[Federal Register Volume 63, Number 159 (Tuesday, August 18, 1998)]
[Proposed Rules]
[Pages 44181-44191]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-21639]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-209446-82]
RIN 1545-AT52
Pass Through of Items of an S Corporation to its Shareholders
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations relating to the
pass through of items of an S corporation to its shareholders, the
adjustments to the basis of stock of the shareholders, and the
treatment of distributions by an S corporation. Changes to the
applicable law were made by the Subchapter S Revision Act of 1982, the
Tax Reform Act of 1984, the Tax Reform Act of 1986, the Technical and
Miscellaneous Revenue Act of 1988, and the Small Business Job
Protection Act of 1996. These proposed regulations provide the public
with guidance needed to comply with the applicable law and will affect
S corporations and their shareholders. This document also contains a
notice of public hearing on these proposed regulations.
DATES: Written comments must be received by November 16, 1998. Outlines
of topics to be discussed at the public hearing scheduled for Tuesday,
December 15, 1998, at 10 a.m. must be received by Tuesday, November 24,
1998.
ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209446-82), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered between the
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-209446-82), Courier's
Desk, Internal Revenue Service, 1111 Constitution Avenue, NW.,
Washington, DC. Alternatively, taxpayers may submit comments
electronically via the Internet by selecting the ``Tax Regs'' option on
the IRS Home Page, or by submitting comments directly to the IRS
Internet site at http://www.irs.ustreas.gov/prod/tax__regs/
comments.html. The public hearing will be held in room 2615, Internal
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations under
section 1366, Deane M. Burke or Terri A. Belanger, (202) 622-3070;
concerning the regulations under sections 1367 and 1368, Brenda
Stewart, (202) 622-3120; concerning submissions and the hearing,
Michael Slaughter, (202) 622-7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in this notice of proposed
rulemaking has been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)). Comments on the collection of information should be
sent to the Office of Management and Budget, Attn: Desk Officer for the
Department of the Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503, with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC
20224. Comments on the collection of information should be received by
October 19, 1998. Comments are specifically requested concerning:
Whether the proposed collection of information is necessary for the
proper performance of the functions of the Internal Revenue Service,
including whether the information will have practical utility;
The accuracy of the estimated burden associated with the proposed
collection of information (see below);
How the quality, utility, and clarity of the information to be
collected may be enhanced;
How the burden of complying with the proposed collection of
information may be minimized, including through the application of
automated collection techniques or other forms of information
technology; and
Estimates of capital or start-up cost and costs of operation,
maintenance, and purchase of service to provide information.
[[Page 44182]]
The collection of information in this proposed regulation is in
Sec. 1.1366-1. This information is required in order for a shareholder
in an S corporation to properly compute its tax liability. This
information will be used to determine whether the amount of tax has
been computed correctly. Responses to this collection of information
are mandatory for shareholders in S corporations. The likely
respondents are individuals and businesses or other for-profit
institutions.
The reporting burden contained in Sec. 1.1366-1 is reflected in the
burden of Form 1040, U.S. Individual Income Tax Return, and Form 1120S,
U.S. Income Tax Return for an S Corporation.
Newly designated Sec. 1.1367-1(g) does not impose a new collection
of information. The election in newly designated Sec. 1.1367-1(g),
previously contained in Sec. 1.1367-1(f), was approved by OMB under OMB
Control Number 1545-1139.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid control number.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Background
This document contains proposed amendments to the Income Tax
Regulations (26 CFR part 1) under sections 1366, 1367, and 1368 of the
Internal Revenue Code of 1986 (Code). Sections 1366, 1367, and 1368
were added by the Subchapter S Revision Act of 1982 (1982 Act) (Public
Law 97-354, 96 Stat. 1669, 1697). Section 1366 was amended by the Tax
Reform Act of 1984 (Public Law 98-369, 98 Stat. 844, 985), the Tax
Reform Act of 1986 (Public Law 99-514, 100 Stat. 2085, 2277, 2343), the
Technical and Miscellaneous Revenue Act of 1988 (Public Law 100-647,
102 Stat. 3406), and the Small Business Job Protection Act of 1996
(1996 Act) (Public Law 104-188, 110 Stat. 1755).
