivables, when received, are built-in gain items. At the same
time, built-in losses would include otherwise deductible
compensation paid after the conversion to the persons who performed
the services that produced the receivables, to the extent such
compensation is attributable to such pre-conversion services. To the
extent such built-in loss items offset the built-in gains from the
receivables, there would be no amount subject to the built-in gains
tax.
H.R. Rep. No. 795, 100th Cong., 2d Sess. 63-64 (1988).
The commentators suggest that the accrual method rule in the final
regulations should be applied without regard to sections 267(a)(2) and
404(a)(5). The Treasury and the IRS disagree with the commentators that
the legislative history quoted above precludes the adoption of the
accrual method rule of the proposed regulations. The accrual method
rule in the proposed regulations was adopted as an administrable method
for both taxpayers and the Service to determine the extent to which an
amount included in income or deducted in the recognition period is
attributable to the pre-recognition period. Nevertheless, in response
to the commentators' requests, the final regulations extend recognized
built-in loss treatment for certain amounts properly deducted under
section 267(a)(2) or 404(a)(5) in the recognition period.
The final regulations provide that an amount properly deducted
under section 267(a)(2) is recognized built-in loss to the extent (i)
all events have occurred that establish the fact of the liability to
pay the amount, and the exact amount of the liability can be
determined, as of the beginning of the recognition period, and (ii) the
amount is paid in the first two and one-half months of the recognition
period, or is paid to an individual that owned less than 5 percent of
the corporation's stock. The final regulations provide that an amount
properly deducted under section 404(a)(5) is recognized built-in loss
to the extent (i) all events have occurred that establish the fact of
the liability to pay the amount, and the exact amount of the liability
can be determined, as of the beginning of the recognition period, and
(ii) the amount is not deductible under section 267(a)(2). The Treasury
and the IRS believe that these rules are relatively easy for taxpayers
and the IRS to apply and also provide relief from the deferral of
deductions under section 267(a)(2) or 404(a)(5). The additional
limitations for amounts deducted under section 267(a)(2) are needed
because of the particular difficulty in determining whether amounts
paid to related parties are attributable to services performed before
or after the beginning of the recognition period.
The final regulations also modify the accrual method rule in the
proposed regulations as follows: (1) An exception from the accrual
method rule for items deducted under Sec. 1.461-4(g) is added (relating
to items in addition to those specified in section 461(h)(2)(C) for
which payment constitutes economic performance); and (2) the exception
from the accrual method rule in the proposed regulations for items
deducted under section 469 is eliminated. The Sec. 1.461-4(g) exception
is added to clarify the section 461(h)(2)(C) exception in the proposed
regulations. The section 469 exception is eliminated because losses
suspended before the recognition period under section 469 cannot be
used in the recognition period under section 1371(b)(1).
D. Section 481 Adjustments
The proposed regulations provide that any item of income or
deduction properly taken into account during the recognition period
under section 481 is recognized built-in gain or loss if the item is
taken into account because of a change of accounting method effective
before the beginning of the second year of the recognition period
(``one-year rule''). In certain cases, this one-year rule has the
effect of (1) omitting income attributable to the corporation's C
period altogether at the corporate level, (2) including income
attributable to the corporation's C period twice at the corporate
level, (3) omitting a deduction attributable to the corporation's C
period altogether at the corporate level, or (4) allowing a deduction
attributable to the corporation's C period twice at the corporate
level, because the section 481 adjustment on the change in accounting
method is not treated as recognized built-in gain or loss. In addition,
the Treasury and the Service believe that in most cases the portion of
a section 481(a) adjustment attributable to the pre-recognition period
and the portion attributable to the recognition period can be
determined without undue administrative difficulty.
The final regulations, therefore, provide that any section 481(a)
adjustment taken into account in the recognition period that prevents
an omission or duplication of income or deduction is recognized built-
in gain or loss to the extent the adjustment relates to items
attributable to periods before the beginning of the recognition period
under the principles for determining recognized built-in gain or loss
in the regulations.
E. Installment Method
The proposed regulations impose a section 1374 tax on income
reported under the installment method either during or after the
recognition period in accordance with Notice 90-27, 1990-1 C.B. 336.
The tax is imposed only to the extent the income would have been
included in net recognized built-in gain if it had been reported in the
year of the sale and all provisions of section 1374 applied including
the taxable income limitation.
Several commentators argue that the proposed regulations wrongly
impose a section 1374 tax on income reported under the installment
method after the recognition period. In addition, they contend that the
proposed regulations wrongly apply the taxable income limitation by
reference to the S corporation's cumulative taxable income from the
year of the installment sale to the year that income is reported under
the installment method (assuming the income had been reported in the
year of the sale) instead of the S corporation's taxable income in the
year that income was reported under the installment method. Further,
they believe that, where income is reported under the installment
method after the recognition period, the proposed regulations are
unclear regarding the proper use of section 1374 attributes and loss
recognized after the recognition period that would have been recognized
built-in loss if it had been recognized during the recognition period.
The final regulations retain the installment method rules in the
proposed regulations because the Treasury and the IRS believe those
rules are necessary to prevent an abuse of section 1374. The final
regulations clarify the use of an S corporation's section 1374
attributes and loss recognized after the recognition period where
income is reported under the installment method for a year after the
recognition period. Section 1374 attributes may be used to the extent
their use is allowed under all applicable provisions of the Code.
However, the S corporation's loss recognized in a year after the
recognition period may not be used to reduce the section 1374 tax.
F. Partnership Items
The proposed regulations generally provide that an S corporation
owning an interest in a partnership must treat its distributive share
of the partnership's items as recognized built-in gain or loss to the
extent the S corporation's distributive share would have been treated
as recognized built-in gain or loss if the items originated in, and
were taken into account directly by, the S corporation (the look-
through rules). The look-through rules generally apply only to the
extent the S corporation had built-in gain or built-in loss in its
partnership interest at the beginning of the recognition period. The
proposed regulations contain a small interest exception from the look-
through rules for any taxable year where the S corporation's
partnership interest has a value less than $100,000 and represents less
than a 10 percent interest in the partnership's capital and profits at
all times during the year. The small interest exception does not apply
if the partnership was formed or availed of with a principal purpose to
avoid the section 1374 tax. The proposed regulations provide that if an
S corporation disposes of its partnership interest during the
recognition period, the amount treated as recognized built-in gain or
loss on the disposition is adjusted to take into account amounts
treated as recognized built-in gain or loss under the look-through
rules. The proposed regulations also provide special rules for section
704(c) gain and loss, and where an S corporation disposes of
distributed partnership assets.
Commentators argue that the look-through rules should apply only
where an S corporation controls the partnership or the primary use of
the partnership by the S corporation is to avoid section 1374 because,
except where the S corporation is the controlling partner, the S
corporation is not likely to have access to information and records
necessary to identify and value partnership section 1374 items. In
addition, the commentators suggest modifying the small interest
exception to the look-through rules so that the small interest test is
generally applied only on the first day of the recognition period. The
commentators believe that subsequent increases or decreases in the fair
market value of the partnership interest should be disregarded.
The final regulations retain the look-through rules. Access to
information and records necessary to identify and value partnership
section 1374 items is not dependent on whether the S corporation is a
controlling partner. Moreover, section 1374 should generally apply to
an S corporation's partnership section 1374 items even where a
principal purpose for using the partnership was not to avoid the
section 1374 tax.
The final regulations, however, modify the small interest exception
to the look-through rules to accommodate the commentators' request for
a rule requiring a valuation of the partnership interest only on the
first day of the recognition period. Under the rule as modified, the
small interest exception generally applies for a taxable year if the S
corporation's interest in the partnership represents less than 10
percent of the partnership's profits and capital at all times during
the taxable year and prior taxable years in the recognition period and
has a value less than $100,000 as of the beginning of the recognition
period. However, if the S corporation contributes an asset to the
partnership in the recognition period and the S corporation held the
asset as of the beginning of the recognition period, the fair market
value of the S corporation's partnership interest as of the beginning
of the recognition period is determined as if the asset was contributed
to the partnership before the beginning of the recognition period
(using the fair market value of the asset as of the beginning of the
recognition period).
G. Valuing Inventory
The proposed regulations provide that the value of an S
corporation's inventory on the first day of the recognition period
equals the amount that a willing buyer would pay a willing seller for
the inventory in a purchase of all the S corporation's assets on that
day. Commentators argue that the rules for valuing inventory in the
proposed regulations are unclear and should be clarified to provide a
non-liquidation, non-distress, bulk sale approach, which generally will
result in a value for the inventory less than retail value.
The final regulations provide that the value of an S corporation's
inventory on the first day of the recognition period generally is
determined by reference to a sale of the entire business of the S
corporation to a buyer that expects to continue to operate that
business. The buyer and seller are presumed not to be under any
compulsion to buy or sell and to have reasonable knowledge of all
relevant facts. Relevant facts include (1) the replacement cost of the
inventory; (2) the expected retail selling price of the inventory; (3)
the seller's incentive to demand a price for the inventory that would
compensate for and provide a fair return for expenditures the seller
incurred to obtain, prepare, carry, and dispose of the inventory before
the sale of the business; and (4) the buyer's incentive to pay a price
for the inventory that would compensate for and provide a fair return
for similar expenditures the buyer expects to incur after the sale of
the business. It is expected that the value of an S corporation's
inventory as determined under the final regulations will generally be
less than its anticipated retail price, but greater than its
replacement cost.