Sections 1367 and 1368 were amended by the Technical Corrections
Act of 1982 (Public Law 97-448, 96 Stat. 2365, 2399-2400), the Tax
Reform Act of 1984 (Public Law 98-369), and the Tax Reform Act of 1986
(Public Law 99-514). Final regulations conforming the regulations to
these amendments were published in the Federal Register on January 3,
1994. The proposed amendments would conform the regulations to
amendments made to sections 1367 and 1368 by the 1996 Act.
Explanation of Provisions
Determination of Shareholder's Tax Liability
Under section 1363, an S corporation generally computes its taxable
income in the same manner as an individual, subject to certain
modifications. Thus, for example, an S corporation is not entitled to a
dividends received deduction under section 243.
Section 1366(a)(1) and the proposed regulations provide rules under
which a shareholder of an S corporation takes into account the
shareholder's pro rata share, as defined under section 1377, of the
corporation's items of income, loss, deduction, or credit. A
shareholder's share of these items is determined for the shareholder's
taxable year in which the taxable year of the S corporation ends. If a
shareholder dies before the end of the corporation's taxable year, the
shareholder's pro rata share of these items is taken into account in
the shareholder's final tax return. If a shareholder is an estate or
trust, and the estate or trust terminates before the end of the
corporation's taxable year, the shareholder's pro rata share of these
items is taken into account in the shareholder's final tax return.
In the case of most items that must be separately stated by an S
corporation, the provisions by which an S corporation accounts to its
shareholders for tax purposes under section 1366 closely parallel the
provisions for a partnership accounting to its partners under section
702. The proposed regulations provide rules outlining this general
pass-through scheme for S corporations to their shareholders.
Under section 1366(a)(1)(A), an S corporation's items of income,
loss, deduction, and credit must be separately stated if their separate
treatment on any shareholder's income tax return could affect the
shareholder's tax liability. These separately stated items include, but
are not limited to, short-term and long-term capital gain or loss,
other items that may be relevant to the shareholder in the computation
of the shareholder's tax liability resulting from the sale or exchange
of capital assets or assets described in section 1231(b), tax-exempt
income, section 170(c) charitable contributions, certain foreign taxes,
items used in determining certain credits, certain itemized deductions,
items of portfolio income or loss and related expenses under section
469, and the corporation's adjustments in computing alternative minimum
tax under sections 56 and 58 and any items of tax preference under
section 57. All items of income, loss, and deduction that are not
separately stated must be combined to compute the nonseparately
computed income or loss of the S corporation under section
1366(a)(1)(B).
Identification of Tax-exempt Income
The proposed regulations define tax-exempt income as income that is
permanently excludable from the gross income of an S corporation and
its shareholders in all circumstances in which the relevant Code
section applies. For example, tax-exempt income includes proceeds of
life insurance contracts that are payable by reason of an individual's
death and that are excludable from gross income under section 101, and
interest on state and local bonds that is excludable from gross income
under section 103.
However, income that is excludible from gross income pursuant to a
provision of the Code that might have the effect of deferring income to
the S corporation or its shareholders is not tax-exempt income. For
example, income from improvements by a lessee on a lessor's property
that is excludible from gross income under section 109 is not tax-
exempt income because, for example, the lessor would recognize the
value of the improvements as income when the property is sold by the
lessor. Similarly, income from the discharge of indebtedness that is
excludible from gross income under section 108 does not constitute tax-
exempt income because the attribute reduction provisions of section
108(b) have the effect of deferring the recognition of such income in
some circumstances while permanently excluding it, in whole or in part,
in other circumstances.
Treasury and the IRS believe that Congress intended that section
108 would allow taxpayers to avoid the immediate adverse tax
consequences that could otherwise result from the inclusion of income
from discharge of indebtedness. The deferral of income excluded under
section 108(a)(1) by reducing the basis of property or other tax
attributes is one method of achieving this purpose. For example, the
legislative history of section 108(a)(1)(D) provides that the exclusion
from gross income for discharge of qualified real property business
indebtedness income simply defers income to the shareholders of an S
corporation and does not result in an adjustment to the basis of the
stock of the corporation. See H.R. Rep. No. 111, 103d Cong., 1st Sess.
625 (1993); H.R. Conf. Rep. No. 213, 103d Cong., 1st Sess. 555 (1993).
Other specific rules apply to the discharge of indebtedness of an S
[[Page 44183]]
corporation. See section 108(d)(7). The legislative history of section
108(d)(7)(A) provides that in order to treat all shareholders in the
same manner, the exclusion of income arising from discharge of
indebtedness and the corresponding reductions in tax attributes
(including losses that are not allowed by reason of any shareholder's
basis limitation) are made at the corporate level. See H.R. Rep. No.