The preamble to the proposed regulations describes a safe harbor
rule that was being considered for publication as a revenue procedure
under which the value of inventory for purposes of section 1374 would
be determined using a formula. One commentator endorsed the general
idea of adopting a safe harbor rule, but objected to the rule described
in the preamble and did not suggest an alternative rule. No
commentators supported the rule described in the preamble of the
proposed regulations or suggested an alternative rule.
At this time, the IRS is not planning to issue a revenue procedure
setting forth a safe harbor rule for valuing inventory. However,
consideration will be given to any safe harbor rule taxpayers may
suggest in the future.
H. Section 1374(d)(8) Transactions
Section 1374(d)(8) imposes a section 1374 tax if an S corporation
acquires assets in a transaction where the S corporation's basis in the
assets is determined by reference to their basis in the hands of a C
corporation (a section 1374(d)(8) transaction) and, thereafter, the S
corporation disposes of the assets. The proposed regulations provide
that a separate determination of tax under section 1374 must be made
for the assets acquired in each section 1374(d)(8) transaction. Thus,
an S corporation's section 1374 attributes held on the day it became an
S corporation may only be used to reduce a section 1374 tax imposed on
dispositions of assets the S corporation held on that day. Similarly,
section 1374 attributes acquired by an S corporation in a section
1374(d)(8) transaction may only be used to reduce a section 1374 tax
imposed on dispositions of assets the S corporation acquired in the
same transaction.
Commentators argue that restrictions on the use of section 1374
attributes acquired by an S corporation in a section 1374(d)(8)
transaction should not be greater than the restrictions that would
apply if the attributes were acquired by a C corporation in a similar
transaction. For example, commentators contend that an S corporation's
net operating loss carryforwards when it changed from C to S status
should be allowed to reduce a section 1374 tax imposed on assets the S
corporation acquires in a section 1374(d)(8) transaction, subject to
all statutory limits on their use including the anti-trafficking rules
of sections 382, 383, and 384.
The final regulations retain the rules in the proposed regulations.
Section 1374(d)(8) imposes a section 1374 tax on the ``net recognized
built-in gain attributable to'' the assets acquired in a particular
transaction. The legislative history under section 1374 states that
``each acquisition of assets from a C corporation is subject to a
separate determination of the amount of net built-in gain * * *.'' H.R.
Rep. No. 795, 100th Cong., 2d Sess. 63 (1988).
I. Effective Date and Additional Rules
The proposed regulations provide that the section 1374 final
regulations will generally apply for taxable years ending on or after
the date the final regulations are published in the Federal Register,
but only where the return is filed pursuant to an S election or a
section 1374(d)(8) transaction occurring on or after that date. The
final regulations retain the effective date in the proposed
regulations.
The proposed regulations provide that if a taxpayer subject to
section 1374, but not generally subject to the regulations, contributes
an asset to a partnership under section 721(a) in contemplation of
making an S election or during the recognition period, section 1374
applies on a disposition of the asset by the partnership as if the S
corporation still owned the asset. This provision applies as of the
effective date of section 1374. Commentators argue that the rule should
apply only for contributions to partnerships after the proposed
regulations were issued. The final regulations retain the rule in the
proposed regulations to prevent an abuse of section 1374.
The proposed regulations provide that the rules in Announcement 86-
128, 1986-51 I.R.B. 22, and Notice 90-27, 1990-1 C.B. 336, apply to
taxpayers subject to section 1374, but not generally subject to the
regulations. Instead of referring to the rules in the Notice and the
Announcement, the final regulations set forth some of the rules
contained in those documents.
Commentators suggest that the regulations allow taxpayers subject
to section 1374, but not generally subject to the regulations, to elect
to be subject to the regulations. The final regulations do not adopt
this suggestion because of the burden of administering elections and
because taxpayers not generally subject to the regulations nonetheless
may take positions consistent with the regulations.
Special Analysis
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It has also been determined that
section 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. Therefore, a Regulatory Flexibility Analysis is not
required. Pursuant to section 7805(f) of the Internal Revenue Code, the
notice of proposed rulemaking for these regulations was submitted to
the Small Business Administration for comment on its impact on small
business.
Drafting Information
The principal author of these regulations is Mark S. Jennings of
the Office of Assistant Chief Counsel (Corporate), 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.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by adding
the following entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.1374-1 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-2 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-3 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-4 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-5 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-6 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-7 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-8 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-9 also issued under 26 U.S.C. 1374(e) and 337(d).
Section 1.1374-10 also issued under 26 U.S.C. 1374(e) and
337(d).
Par. 2. An undesignated center heading is added immediately
following Sec. 1.1375-1 to read as follows:
Section 1374 Before the Tax Reform Act of 1986
Sec. 1.1374-1 [Redesignated as Sec. 1.1374-1A]
Par. 3. Section 1.1374-1 is redesignated as Sec. 1.1374-1A and
transferred under the new undesignated centerheading.
Par. 4. Sections 1.1374-0 through 1.1374-10 are added to read as
follows:
Sec. 1.1374-0 Table of contents.
This section lists the major paragraph headings for Secs. 1.1374-1
through 1.1374-10.
Sec. 1.1374-1 General rules and definitions
(a) Computation of tax.
(b) Anti-trafficking rules.
(c) Section 1374 attributes.
(d) Recognition period.
(e) Predecessor corporation.
Sec. 1.1374-2 Net recognized built-in gain
(a) In general.
(b) Allocation rule.
(c) Recognized built-in gain carryover.
(d) Accounting methods.
(e) Example.
Sec. 1.1374-3 Net unrealized built-in gain
(a) In general.
(b) Example.
Sec. 1.1374-4 Recognized built-in gain or loss
(a) Sales and exchanges.
(1) In general.
(2) Oil and gas property.
(3) Examples.
(b) Accrual method rule.
(1) Income items.
(2) Deduction items.
(3) Examples.
(c) Section 267(a)(2) and 404(a)(5) deductions.
(1) Section 267(a)(2).
(2) Section 404(a)(5).
(3) Examples.
(d) Section 481(a) adjustments.
(1) In general.
(2) Examples.
(e) Section 995(b)(2) deemed distributions.
(f) Discharge of indebtedness and bad debts.
(g) Completion of contract.
(h) Installment method.
(1) In general.
(2) Limitation on amount subject to tax.
(3) Rollover rule.
(4) Use of losses and section 1374 attributes.
(5) Examples.
(i) Partnership interests.
(1) In general.
(2) Limitations.
(i) Partnership RBIG.
(ii) Partnership RBIL.
(3) Disposition of partnership interest.
(4) RBIG and RBIL limitations.
(i)-Sale of partnership interest.
(ii) Amounts of limitations.
(5) Small interest exception.
(i) In general.
(ii) Contributed assets.
(iii) Anti-abuse rule.
(6) Section 704(c) gain or loss.
(7) Disposition of distributed partnership asset.
(8) Examples.
Sec. 1.1374-5 Loss carryforwards
(a) In general.
(b) Example.--
Sec. 1.1374-6 Credits and credit carryforwards
(a) In general.
(b) Limitations.
(c) Examples.
Sec. 1.1374-7 Inventory
(a) Valuation.
(b) Identity of dispositions.
Sec. 1.1374-8 Section 1374(d)(8) transactions
(a) In general.
(b) Separate determination of tax.
(c) Taxable income limitation.
(d) Examples.
Sec. 1.1374-9 Anti-stuffing rule
Sec. 1.1374-10 Effective date and additional rules
(a) In general.
(b) Additional rules.
(1) Certain transfers to partnerships.
(2) Certain inventory dispositions.
(3) Certain contributions of built-in loss assets.
(4) Certain installment sales.
(i) In general.
(ii) Examples.
Sec. 1.1374-1 General rules and definitions.
(a) Computation of tax. The tax imposed on the income of an S
corporation by section 1374(a) for any taxable year during the
recognition period is computed as follows--
(1) Step One: Determine the net recognized built-in gain of the
corporation for the taxable year under section 1374(d)(2) and
Sec. 1.1374-2;
(2) Step Two: Reduce the net recognized built-in gain (but not
below zero) by any net operating loss and capital loss carryforward
allowed under section 1374(b)(2) and Sec. 1.1374-5;
(3) Step Three: Compute a tentative tax by applying the rate of tax
determined under section 1374(b)(1) for the taxable year to the amount
determined under paragraph (a)(2) of this section;
(4) Step Four: Compute the final tax by reducing the tentative tax
(but not below zero) by any credit allowed under section 1374(b)(3) and
Sec. 1.1374-6.
(b) Anti-trafficking rules. If section 382, 383, or 384 would have
applied to limit the use of a corporation's recognized built-in loss or
section 1374 attributes at the beginning of the first day of the
recognition period if the corporation had remained a C corporation,
these sections apply to limit their use in determining the S
corporation's pre-limitation amount, taxable income limitation, net
unrealized built-in gain limitation, deductions against net recognized
built-in gain, and credits against the section 1374 tax.
(c) Section 1374 attributes. Section 1374 attributes are the loss
carryforwards allowed under section 1374(b)(2) as a deduction against
net recognized built-in gain and the credit and credit carryforwards
allowed under section 1374(b)(3) as a credit against the section 1374
tax.
(d) Recognition period. The recognition period is the 10-year (120-
month) period beginning on the first day the corporation is an S
corporation or the day an S corporation acquires assets in a section
1374(d)(8) transaction. For example, if the first day of the
recognition period is July 14, 1996, the last day of the recognition
period is July 13, 2006. If the recognition period for certain assets
ends during an S corporation's taxable year (for example, because the
corporation was on a fiscal year as a C corporation and changed to a
calendar year as an S corporation or because an S corporation acquired
assets in a section 1374(d)(8) transaction during a taxable year), the
S corporation must determine its pre-limitation amount (as defined in
Sec. 1.1374-2(a)(1)) for the year as if the corporation's books were
closed at the end of the recognition period.
(e) Predecessor corporation. For purposes of section 1374(c)(1), if
the basis of an asset of the S corporation is determined (in whole or
in part) by reference to the basis of the asset (or any other property)
in the hands of another corporation, the other corporation is a
predecessor corporation of the S corporation.
Sec. 1.1374-2 Net recognized built-in gain.-
(a) In general. An S corporation's net recognized built-in gain for
any taxable year is the least of--
(1) Its taxable income determined by using all rules applying to C
corporations and considering only its recognized built-in gain,
recognized built-in loss, and recognized built-in gain carryover (pre-
limitation amount);
(2) Its taxable income determined by using all rules applying to C
corporations as modified by section 1375(b)(1)(B) (taxable income
limitation); and
(3) The amount by which its net unrealized built-in gain exceeds
its net recognized built-in gain for all prior taxable years (net
unrealized built-in gain limitation).
(b) Allocation rule. If an S corporation's pre-limitation amount
for any taxable year exceeds its net recognized built-in gain for that
year, the S corporation's net recognized built-in gain consists of a
ratable portion of each item of income, gain, loss, and deduction
included in the pre-limitation amount.
(c) Recognized built-in gain carryover. If an S corporation's net
recognized built-in gain for any taxable year is equal to its taxable
income limitation, the amount by which its pre-limitation amount
exceeds its taxable income limitation is a recognized built-in gain
carryover included in its pre-limitation amount for the succeeding
taxable year. The recognized built-in gain carryover consists of that
portion of each item of income, gain, loss, and deduction not included
in the S corporation's net recognized built-in gain for the year the
carryover arose, as determined under paragraph (b) of this section.
(d) Accounting methods. In determining its taxable income for pre-
limitation amount and taxable income limitation purposes, a corporation
must use the accounting method(s) it uses for tax purposes as an S
corporation.
(e) Example. The rules of this section are illustrated by the
following example.
Example. Net recognized built-in gain. X is a calendar year C
corporation that elects to become an S corporation on January 1,
1996. X has a net unrealized built-in gain of $50,000 and no net
operating loss or capital loss carryforwards. In 1996, X has a pre-
limitation amount of $20,000, consisting of ordinary income of
$15,000 and capital gain of $5,000, a taxable income limitation of
$9,600, and a net unrealized built-in gain limitation of $50,000.
Therefore, X's net recognized built-in gain for 1996 is $9,600,
because that is the least of the three amounts described in
paragraph (a) of this section. Under paragraph (b) of this section,
X's net recognized built-in gain consists of recognized built-in
ordinary income of $7,200 [$15,000 x ($9,600/$20,000)=$7,200] and
recognized built-in capital gain of $2,400 [$5,000 x ($9,600/
$20,000)=$2,400]. Under paragraph (c) of this section, X has a
recognized built-in gain carryover to 1997 of $10,400
($20,000-$9,600=$10,400), consisting of $7,800
($15,000-$7,200=$7,800) of recognized built-in ordinary income and
$2,600 ($5,000-$2,400=$2,600) of recognized built-in capital gain.
Sec. 1.1374-3 Net unrealized built-in gain.
(a) In general. An S corporation's net unrealized built-in gain is
the total of the following--
(1) The amount that would be the amount realized if, at the
beginning of the first day of the recognition period, the corporation
had remained a C corporation and had sold all its assets at fair market
value to an unrelated party that assumed all its liabilities; decreased
by
(2) Any liability of the corporation that would be included in the
amount realized on the sale referred to in paragraph (a)(1) of this
section, but only if the corporation would be allowed a deduction on
payment of the liability; decreased by
(3) The aggregate adjusted bases of the corporation's assets at the
time of the sale referred to in paragraph (a)(1) of this section;
increased or decreased by
(4) The corporation's section 481 adjustments that would be taken
into account on the sale referred to in paragraph (a)(1) of this
section; and increased by
(5) Any recognized built-in loss that would not be allowed as a
deduction under section 382, 383, or 384 on the sale referred to in
paragraph (a)(1) of this section.
(b) Example. The rules of this section are illustrated by the
following example.
Example. Net unrealized built-in gain. (i) (a) X, a calendar
year C corporation using the cash method, elects to become an S
corporation on January 1, 1996. On December 31, 1995, X has assets
and liabilities as follows:
------------------------------------------------------------------------
Assets FMV Basis
------------------------------------------------------------------------
Factory....................................... $500,000 $900,000
Accounts Receivable........................... 300,000 0
Goodwill...................................... 250,000 0
-------------------------
Total................................... 1,050,000 900,000
Liabilities Amount
Mortgage...................................... $200,000
Accounts Payable.............................. 100,000
-------------
Total................................... 300,000 ...........
------------------------------------------------------------------------
(b) Further, X must include a total of $60,000 in taxable income
in 1996, 1997, and 1998 under section 481(a).
(ii) If, on December 31, 1995, X sold all its assets to a third
party that assumed all its liabilities, X's amount realized would be
$1,050,000 ($750,000 cash received+$300,000 liabilities
assumed=$1,050,000). Thus, X's net unrealized built-in gain is
determined as follows:
Amount realized -....................................... $1,050,000
Deduction allowed-...................................... (100,000)
Basis of X's assets--................................... (900,000)
Section 481 adjustments................................. 60,000
---------------
Net unrealized built-in gain-..................... 110,000
Sec. 1.1374-4 Recognized built-in gain or loss.
(a) Sales and exchanges--(1) In general. Section 1374(d)(3) or
1374(d)(4) applies to any gain or loss recognized during the
recognition period in a transaction treated as a sale or exchange for
federal income tax purposes.
(2) Oil and gas property. For purposes of paragraph (a)(1) of this
section, an S corporation's adjusted basis in oil and gas property
equals the sum of the shareholders' adjusted bases in the property as
determined in section 613A(c)(11)(B).
(3) Examples. The rules of this paragraph (a) are illustrated by
the following examples.
Example 1. Production and sale of oil. X is a C corporation that
purchased a working interest in an oil and gas property for $100,000
on July 1, 1993. X elects to become an S corporation effective
January 1, 1996. On that date, the working interest has a fair
market value of $250,000 and an adjusted basis of $50,000, but no
oil has as yet been extracted. In 1996, X begins production of the
working interest, sells oil that it has produced to a refinery for
$75,000, and includes that amount in gross income. Under paragraph
(a)(1) of this section, the $75,000 is not recognized built-in gain
because as of the beginning of the recognition period X held only a
working interest in the oil and gas property (since the oil had not
yet been extracted from the ground), and not the oil itself.
Example 2. Sale of oil and gas property. Y is a C corporation
that elects to become an S corporation effective January 1, 1996. Y
has two shareholders, A and B. A and B each own 50 percent of Y's
stock. In addition, Y owns a royalty interest in an oil and gas
property with a fair market value of $300,000 and an adjusted basis
of $200,000. Under section 613A(c)(11)(B), Y's $200,000 adjusted
basis in the royalty interest is allocated $100,000 to A and
$100,000 to B. During 1996, A and B take depletion deductions with
respect to the royalty interest of $10,000 and $15,000,
respectively. As of January 1, 1997, A and B have a basis in the
royalty interest of $90,000 and $85,000, respectively. On January 1,
1997, Y sells the royalty interest for $250,000. Under paragraph
(a)(1) of this section, Y has gain recognized and recognized built-
in gain of $75,000 ($250,000-($90,000+$85,000)=$75,000) on the sale.
(b) Accrual method rule--(1) Income items. Except as otherwise
provided in this section, any item of income properly taken into
account during the recognition period is recognized built-in gain if
the item would have been properly included in gross income before the
beginning of the recognition period by an accrual method taxpayer
(disregarding any method of accounting for which an election by the
taxpayer must be made unless the taxpayer actually used the method when
it was a C corporation).
(2) Deduction items. Except as otherwise provided in this section,
any item of deduction properly taken into account during the
recognition period is recognized built-in loss if the item would have
been properly allowed as a deduction against gross income before the
beginning of the recognition period to an accrual method taxpayer
(disregarding any method of accounting for which an election by the
taxpayer must be made unless the taxpayer actually used the method when
it was a C corporation). In determining whether an item would have been
properly allowed as a deduction against gross income by an accrual
method taxpayer for purposes of this paragraph, section 461(h)(2)(C)
and Sec. 1.461-4(g) (relating to liabilities for tort, worker's
compensation, breach of contract, violation of law, rebates, refunds,
awards, prizes, jackpots, insurance contracts, warranty contracts,
service contracts, taxes, and other liabilities) do not apply.