432, 98th Cong., 2d Sess., pt. 2, 1640-41 (1984). Furthermore, the
legislative history of section 108 indicates that any cancellation of
indebtedness income remaining after the reduction of the S
corporation's tax attributes does not result in income or have other
tax consequences. See S. Rep. No. 1035, 96th Cong., 2d Sess. 2 (1980).
Thus, the absence of a stock basis increase for income of an S
corporation excluded under section 108(a) is consistent with the
legislative history of section 108 (and its purpose to avoid the
immediate adverse tax consequences that could otherwise result from the
inclusion of income from discharge of indebtedness) and the specific
rules that apply to the discharge of indebtedness income of S
corporations.
Finally, even though a partner is entitled to an increase in the
basis of the partner's interest for income from discharge of
indebtedness of a partnership that is excluded under section 108(a), a
shareholder of an S corporation is not entitled to an increase in stock
basis under similar circumstances. This difference is appropriate
because the principal provisions of section 108 are applied at the
corporate level in the case of an S corporation but at the partner
level in the case of a partnership. See section 108(d)(6). A basis
increase in the partner's interest in the partnership is necessary in
order to apply these provisions at the partner level because, for
example, the income may properly be excluded by some partners and
included by others, and in order to offset the basis reduction that
will occur under section 752(b) as the result of the deemed
distribution arising out of the decrease in the partner's share of
partnership liabilities. These considerations are not present in the
case of an S corporation.
Accordingly, Treasury and the IRS believe that income excluded by
an S corporation pursuant to section 108 is not tax-exempt income for
purposes of section 1366 whether or not the application of section 108
in a particular circumstance results in the permanent exclusion, in
whole or in part, of income. See also Nelson v. Commissioner, 110 T.C.
114 (1998).
Pass Through of Character and Gross Income
Consistent with the adoption of parallel operational rules between
sections 702 and 1366, the items of an S corporation are generally
characterized in the same manner that partnership items are
characterized. The partnership rules provide that the character of a
partnership item reported by a partner is generally determined at the
entity level under a conduit rule. The proposed regulations provide a
similar conduit rule under which the character of a corporate item that
is passed through to and reported by a shareholder is generally
determined at the corporate level. However, exceptions to the general
rule apply for contributions of either noncapital gain property or
capital loss property if an S corporation is formed or availed of by
any shareholder or shareholders for a principal purpose of selling or
exchanging the property to alter the character of the gain or loss. The
character of the gain or loss will be the same as it would have been if
the property were in the hands of the shareholder or shareholders at
the time of the sale or exchange.
Section 1366(c), like section 702(c), provides for the pass through
of gross income to a shareholder for federal income tax purposes. Thus,
where it is necessary to determine the amount or character of the gross
income of a shareholder, the shareholder's gross income includes the
shareholder's pro rata share of the gross income of the S corporation.
This amount is the amount of gross income of the corporation used to
derive the shareholder's pro rata share of S corporation taxable income
or loss. See Rev. Rul. 87-121 (1987-2 C.B. 217).
Limitation on Losses and Deductions
In general, section 1366(d)(1) and the proposed regulations provide
that the amount of losses and deductions taken into account by a
shareholder for any taxable year may not exceed the sum of the
shareholder's adjusted bases in the stock of the S corporation and in
any indebtedness of the S corporation to the shareholder. Moreover, any
loss or deduction for the taxable year not taken into account by a
shareholder by reason of the basis limitation rule is treated under
section 1366(d)(2) and the proposed regulations as incurred by the
corporation with respect to that shareholder in the corporation's first
succeeding taxable year, and subsequent taxable years. For purposes of
the basis limitation rule in section 1366(d), the basis of stock
acquired by gift is the basis of the stock for determining loss under
section 1015. The basis rules under section 1015 operate to minimize
the loss recognized by a donee upon the sale or exchange of the loss
stock acquired by gift. Therefore, the basis limitation rule limits a
donee shareholder's pass-through items of loss or deduction to the
basis used for determining loss upon the sale or exchange of the stock
acquired by gift.