(3) Examples. The rules of this paragraph (b) are illustrated by
the following examples.
Example 1. Accounts receivable. X is a C corporation using the
cash method that elects to become an S corporation effective January
1, 1996. On January 1, 1996, X has $50,000 of accounts receivable
for services rendered before that date. On that date, the accounts
receivable have a fair market value of $40,000 and an adjusted basis
of $0. In 1996, X collects $50,000 on the accounts receivable and
includes that amount in gross income. Under paragraph (b)(1) of this
section, the $50,000 included in gross income in 1996 is recognized
built-in gain because it would have been included in gross income
before the beginning of the recognition period if X had been an
accrual method taxpayer. However, if X instead disposes of the
accounts receivable for $45,000 on July 1, 1996, in a transaction
treated as a sale or exchange for federal income tax purposes, X
would have recognized built-in gain of $40,000 on the disposition.
Example 2. Contingent liability. Y is a C corporation using the
cash method that elects to become an S corporation effective January
1, 1996. In 1995, a lawsuit was filed against Y claiming $1,000,000
in damages. In 1996, Y loses the lawsuit, pays a $500,000 judgment,
and properly claims a deduction for that amount. Under paragraph
(b)(2) of this section, the $500,000 deduction allowed in 1996 is
not recognized built-in loss because it would not have been allowed
as a deduction against gross income before the beginning of the
recognition period if Y had been an accrual method taxpayer (even
disregarding section 461(h)(2)(C) and Sec. 1.461-4(g)).
Example 3. Deferred payment liabilities. X is a C corporation
using the cash method that elects to become an S corporation on
January 1, 1996. In 1995, X lost a lawsuit and became obligated to
pay $150,000 in damages. Under section 461(h)(2)(C), this amount is
not allowed as a deduction until X makes payment. In 1996, X makes
payment and properly claims a deduction for the amount of the
payment. Under paragraph (b)(2) of this section, the $150,000
deduction allowed in 1996 is recognized built-in loss because it
would have been allowed as a deduction against gross income before
the beginning of the recognition period if X had been an accrual
method taxpayer (disregarding section 461(h)(2)(C) and Sec. 1.461-
4(g)).
Example 4. Deferred prepayment income. Y is a C corporation
using an accrual method that elects to become an S corporation
effective January 1, 1996. In 1995, Y received $2,500 for services
to be rendered in 1996, and properly elected to include the $2,500
in gross income in 1996 under Rev. Proc. 71-21, 1971-2 C.B. 549 (see
Sec. 601.601(d)(2)(ii)(b) of this chapter). Under paragraph (b)(1)
of this section, the $2,500 included in gross income in 1996 is not
recognized built-in gain because it would not have been included in
gross income before the beginning of the recognition period by an
accrual method taxpayer using the method that Y actually used before
the beginning of the recognition period.
Example 5. Change in method. X is a C corporation using an
accrual method that elects to become an S corporation effective
January 1, 1996. In 1995, X received $5,000 for services to be
rendered in 1996, and properly included the $5,000 in gross income.
In 1996, X properly elects to include the $5,000 in gross income in
1996 under Rev. Proc. 71-21, 1971-2 C.B. 549 (see
Sec. 601.601(d)(2)(ii)(b) of this chapter). As a result of the
change in method of accounting, X has a $5,000 negative section
481(a) adjustment. Under paragraph (b)(1) of this section, the
$5,000 included in gross income in 1996 is recognized built-in gain
because it would have been included in gross income before the
beginning of the recognition period by an accrual method taxpayer
using the method that X actually used before the beginning of the
recognition period. In addition, the $5,000 negative section 481(a)
adjustment is recognized built-in loss because it relates to an item
(the $5,000 X received for services in 1995) attributable to periods
before the beginning of the recognition period under the principles
for determining recognized built-in gain or loss in this section.
See paragraph (d) of this section for rules regarding section 481(a)
adjustments.
(c)-Section 267(a)(2) and 404(a)(5) deductions--(1) Section
267(a)(2). Notwithstanding paragraph (b)(2) of this section, any amount
properly deducted in the recognition period under section 267(a)(2),
relating to payments to related parties, is recognized built-in loss to
the extent--
(i) All events have occurred that establish the fact of the
liability to pay the amount, and the exact amount of the liability can
be determined, as of the beginning of the recognition period; and
(ii) The amount is paid--
(A) In the first two and one-half months of the recognition period;
or
(B) To a related party owning, under the attribution rules of
section 267, less than 5 percent, by voting power and value, of the
corporation's stock, both as of the beginning of the recognition period
and when the amount is paid.
(2) Section 404(a)(5). Notwithstanding paragraph (b)(2) of this
section, any amount properly deducted in the recognition period under
section 404(a)(5), relating to payments for deferred compensation, is
recognized built-in loss to the extent--
(i) All events have occurred that establish the fact of the
liability to pay the amount, and the exact amount of the liability can
be determined, as of the beginning of the recognition period; and
(ii) The amount is not paid to a related party to which section
267(a)(2) applies.
(3) Examples. The rules of this paragraph (c) are illustrated by
the following examples.
Example 1. Fixed annuity. X is a C corporation that elects to
become an S corporation effective January 1, 1996. On December 31,
1995, A is age 60, has provided services to X as an employee for 20
years, and is a vested participant in X's unfunded nonqualified
retirement plan. Under the plan, A receives $1,000 per month upon
retirement until death. The plan provides no additional benefits. A
retires on December 31, 1997, after working for X for 22 years. A at
no time is a shareholder of X. X's deductions under section
404(a)(5) in the recognition period on paying A the $1,000 per month
are recognized built-in loss because all events have occurred that
establish the fact of the liability to pay the amount, and the exact
amount of the liability can be determined, as of the beginning of
the recognition period.
Example 2. Increase in annuity for working beyond 20 years. The
facts are the same as Example 1, except that under the plan A
receives $1,000 per month, plus $100 per month for each year A works
for X beyond 20 years, upon retirement until death. X's deductions
on paying A the $1,000 per month are recognized built-in loss.
However, X's deductions on paying A the $200 per month for the two
years A worked for X beyond 20 years are not recognized built-in
loss because all events have not occurred that establish the fact of
the liability to pay the amount, and the exact amount of the
liability cannot be determined, as of the beginning of the
recognition period.
Example 3. Cost of living adjustment. The facts are the same as
Example 1, except that under the plan A receives $1,000 per month,
plus annual cost of living adjustments, upon retirement until death.
X's deductions under section 404(a)(5) on paying A the $1,000 per
month are recognized built-in loss. However, X's deductions under
section 404(a)(5) on paying A the annual cost of living adjustment
are not recognized built-in loss because all events have not
occurred that establish the fact of the liability to pay the amount,
and the exact amount of the liability cannot be determined, as of
the beginning of the recognition period.
(d) Section 481(a) adjustments--(1) In general. Any section 481(a)
adjustment taken into account in the recognition period is recognized
built-in gain or loss to the extent the adjustment relates to items
attributable to periods before the beginning of the recognition period
under the principles for determining recognized built-in gain or loss
in this section. The principles for determining recognized built-in
gain or loss in this section include, for example, the accrual method
rule under paragraph (b) of this section.
(2) Examples. The rules of this paragraph (d) are illustrated by
the following examples.
Example 1. Omitted item attributable to prerecognition period. X
is a C corporation that elects to become an S corporation effective
January 1, 1996. X improperly capitalizes repair costs and recovers
the costs through depreciation of the related assets. In 1999, X
properly changes to deducting repair costs as they are incurred.
Under section 481(a), the basis of the related assets are reduced by
an amount equal to the excess of the repair costs incurred before
the year of change over the repair costs recovered through
depreciation before the year of change. In addition, X has a
negative section 481(a) adjustment equal to the basis reduction.
Under paragraph (d)(1) of this section, the portion of X's negative
section 481(a) adjustment relating to the repair costs incurred
before the recognition period is recognized built-in loss because
those repair costs are items attributable to periods before the
beginning of the recognition period under the principles for
determining recognized built-in gain or loss in this section.
Example 2. Duplicated item attributable to prerecognition
period. Y is a C corporation that elects to become an S corporation
effective January 1, 1996. Y improperly uses an accrual method
without regard to the economic performance rules of section 461(h)
to account for worker's compensation claims. As a result, Y takes
deductions when claims are filed. In 1999, Y properly changes to an
accrual method with regard to the economic performance rules under
section 461(h)(2)(C) for worker's compensation claims. As a result,
Y takes deductions when claims are paid. The positive section 481(a)
adjustment resulting from the change is equal to the amount of
claims filed, but unpaid, before the year of change. Under paragraph
(b)(2) of this section, the deduction allowed in the recognition
period for claims filed, but unpaid, before the recognition period
is recognized built-in loss because a deduction was allowed for
those claims before the recognition period under an accrual method
without regard to section 461(h)(2)(C). Under paragraph (d)(1) of
this section, the portion of Y's positive section 481(a) adjustment
relating to claims filed, but unpaid, before the recognition period
is recognized built-in gain because those claims are items
attributable to periods before the beginning of the recognition
period under the principles for determining recognized built-in gain
or loss in this section.
(e) Section 995(b)(2) deemed distributions. Any item of income
properly taken into account during the recognition period under section
995(b)(2) is recognized built-in gain if the item results from a DISC
termination or disqualification occurring before the beginning of the
recognition period.
(f) Discharge of indebtedness and bad debts. Any item of income or
deduction properly taken into account during the first year of the
recognition period as discharge of indebtedness income under section
61(a)(12) or as a bad debt deduction under section 166 is recognized
built-in gain or loss if the item arises from a debt owed by or to an S
corporation at the beginning of the recognition period.
(g) Completion of contract. Any item of income properly taken into
account during the recognition period under the completed contract
method (as described in Sec. 1.451-3(d)) where the corporation began
performance of the contract before the beginning of the recognition
period is recognized built-in gain if the item would have been included
in gross income before the beginning of the recognition period under
the percentage of completion method (as described in Sec. 1.451-3(c)).
Any similar item of deduction is recognized built-in loss if the item
would have been allowed as a deduction against gross income before the
beginning of the recognition period under the percentage of completion
method.
(h) Installment method--(1) In general. If a corporation sells an
asset before or during the recognition period and reports the income
from the sale using the installment method under section 453 during or
after the recognition period, that income is subject to tax under
section 1374.
(2) Limitation on amount subject to tax. For purposes of paragraph
(h)(1) of this section, the taxable income limitation under
Sec. 1.1374-2(a)(2) is equal to the amount by which the S corporation's
net recognized built-in gain would have been increased from the year of
the sale to the earlier of the year the income is reported under the
installment method or the last year of the recognition period, assuming
all income from the sale had been reported in the year of the sale and
all provisions of section 1374 applied. For purposes of the preceding
sentence, if the corporation sells the asset before the recognition
period, the income from the sale that is not reported before the
recognition period is treated as having been reported in the first year
of the recognition period.
(3) Rollover rule. If the limitation in paragraph (h)(2) of this
section applies, the excess of the amount reported under the
installment method over the amount subject to tax under the limitation
is treated as if it were reported in the succeeding taxable year(s),
but only for succeeding taxable year(s) in the recognition period. The
amount reported in the succeeding taxable year(s) under the preceding
sentence is reduced to the extent that the amount not subject to tax
under the limitation in paragraph (h)(2) of this section was not
subject to tax because the S corporation had an excess of recognized
built-in loss over recognized built-in gain in the taxable year of the
sale and succeeding taxable year(s) in the recognition period.
(4) Use of losses and section 1374 attributes. If income is
reported under the installment method by an S corporation for a taxable
year after the recognition period and the income is subject to tax
under paragraph (h)(1) of this section, the S corporation's section
1374 attributes may be used to the extent their use is allowed under
all applicable provisions of the Code in determining the section 1374
tax. However, the S corporation's loss recognized for a taxable year
after the recognition period that would have been recognized built-in
loss if it had been recognized in the recognition period may not be
used in determining the section 1374 tax.
(5) Examples. The rules of this paragraph (h)are illustrated by the
following examples.
Example 1. Rollover rule. X is a C corporation that elects to
become an S corporation effective January 1, 1996. On that date, X
sells Blackacre with a basis of $0 and a value of $100,000 in
exchange for a $100,000 note bearing a market rate of interest
payable on January 1, 2001. X does not make the election under
section 453(d) and, therefore, reports the $100,000 gain using the
installment method under section 453. In the year 2001, X has income
of $100,000 on collecting the note, unexpired C year attributes of
$0, recognized built-in loss of $0, current losses of $100,000, and
taxable income of $0. If X had reported the $100,000 gain in 1996,
X's net recognized built-in gain from 1996 through 2001 would have
been $75,000 greater than otherwise. Under paragraph (h) of this
section, X has $75,000 net recognized built-in gain subject to tax
under section 1374. X also must treat the $25,000 excess of the
amount reported, $100,000, over the amount subject to tax, $75,000,
as income reported under the installment method in the succeeding
taxable year(s) in the recognition period, except to the extent X
establishes that the $25,000 was not subject to tax under section
1374 in the year 2001 because X had an excess of recognized built-in
loss over recognized built-in gain in the taxable year of the sale
and succeeding taxable year(s) in the recognition period.
Example 2. Use of losses. Y is a C corporation that elects to
become an S corporation effective January 1, 1996. On that date, Y
sells Whiteacre with a basis of $0 and a value of $250,000 in
exchange for a $250,000 note bearing a market rate of interest
payable on January 1, 2006. Y does not make the election under
section 453(d) and, therefore, reports the $250,000 gain using the
installment method under section 453. In the year 2006, Y has income
of $250,000 on collecting the note, unexpired C year attributes of
$0, loss of $100,000 that would have been recognized built-in loss
if it had been recognized in the recognition period, current losses
of $150,000, and taxable income of $0. If Y had reported the
$250,000 gain in 1996, X's net recognized built-in gain from 1996
through 2005 (that is, during the recognition period) would have
been $225,000 greater than otherwise. Under paragraph (h) of this
section, X has $225,000 net recognized built-in gain subject to tax
under section 1374.
Example 3. Use of section 1374 attribute. Z is a C corporation
that elects to become an S corporation effective January 1, 1996. On
that date, Z sells Greenacre with a basis of $0 and a value of
$500,000 in exchange for a $500,000 note bearing a market rate of
interest payable on January 1, 2011. Z does not make the election
under section 453(d) and, therefore, reports the $500,000 gain using
the installment method under section 453. In the year 2011, Z has
income of $500,000 on collecting the note, loss of $0 that would
have been recognized built-in loss if it had been recognized in the
recognition period, current losses of $0, taxable income of
$500,000, and a minimum tax credit of $60,000 arising in 1995. None
of Z's minimum tax credit is limited under sections 53(c) or 383. If
Z had reported the $500,000 gain in 1996, Z's net recognized built-
in gain from 1996 through 2005 (that is, during the recognition
period) would have been $350,000 greater than otherwise. Under
paragraph (h) of this section, Z has $350,000 net recognized built-
in gain subject to tax under section 1374, a tentative section 1374
tax of $122,500 ($350,000 x .35 = $122,500), and a section 1374
tax after using its minimum tax credit arising in 1995 of $62,250
($122,500 - $60,000 = $62,250).
(i) Partnership interests--(1) In general. If an S corporation owns
a partnership interest at the beginning of the recognition period or
transfers property to a partnership in a transaction to which section
1374(d)(6) applies during the recognition period, the S corporation
determines the effect on net recognized built-in gain from its
distributive share of partnership items as follows--
(i) Step One: Apply the rules of section 1374(d) to the S
corporation's distributive share of partnership items of income, gain,
loss, or deduction included in income or allowed as a deduction under
the rules of subchapter K to determine the extent to which it would
have been treated as recognized built-in gain or loss if the
partnership items had originated in and been taken into account
directly by the S corporation (partnership 1374 items);
(ii) Step Two: Determine the S corporation's net recognized built-
in gain without partnership 1374 items;
(iii) Step Three: Determine the S corporation's net recognized
built-in gain with partnership 1374 items; and
(iv) Step Four: If the amount computed under Step Three (paragraph
(i)(1)(iii) of this section) exceeds the amount computed under Step Two
(paragraph (i)(1)(ii) of this section), the excess (as limited by
paragraph (i)(2)(i) of this section) is the S corporation's partnership
RBIG, and the S corporation's net recognized built-in gain is the sum
of the amount computed under Step Two (paragraph (i)(1)(ii) of this
section) plus the partnership RBIG. If the amount computed under Step
Two (paragraph (i)(1)(ii) of this section) exceeds the amount computed
under Step Three (paragraph (i)(1)(iii) of this section), the excess
(as limited by paragraph (i)(2)(ii) of this section) is the S
corporation's partnership RBIL, and the S corporation's net recognized
built-in gain is the remainder of the amount computed under Step Two
(paragraph (i)(1)(ii) of this section) after subtracting the
partnership RBIL.
(2) Limitations--(i) Partnership RBIG. An S corporation's
partnership RBIG for any taxable year may not exceed the excess (if
any) of the S corporation's RBIG limitation over its partnership RBIG
for prior taxable years. The preceding sentence does not apply if a
corporation forms or avails of a partnership with a principal purpose
of avoiding the tax imposed under section 1374.
(ii) Partnership RBIL. An S corporation's partnership RBIL for any
taxable year may not exceed the excess (if any) of the S corporation's
RBIL limitation over its partnership RBIL for prior taxable years.
(3) Disposition of partnership interest. If an S corporation
disposes of its partnership interest, the amount that may be treated as
recognized built-in gain may not exceed the excess (if any) of the S
corporation's RBIG limitation over its partnership RBIG during the
recognition period. Similarly, the amount that may be treated as
recognized built-in loss may not exceed the excess (if any) of the S
corporation's RBIL limitation over its partnership RBIL during the
recognition period.
(4) RBIG and RBIL limitations--(i) Sale of partnership interest. An
S corporation's RBIG or RBIL limitation is the total of the following--
(A) The amount that would be the amount realized if, at the
beginning of the first day of the recognition period, the corporation
had remained a C corporation and had sold its partnership interest (and
any assets the corporation contributed to the partnership during the
recognition period) at fair market value to an unrelated party;
decreased by
(B) The corporation's adjusted basis in the partnership interest
(and any assets the corporation contributed to the partnership during
the recognition period) at the time of the sale referred to in
paragraph (i)(4)(i)(A) of this section; and increased or decreased by
(C) The corporation's allocable share of the partnership's section
481(a) adjustments at the time of the sale referred to in paragraph
(i)(4)(i)(A) of this section.