The proposed regulations provide that if a shareholder's aggregate
pro rata share of the items of loss and deduction exceeds the sum of
the shareholder's adjusted bases in stock and debt, the limitation on
losses and deductions must be allocated among the shareholder's pro
rata share of each loss or deduction. This allocation is determined by
taking the proportion that each loss or deduction bears to the total of
all losses and deductions, including those previously disallowed.
Also under the proposed regulations, a shareholder's disallowed
losses and deductions are personal to that shareholder and cannot be
transferred. Moreover, if a shareholder transfers all of the
shareholder's stock in an S corporation, any disallowed loss or
deduction is permanently disallowed.
The proposed regulations provide special rules for a shareholder to
carry over disallowed losses and deductions to any post-termination
transition period. Those special rules generally follow the limitation
rules provided in the proposed regulations for years in which the S
corporation election is in effect, except that the amount of losses and
deductions that may be taken into account is limited to the adjusted
basis of the shareholder's stock (rather than stock and debt) in the
corporation determined at the close of the post-termination transition
period. See section 1366(d)(3)(B).
Finally, the proposed regulations provide rules regarding the
carryover of disallowed losses and deductions in the event of certain
corporate reorganizations. If a corporation acquires, in a transaction
to which section 381(a) applies, the assets of another S corporation
for which disallowed losses and deductions would carry over with
respect to a shareholder under section 1366(d)(2), except for the
reorganization, the losses and deductions will be available to that
shareholder. Where the acquiring corporation is an S corporation, the
losses and deductions will be treated as incurred by the acquiring S
corporation with respect to that shareholder. Where the acquiring
corporation is a C corporation, the proposed regulations provide
special rules for a shareholder
[[Page 44184]]
to carry over disallowed losses and deductions to any post-termination
transition period under section 1377 if the shareholder is a
shareholder of the C corporation after the transaction.
In the case of an S corporation that transfers a part of its assets
constituting an active trade or business to another corporation in a
transaction to which section 368(a)(1)(D) applies, and immediately
thereafter the stock and securities of the controlled corporation are
distributed in a distribution or exchange to which section 355 (or so
much of section 356 as relates to section 355) applies, any disallowed
loss or deduction with respect to a shareholder of the distributing
corporation immediately before the transaction is allocated between the
distributing corporation and the controlled corporation with respect to
the shareholder. This allocation is made in proportion to the fair
market value of the shareholder's stock of the distributing corporation
and the shareholder's stock of the controlled corporation, determined
immediately after the transaction.
Treatment of Family Group
In general, the proposed regulations provide for the reallocation
of items of the corporation among family members under certain
conditions. Section 1366(e) requires a determination of whether an
individual family member who renders services for or provides capital
to the S corporation has received reasonable compensation. The proposed
regulations provide that in determining a reasonable allowance for
services rendered for, or capital furnished to, the S corporation, all
the facts and circumstances are considered, including the amount that
ordinarily would be paid in order to obtain comparable services or
capital from a person who is neither a member of that family nor a
shareholder in the corporation.
For purposes of section 1366(e), similar rules apply to services
rendered, or capital furnished, to an S corporation by a pass-through
entity in which a member of a shareholder's family holds an interest.
The proposed regulations provide that if the pass-through entity does
not receive reasonable compensation for the services rendered or
capital furnished, the Commissioner may prescribe adjustments to the
pass-through entity and the corporation as necessary to reflect the
value of the services rendered or capital furnished.
Special Rules
Section 1366(f) and the proposed regulations provide special rules
limiting the pass through of certain items of an S corporation to its
shareholders. Section 1366(f)(1) and the proposed regulations provide
that the pass-through rules under section 1366(a) are inapplicable with
respect to any credit allowable under section 34 (relating to certain
uses of gasoline and special fuels). In addition, section 1366(f) (2)
and (3) and the proposed regulations provide for a reduction in the
pass through of items for tax imposed on an S corporation under section
1374 or section 1375.
Adjustments to Basis of Stock
Section 1367(a) and Sec. 1.1367-1 prescribe adjustments required by
subchapter S to the basis of a shareholder's stock in an S corporation
and the manner in which those adjustments are made. Section 1.1367-1
requires a shareholder in an S corporation to adjust the basis of the
shareholder's stock for items of income and loss for any taxable year
before adjusting the basis for distributions.
Section 1309 of the 1996 Act amended section 1368 to require that
in the case of any distribution made during any taxable year, the
adjusted basis of the stock is determined with regard to the
adjustments provided in section 1367(a)(1) for the taxable year. Thus,
the adjustments for distributions made by the S corporation during the
taxable year are taken into account before applying the loss limitation
for the year.