(ii) Amounts of limitations. If the result in paragraph (i)(4)(i)
of this section is a positive amount, the S corporation has a RBIG
limitation equal to that amount and a RBIL limitation of $0, but if the
result in paragraph (i)(4)(i) of this section is a negative amount, the
S corporation has a RBIL limitation equal to that amount and a RBIG
limitation of $0.
(5) Small interest exception--(i) In general. Paragraph (i)(1) of
this section does not apply to a taxable year in the recognition period
if the S corporation's partnership interest represents less than 10
percent of the partnership's capital and profits at all times during
the taxable year and prior taxable years in the recognition period, and
the fair market value of the S corporation's partnership interest as of
the beginning of the recognition period is less than $100,000.
(ii) Contributed assets. For purposes of paragraph (i)(5)(i) of
this section, if the S corporation contributes any assets to the
partnership during the recognition period and the S corporation held
the assets as of the beginning of the recognition period, the fair
market value of the S corporation's partnership interest as of the
beginning of the recognition period is determined as if the assets were
contributed to the partnership before the beginning of the recognition
period (using the fair market value of each contributed asset as of the
beginning of the recognition period). The contribution does not affect
whether paragraph (i)(5)(i) of this section applies for taxable years
in the recognition period before the taxable year in which the
contribution was made.
(iii) Anti-abuse rule. Paragraph (i)(5)(i) of this section does not
apply if a corporation forms or avails of a partnership with a
principal purpose of avoiding the tax imposed under section 1374.
(6) Section 704(c) gain or loss. Solely for purposes of section
1374, an S corporation's section 704(c) gain or loss amount with
respect to any asset is not reduced during the recognition period,
except for amounts treated as recognized built-in gain or loss with
respect to that asset under this paragraph.
(7) Disposition of distributed partnership asset. If on the first
day of the recognition period an S corporation holds an interest in a
partnership that holds an asset and during the recognition period the
partnership distributes the asset to the S corporation that thereafter
disposes of the asset, the asset is treated as having been held by the
S corporation on the first day of the recognition period and as having
the fair market value and adjusted basis in the hands of the S
corporation that it had in the hands of the partnership on that day.
(8) Examples. The rules of this paragraph (i) are illustrated by
the following examples.
Example 1. Pre-conversion partnership interest. X is a C
corporation that elects to become an S corporation on January 1,
1996. On that date, X owns a 50 percent interest in partnership P
and P owns (among other assets) Blackacre with a basis of $25,000
and a value of $45,000. In 1996, P buys Whiteacre for $50,000. In
1999, P sells Blackacre for $55,000 and recognizes a gain of $30,000
of which $15,000 is included in X's distributive share. P also sells
Whiteacre in 1999 for $42,000 and recognizes a loss of $8,000 of
which $4,000 is included in X's distributive share. Under this
paragraph and section 1374(d)(3), X's $15,000 gain is presumed to be
recognized built-in gain and thus treated as a partnership 1374
item, but this presumption is rebutted if X establishes that P's
gain would have been only $20,000 ($45,000-$25,000=$20,000) if
Blackacre had been sold on the first day of the recognition period.
In such a case, only X's distributive share of the $20,000 built-in
gain, $10,000, would be treated as a partnership 1374 item. Under
this paragraph and section 1374(d)(4), X's $4,000 loss is not
treated as a partnership 1374 item because P did not hold Whiteacre
on the first day of the recognition period.
Example 2. Post-conversion contribution. Y is a C corporation
that elects to become an S corporation on January 1, 1996. On that
date, Y owns (among other assets) Blackacre with a basis of $100,000
and a value of $200,000. On January 1, 1998, when Blackacre has a
basis of $100,000 and a value of $200,000, Y contributes Blackacre
to partnership P for a 50 percent interest in P. On January 1, 2000,
P sells Blackacre for $300,000 and recognizes a gain of $200,000 on
the sale ($300,000-$100,000=$200,000). P is allocated $100,000 of
the gain under section 704(c), and another $50,000 of the gain for
its fifty percent share of the remainder, for a total of $150,000.
Under this paragraph and section 1374(d)(3), if Y establishes that
P's gain would have been only $100,000 ($200,000-$100,000=$100,000)
if Blackacre had been sold on the first day of the recognition
period, Y would treat only $100,000 as a partnership 1374 item.
Example 3. RBIG limitation of $100,000 or $50,000. X is a C
corporation that elects to become an S corporation on January 1,
1996. On that date, X owns a 50 percent interest in partnership P
with a RBIG limitation of $100,000 and a RBIL limitation of $0. P
owns (among other assets) Blackacre with a basis of $50,000 and a
value of $200,000. In 1996, P sells Blackacre for $200,000 and
recognizes a gain of $150,000 of which $75,000 is included in X's
distributive share and treated as a partnership 1374 item. X's net
recognized built-in gain for 1996 computed without partnership 1374
items is $35,000 and with partnership 1374 items is $110,000. Thus,
X has a partnership RBIG of $75,000 except as limited under
paragraph (i)(2)(i) of this section. Because X's RBIG limitation is
$100,000, X's partnership RBIG of $75,000 is not limited and X's net
recognized built-in gain for the year is $110,000
($35,000+$75,000=$110,000). However, if X had a RBIG limitation of
$50,000 instead of $100,000, X's partnership RBIG would be limited
to $50,000 under paragraph (i)(2)(i) of this section and X's net
recognized built-in gain would be $85,000 ($35,000+$50,000=$85,000).
Example 4. RBIL limitation of $60,000 or $40,000. Y is a C
corporation that elects to become an S corporation on January 1,
1996. On that date, Y owns a 50 percent interest in partnership P
with a RBIG limitation of $0 and a RBIL limitation of $60,000. P
owns (among other assets) Blackacre with a basis of $225,000 and a
value of $125,000. In 1996, P sells Blackacre for $125,000 and
recognizes a loss of $100,000 of which $50,000 is included in Y's
distributive share and treated as a partnership 1374 item. Y's net
recognized built-in gain for 1996 computed without partnership 1374
items is $75,000 and with partnership 1374 items is $25,000. Thus, Y
has a partnership RBIL of $50,000 for the year except as limited
under paragraph (i)(2)(ii) of this section. Because Y's RBIL
limitation is $60,000, Y's partnership RBIL for the year is not
limited and Y's net recognized built-in gain for the year is $25,000
($75,000-$50,000=$25,000). However, if Y had a RBIL limitation of
$40,000 instead of $60,000, Y's partnership RBIL would be limited to
$40,000 under paragraph (i)(2)(ii) of this section and Y's net
recognized built-in gain for the year would be $35,000
($75,000-$40,000=$35,000).
Example 5. RBIG limitation of $0. (i) X is a C corporation that
elects to become an S corporation on January 1, 1996. X owns a 50
percent interest in partnership P with a RBIG limitation of $0 and a
RBIL limitation of $25,000.
(a) In 1996, P's partnership 1374 items are--
(1) Ordinary income of $25,000; and
(2) Capital gain of $75,000.
(b) X itself has--
(1) Recognized built-in ordinary income of $40,000; and
(2) Recognized built-in capital loss of $90,000.
(ii) X's net recognized built-in gain for 1996 computed without
partnership 1374 items is $40,000 and with partnership 1374 items is
$65,000 ($40,000+$25,000=$65,000). Thus, X's partnership RBIG is
$25,000 for the year except as limited under paragraph (i)(2)(i) of
this section. Because X's RBIG limitation is $0, X's partnership
RBIG of $25,000 is limited to $0 and X's net recognized built-in
gain for the year is $40,000.
Example 6. RBIL limitation of $0. (i) Y is a C corporation that
elects to become an S corporation on January 1, 1996. Y owns a 50
percent interest in partnership P with a RBIG limitation of $60,000
and a RBIL limitation of $0.
(a) In 1996, P's partnership 1374 items are---
(1) Ordinary income of $25,000; and
(2) Capital loss of $90,000.
(b) Y itself has--
(1) recognized built-in ordinary income of $40,000; and
(2) recognized built-in capital gain of $75,000.
(ii) Y's net recognized built-in gain for 1996 computed without
partnership 1374 items is $115,000 ($40,000+$75,000=$115,000) and
with partnership 1374 items is $65,000 ($40,000+$25,000=$65,000).
Thus, Y's partnership RBIL is $50,000 for the year except as limited
under paragraph (i)(2)(ii) of this section. Because Y's RBIL
limitation is $0, Y's partnership RBIL of $50,000 is limited to $0
and Y's net recognized built-in gain is $115,000.
Example 7. Disposition of partnership interest. X is a C
corporation that elects to become an S corporation on January 1,
1996. On that date, X owns a 50 percent interest in partnership P
with a RBIG limitation of $200,000 and a RBIL limitation of $0. P
owns (among other assets) Blackacre with a basis of $20,000 and a
value of $140,000. In 1996, P sells Blackacre for $140,000 and
recognizes a gain of $120,000 of which $60,000 is included in X's
distributive share and treated as a partnership 1374 item. X's net
recognized built-in gain for 1996 computed without partnership 1374
items is $95,000 and with partnership 1374 items is $155,000. Thus,
X has a partnership RBIG of $60,000. In 1999, X sells its entire
interest in P for $350,000 and recognizes a gain of $250,000. Under
paragraph (i)(3) of this section, X's recognized built-in gain on
the sale is limited by its RBIG limitation to $140,000
($200,000-$60,000=$140,000).