The proposed regulations amend Sec. 1.1367-1 to provide that for
taxable years of the corporation beginning on or after August 18, 1998,
adjustments to the basis of a share of stock are made in the following
order: (1) Increases for income items and the excess of deductions for
depletion over the basis of the property subject to depletion; (2)
decreases for distributions; (3) decreases for noncapital,
nondeductible expenses, and certain oil and gas depletion deductions;
and (4) decreases for items of loss or deduction.
Adjustments Required Before Determining Tax Effect of Distribution
Section 1368 provides rules for determining the source of a
distribution made by an S corporation with respect to its stock and the
tax effect of the distribution on the shareholders. Under Sec. 1.1368-
1, the determination whether a distribution is made out of the
accumulated adjustments account (AAA) or earnings and profits is made
only after the AAA has been adjusted to reflect: (1) Increases for
income items (other than income that is exempt from tax) and the excess
of the deductions for depletion over the basis of the property subject
to depletion; (2) decreases for noncapital, nondeductible expenses
(other than federal taxes attributable to any taxable year in which the
corporation was a C corporation and expenses related to income that is
exempt from tax); (3) decreases for certain oil and gas depletion
deductions; (4) decreases for items of loss or deduction; and (5) the
effect of certain redemptions.
Consistent with the proposed amendments to Sec. 1.1367-1, the
proposed regulations amend Sec. 1.1368-2 to provide that for taxable
years of the corporation beginning on or after August 18, 1998, the
adjustments to the AAA are made in the same order as the adjustments to
the basis of a share of stock under Sec. 1.1367-1 of the proposed
regulations. For purposes of determining the amount of any distribution
made from the AAA, decreases to the AAA to reflect distributions are
made without taking into account any net negative adjustments as
defined in section 1368(e)(1)(C)(ii).
Section 1311(a) of the 1996 Act generally eliminated the S
corporation earnings and profits of a corporation accumulated in those
taxable years beginning before January 1, 1983, for which the
corporation was an electing small business corporation under the
provisions of subchapter S of the Code as then in effect, if the
corporation was also an S corporation for its first taxable year
beginning after December 31, 1996. Several provisions of the existing
final regulations under subchapter S, which were adopted before the
1996 Act amendments, refer separately to S corporation earnings and
profits and C corporation earnings and profits. See, e.g., Sec. 1.1368-
1(f)(2)(iii). Treasury and the IRS specifically request comments on the
extent, if any, to which these regulations should be amended in view of
the general elimination of S corporation earnings and profits. Treasury
and the IRS also request comments on whether section 1311(a) of the
1996 Act applies to qualified casualty insurance electing small
business corporations and qualified oil corporations, within the
meaning of section 6(c) of the 1982 Act.
Proposed Effective Date
The regulations under section 1366 and the amendments to the
regulations under sections 1367 and 1368 are proposed to be effective
for taxable years of the corporation beginning on or after August 18,
1998.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a
[[Page 44185]]
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)
does not apply to these regulations. It is hereby certified that the
collection of information in these regulations will not have a
significant economic impact on a substantial number of small entities.
This certification is based upon the fact that these regulations do not
impose a collection of information that is not already required by the
underlying statute or the current regulations and reflected in the
appropriate forms. Therefore, a Regulatory Flexibility Analysis under
the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.
Pursuant to section 7805(f) of the Internal Revenue Code, this notice
of proposed rulemaking will be submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its impact
on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments that are submitted
timely (a signed original and eight (8) copies) to the IRS. All
comments will be made available for public inspection and copying.
A public hearing has been scheduled for Tuesday, December 15, 1998,
at 10 a.m. in room 2615, Internal Revenue Building, 1111 Constitution
Avenue NW., Washington, DC. Because of access restrictions, visitors
will not be admitted beyond the Internal Revenue Building lobby more
than 15 minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit written comments (a signed original and eight (8) copies) by
November 16, 1998. The outline of topics to be discussed at the hearing
must be received by Tuesday, November 24, 1998.