Example 8. Section 704(c) case. Y is a C corporation that elects
to become an S corporation on January 1, 1996. On that date, Y
contributes Asset 1, 5-year property with a value of $40,000 and a
basis of $0, and an unrelated party contributes $40,000 in cash,
each for a 50 percent interest in partnership P. The partnership
adopts the traditional method under Sec. 1.704-3(b). If P sold Asset
1 for $40,000 immediately after it was contributed by Y, P's $40,000
gain would be allocated to Y under section 704(c). Instead, Asset 1
is sold by P in 1999 for $36,000 and P recognizes gain of $36,000
($36,000-$0=$36,000) on the sale. However, because book depreciation
of $8,000 per year has been taken on Asset 1 in 1996, 1997, and
1998, Y is allocated only $16,000 of P's $36,000 gain
($40,000-(3 x $8,000)=($16,000-$0)=$16,000) under section 704(c).
The remaining $20,000 of P's $36,000 gain ($36,000-$16,000=$20,000)
is allocated 50 percent to each partner under section 704(b). Thus,
a total of $26,000 ($16,000+$10,000=$26,000) of P's $36,000 gain is
allocated to Y. However, under paragraph (i)(6) of this section, Y
treats $36,000 as a partnership 1374 item on P's sale of Asset 1.
Example 9. Disposition of distributed partnership asset. X is a
C corporation that elects to become an S corporation on January 1,
1996. On that date, X owns a fifty percent interest in partnership P
and P owns (among other assets) Blackacre with a basis of $20,000
and a value of $40,000. On January 1, 1998, P distributes Blackacre
to X, when Blackacre has a basis of $20,000 and a value of $50,000.
Under section 732(a)(1), X has a transferred basis of $20,000 in
Blackacre. On January 1, 1999, X sells Blackacre for $60,000 and
recognizes a gain of $40,000. Under paragraph (i)(7) of this section
and section 1374(d)(3), X has recognized built-in gain from the sale
of $20,000, the amount of built-in gain in Blackacre on the first
day of the recognition period.
Sec. 1.1374-5 Loss carryforwards.
(a) In general. The loss carryforwards allowed as deductions
against net recognized built-in gain under section 1374(b)(2) are
allowed only to the extent their use is allowed under the rules
applying to C corporations. Any other loss carryforwards, such as
charitable contribution carryforwards under section 170(d)(2), are not
allowed as deductions against net recognized built-in gain.
(b) Example. The rules of this section are illustrated by the
following example.
Example. Section 382 limitation. X is a C corporation that has
an ownership change under section 382(g)(1) on January 1, 1994. On
that date, X has a fair market value of $500,000, NOL carryforwards
of $400,000, and a net unrealized built-in gain under section
382(h)(3)(A) of $0. Assume X's section 382 limitation under section
382(b)(1) is $40,000. X elects to become an S corporation on January
1, 1998. On that date, X has NOL carryforwards of $240,000 (having
used $160,000 of its pre-change net operating losses in its 4
preceding taxable years) and a section 1374 net unrealized built-in
gain of $250,000. In 1998, X has net recognized built-in gain of
$100,000. X may use $40,000 of its NOL carryforwards as a deduction
against its $100,000 net recognized built-in gain, because X's
section 382 limitation is $40,000.
Sec. 1.1374-6 Credits and credit carryforwards.
(a) In general. The credits and credit carryforwards allowed as
credits against the section 1374 tax under section 1374(b)(3) are
allowed only to the extent their use is allowed under the rules
applying to C corporations. Any other credits or credit carryforwards,
such as foreign tax credits under section 901, are not allowed as
credits against the section 1374 tax.
(b) Limitations. The amount of business credit carryforwards and
minimum tax credit allowed against the section 1374 tax are subject to
the limitations described in section 38(c) and section 53(c),
respectively, as modified by this paragraph. The tentative tax
determined under paragraph (a)(3) of Sec. 1.1374-1 is treated as the
regular tax liability described in sections 38(c)(1) and 53(c)(1), and
as the net income tax and net regular tax liability described in
section 38(c)(1). The tentative minimum tax described in section 55(b)
is determined using the rate of tax applicable to corporations and
without regard to any alternative minimum tax foreign tax credit
described in that section and by treating the net recognized built-in
gain determined under Sec. 1.1374-2, modified to take into account the
adjustments of sections 56 and 58 applicable to corporations and the
preferences of section 57, as the alternative minimum taxable income
described in section 55(b)(2).
(c) Examples. The rules of this section are illustrated by the
following examples.
Example 1. Business credit carryforward. X is a C corporation
that elects to become an S corporation effective January 1, 1996. On
that date, X has a $500,000 business credit carryforward from a C
year and Asset #1 with a fair market value of $400,000, a basis for
regular tax purposes of $95,000, and a basis for alternative minimum
tax purposes of $150,000. In 1996, X has net recognized built-in
gain of $305,000 from selling Asset #1 for $400,000. Thus, X's
tentative tax under paragraph (a)(3) of Sec. 1.1374-1 and regular
tax liability under paragraph (b) of this section is $106,750
($400,000-$95,000=$305,000 x .35= $106,750, assuming a 35 percent
tax rate). Also, X's tentative minimum tax determined under
paragraph (b) of this section is $47,000
[$400,000-$150,000=$250,000-$15,000 ($40,000 corporate exemption
amount -$25,000 phase-out=$15,000)=$235,000 x .20=$47,000,
assuming a 20 percent tax rate]. Thus, the business credit
limitation under section 38(c) is $59,750 [$106,750-$47,000 (the
greater of $47,000 or $20,438 (.25 x $81,750
($106,750-$25,000=$81,750))) = $59,750]. As a result, X's section
1374 tax is $47,000 ($106,750-$59,750= $47,000) for 1996 and X has
$440,250 ($500,000-$59,750 = $440,250) of business credit
carryforwards for succeeding taxable years.
Example 2. Minimum tax credit. Y is a C corporation that elects
to become an S corporation effective January 1, 1996. On that date,
Asset#1 has a fair market value of $5,000,000, a basis for regular
tax purposes of $4,000,000, and a basis for alternative minimum tax
purposes of $4,750,000. Y also has a minimum tax credit of $310,000
from 1995. Y has no other assets, no net operating or capital loss
carryforwards, and no business credit carryforwards. In 1996, Y's
only transaction is the sale of Asset 1 for $5,000,000.
Therefore, Y has net recognized built-in gain in 1996 of $1,000,000
($5,000,000-$4,000,000=$1,000,000) and a tentative tax under
paragraph (a)(3) of Sec. 1.1374-1 of $350,000
($1,000,000 x .35=$350,000, assuming a 35 percent tax rate). Also,
Y's tentative minimum tax determined under paragraph (b) of this
section is $47,000 [$5,000,000-$4,750,000=$250,000-$15,000 ($40,000
corporate exemption amount -$25,000 phase-out = $15,000) =
$235,000 x .20 = $47,000, assuming a 20 percent tax rate]. Thus, Y
may use its minimum tax credit in the amount of $303,000
($350,000-$47,000=$303,000) to offset its section 1374 tentative
tax. As a result, Y's section 1374 tax is $47,000
($350,000-$303,000=$47,000) in 1996 and Y has a minimum tax credit
attributable to years for which Y was a C corporation of $7,000
($310,000-$303,000=$7,000).
Sec. 1.1374-7 Inventory.
(a) Valuation. The fair market value of the inventory of an S
corporation on the first day of the recognition period equals the
amount that a willing buyer would pay a willing seller for the
inventory in a purchase of all the S corporation's assets by a buyer
that expects to continue to operate the S corporation's business. For
purposes of the preceding sentence, the buyer and seller are presumed
not to be under any compulsion to buy or sell and to have reasonable
knowledge of all relevant facts.
(b) Identity of dispositions. The inventory method used by an S
corporation for tax purposes must be used to identify whether the
inventory it disposes of during the recognition period is inventory it
held on the first day of that period. Thus, a corporation using the
LIFO method does not dispose of inventory it held on the first day of
the recognition period unless the carrying value of its inventory for a
taxable year during that period is less than the carrying value of its
inventory on the first day of the recognition period (determined using
the LIFO method as described in section 472). However, if a corporation
changes its method of accounting for inventory (for example, from the
FIFO method to the LIFO method or from the LIFO method to the FIFO
method) with a principal purpose of avoiding the tax imposed under
section 1374, it must use its former method to identify its
dispositions of inventory.
Sec. 1.1374-8 Section 1374(d)(8) transactions.
(a)-In general. If any S corporation acquires any asset in a
transaction in which the S corporation's basis in the asset is
determined (in whole or in part) by reference to a C corporation's
basis in the assets (or any other property) (a section 1374(d)(8)
transaction), section 1374 applies to the net recognized built-in gain
attributable to the assets acquired in any section 1374(d)(8)
transaction.
(b) Separate determination of tax. For purposes of the tax imposed
under section 1374(d)(8), a separate determination of tax is made with
respect to the assets the S corporation acquires in one section
1374(d)(8) transaction from the assets the S corporation acquires in
another section 1374(d)(8) transaction and from the assets the
corporation held when it became an S corporation. Thus, an S
corporation's section 1374 attributes when it became an S corporation
may only be used to reduce the section 1374 tax imposed on dispositions
of assets the S corporation held at that time. Similarly, an S
corporation's section 1374 attributes acquired in a section 1374(d)(8)
transaction may only be used to reduce a section 1374 tax imposed on
dispositions of assets the S corporation acquired in the same
transaction.
(c)-Taxable income limitation. For purposes of paragraph (a) of
this section, an S corporation's taxable income limitation under
Sec. 1.1374-2(a)(2) for any taxable year is allocated between or among
each of the S corporation's separate determinations of net recognized
built-in gain for that year (determined without regard to the taxable
income limitation) based on the ratio of each of those determinations
to the sum of all of those determinations.
(d) Examples. The rules of this section are illustrated by the
following examples.
Example 1. Separate determination of tax. (i) X is a C
corporation that elected to become an S corporation effective
January 1, 1986 (before section 1374 was amended in the Tax Reform
Act of 1986). X has a net operating loss carryforward of $20,000
arising in 1985 when X was a C corporation. On January 1, 1996, Y
(an unrelated C corporation) merges into X in a transaction to which
section 368(a)(1)(A) applies. Y has no loss carryforwards, credits,
or credit carryforwards. The assets X acquired from Y are subject to
tax under section 1374 and have a net unrealized built-in gain of
$150,000.
(ii) In 1996, X has a pre-limitation amount of $50,000 on
dispositions of assets acquired from Y and a taxable income
limitation of $100,000 (because only one group of assets is subject
to section 1374, there is no allocation of the taxable income
limitation). As a result, X has a net recognized built-in gain on
those assets of $50,000. X's $20,000 net operating loss carryforward
may not be used as a deduction against its $50,000 net recognized
built-in gain on the assets X acquired from Y. Therefore, X has a
section 1374 tax of $17,500 ($50,000 x .35 = $17,500, assuming a
35 percent tax rate) for its 1996 taxable year.
Example 2. Allocation of taxable income limitation. (i) Y is a C
corporation that elects to become an S corporation effective January
1, 1996. The assets Y holds when it becomes an S corporation have a
net unrealized built-in gain of $5,000. Y has no loss carryforwards,
credits, or credit carryforwards. On January 1, 1997, Z (an
unrelated C corporation) merges into Y in a transaction to which
section 368(a)(1)(A) applies. Z has no loss carryforwards, credits,
or credit carryforwards. The assets Y acquired from Z are subject to
tax under section 1374 and have a net unrealized built-in gain of
$80,000.
(ii) In 1997, Y has a pre-limitation amount on the assets it
held when it became an S corporation of $15,000, a pre-limitation
amount on the assets Y acquired from Z of $15,000, and a taxable
income limitation of $10,000. However, because the assets Y held on
becoming an S corporation have a net unrealized built-in gain of
$5,000, its net recognized built-in gain on those assets is limited
to $5,000 before taking into account the taxable income limitation.
Y's taxable income limitation of $10,000 is allocated between the
assets Y held on becoming an S corporation and the assets Y acquired
from Z for purposes of determining the net recognized built-in gain
from each pool of assets. Thus, Y's net recognized built-in gain on
the assets Y held on becoming an S corporation is $2,500 [$10,000
x ($5,000/$20,000) = $2,500]. Y's net recognized built-in gain on
the assets Y acquired from Z is $7,500 [$10,000 x ($15,000/
$20,000) = $7,500]. Therefore, Y has a section 1374 tax of $3,500
[($2,500 + $7,500) x .35 = $3,500, assuming a 35 percent tax rate]
for its 1997 taxable year.
Sec. 1.1374-9 Anti-stuffing rule.-
If a corporation acquires an asset before or during the recognition
period with a principal purpose of avoiding the tax imposed under
section 1374, the asset and any loss, deduction, loss carryforward,
credit, or credit carryforward attributable to the asset is disregarded
in determining the S corporation's pre-limitation amount, taxable
income limitation, net unrealized built-in gain limitation, deductions
against net recognized built-in gain, and credits against the section
1374 tax.
Sec. 1.1374-10 Effective date and additional rules.
(a) In general. Sections 1.1374-1 through 1.1374-9 apply for
taxable years ending on or after December 27, 1994, but only in cases
where the S corporation's return for the taxable year is filed pursuant
to an S election or a section 1374(d)(8) transaction occurring on or
after December 27, 1994.
(b) Additional rules. This paragraph (b) provides rules applicable
to certain S corporations, assets, or transactions to which
Secs. 1.1374-1 through 1.1374-9 do not apply.
(1) Certain transfers to partnerships. If a corporation transfers
an asset to a partnership in a transaction to which section 721(a)
applies and the transfer is made in contemplation of an S election or
during the recognition period, section 1374 applies on a disposition of
the asset by the partnership as if the S corporation had disposed of
the asset itself. This paragraph (b)(1) applies as of the effective
date of section 1374, unless the recognition period with respect to the
contributed asset is pursuant to an S election or a section 1374(d)(8)
transaction occurring on or after December 27, 1994.
(2) Certain inventory dispositions. For purposes of section
1374(d)(2)(A), the inventory method used by the taxpayer for tax
purposes (FIFO, LIFO, etc.) must be used to identify whether goods
disposed of following conversion to S corporation status were held by
the corporation at the time of conversion. Thus, for example, a
corporation using the LIFO inventory method will not be subject to the
built-in gain tax with respect to sales of inventory except to the
extent that a LIFO layer existing prior to the beginning of the first
taxable year as an S corporation is invaded after the beginning of that
year. This paragraph (b)(2) applies as of the effective date of section
1374, unless the recognition period with respect to the inventory is
pursuant to an S election or a section 1374(d)(8) transaction occurring
on or after December 27, 1994.
(3) Certain contributions of built-in loss assets. If a built-in
loss asset (that is, an asset with an adjusted tax basis in excess of
its fair market value) is contributed to a corporation within 2 years
before the earlier of the beginning of its first taxable year as an S
corporation, or the filing of its S election, the loss inherent in the
asset will not reduce net unrealized built-in gain, as defined in
section 1374(d)(1), unless the taxpayer demonstrates a clear and
substantial relationship between the contributed property and the
conduct of the corporation's current or future business enterprises.
This paragraph (b)(3) applies as of the effective date of section 1374,
unless the recognition period with respect to the contributed asset is
pursuant to an S election or a section 1374(d)(8) transaction occurring
on or after December 27, 1994.
(4) Certain installment sales--(i) In general. If a taxpayer sells
an asset either prior to or during the recognition period and
recognizes income either during or after the recognition period from
the sale under the installment method, the income will, when
recognized, be taxed under section 1374 to the extent it would have
been so taxed in prior taxable years if the selling corporation had
made the election under section 453(d) not to report the income under
the installment method. For purposes of determining the extent to which
the income would have been subject to tax if the section 453(d)
election had not been made, the taxable income limitation of section
1374(d)(2)(A)(ii) and the built-in gain carryover rule of section
1374(d)(2)(B) will be taken into account. This paragraph (b)(4) applies
for installment sales occurring on or after March 26, 1990, and before
December 27, 1994.
(ii) Examples. The rules of this paragraph (b)(4) are illustrated
by the following examples.
Example 1. In year 1 of the recognition period under section
1374, a corporation realizes a gain of $100,000 on the sale of an
asset with built-in gain. The corporation is to receive full payment
for the asset in year 11. Because the corporation does not make an
election under section 453(d), all $100,000 of the gain from the
sale is reported under the installment method in year 11. If the
corporation had made an election under section 453(d) with respect
to the sale, the gain would have been recognized in year 1 and,
taking into account the corporation's income and gains from other
sources, application of the taxable income limitation of section
1374(d)(2)(A)(ii) and the built-in gain carryover rule of section
1374(d)(2)(B) would have resulted in $40,000 of the gain being
subject to tax during the recognition period under section 1374.
Therefore, $40,000 of the gain recognized in year 11 is subject to
tax under section 1374.
Example 2. In year 1 of the recognition period under section
1374, a corporation realizes a gain of $100,000 on the sale of an
asset with built-in gain. The corporation is to receive full payment
for the asset in year 6. Because the corporation does not make an
election under section 453(d), all $100,000 of the gain from the
sale is reported under the installment method in year 6. If the
corporation had made an election under section 453(d) with respect
to the sale, the gain would have been recognized in year 1 and,
taking into account the corporation's income and gains from other
sources, application of the taxable income limitation of section
1374(d)(2)(A)(ii) and the built-in gain carryover rule of section
1374(d)(2)(B) would have resulted in all of the gain being subjected
to tax under section 1374 in years 1 through 5. Therefore,
notwithstanding that the taxable income limitation of section
1374(d)(2)(A)(ii) might otherwise limit the taxation of the gain
recognized in year 6, the entire $100,000 of gain will be subject to
tax under section 1374 when it is recognized in year 6.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: November 23, 1994.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 94-31429 Filed 12-23-94; 8:45 am]
BILLING CODE 4830-01-U