A period of 10 minutes will be allotted for each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
Drafting Information. The principal authors of these proposed
regulations are Deane M. Burke, Terri A. Belanger, and Brenda Stewart
of the Office of Chief Counsel (Passthroughs and Special Industries),
Internal Revenue Service. However, other personnel from the IRS and
Treasury Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAX
Paragraph 1. The authority citation for part 1 continues to read in
part:
Authority: 26 U.S.C. 7805 * * *
Secs. 1.1366-1 and 1.1366-2 [Removed]
Par. 2. Sections 1.1366-1 and 1.1366-2 are removed.
Par. 3. Sections 1.1366-0 through 1.1366-5 are added to read as
follows:
Sec. 1.1366-0 Table of contents.
The following table of contents is provided to facilitate the use
of Secs. 1.1366-1 through 1.1366-5:
Sec. 1.1366-1 Shareholder's share of items of an S corporation.
(a) Determination of shareholder's tax liability.
(1) In general.
(2) Separately stated items of income, loss, deduction, or
credit.
(3) Nonseparately computed income or loss.
(4) Separate activities requirement.
(5) Aggregation of deductions or exclusions for purposes of
limitations.
(b) Character of items constituting pro rata share.
(1) In general.
(2) Exception for contribution of noncapital gain property.
(3) Exception for contribution of capital loss property.
(c) Gross income of a shareholder.
(1) In general.
(2) Gross income for substantial omission of items.
(d) Shareholders holding stock subject to community property laws.
(e) Net operating loss deduction of shareholder of S corporation.
(f) Cross-reference.
Sec. 1.1366-2 Limitations on deduction of pass-through items of an
S corporation to its shareholders.
(a) In general.
(1) Limitation on losses and deductions.
(2) Carryover of disallowance.
(3) Basis limitation amount.
(i) Stock portion.
(ii) Indebtedness portion.
(4) Limitation on losses and deductions allocated to each item.
(5) Nontransferability of losses and deductions.
(6) Basis of stock acquired by gift.
(b) Special rules for carryover of disallowed losses and deductions
to post-termination transition period described in section 1377(b).
(1) In general.
(2) Limitation on losses and deductions.
(3) Limitation on losses and deductions allocated to each item.
(4) Adjustment to the basis of stock.
(c) Carryover of disallowed losses and deductions in the case of
liquidations, reorganizations, and divisions.
(1) Liquidations and reorganizations.
(2) Corporate separations to which section 368(a)(1)(D) applies.
Sec. 1.1366-3 Treatment of family groups.
(a) In general.
(b) Examples.
Sec. 1.1366-4 Special rules limiting the pass through of certain
items of an S corporation to its shareholders.
(a) Pass through inapplicable to section 34 credit.
(b) Reduction in pass through for tax imposed on built-in gains.
(c) Reduction in pass through for tax imposed on excess net passive
income.
Sec. 1.1366-5 Effective date.
Sec. 1.1366-1 Shareholder's share of items of an S corporation.
(a) Determination of shareholder's tax liability--(1) In general.
An S corporation must report, and a shareholder is required to take
into account in the shareholder's return, the shareholder's pro rata
share, whether or not distributed, of the S corporation's items of
income, loss, deduction, or credit described in paragraphs (a)(2), (3),
and (4) of this section. A shareholder's pro rata share is determined
in accordance with the provisions of section 1377(a) and the
regulations thereunder. The shareholder takes these items into account
in determining the shareholder's taxable income and tax liability for
the shareholder's taxable year with or within which the taxable year of
the corporation ends. If the shareholder dies (or if the shareholder is
an estate or trust and the estate or trust terminates) before the end
of the taxable year of the corporation, the shareholder's pro rata
share of these items is taken into account on the shareholder's final
return. For the limitation on allowance of a shareholder's pro rata
share of S corporation losses or deductions, see section 1366(d) and
Sec. 1.1366-2.
(2) Separately stated items of income, loss, deduction, or credit.
Each shareholder must take into account separately the shareholder's
pro rata share of any item of income (including tax-exempt income),
loss, deduction, or credit of the S corporation that if separately
taken into account by any
[[Page 44186]]
shareholder could affect the shareholder's tax liability for that
taxable year differently than if the shareholder did not take the item
into account separately. The separately stated items of the S
corporation include, but are not limited to, the following items--
(i) The corporation's combined net amount of gains and losses from
sales or exchanges of capital assets grouped by applicable holding
periods, by applicable rate of tax under section 1(h), and by any other
classification that may be relevant in determining the shareholder's
tax liability;
(ii) The corporation's combined net amount of gains and losses from
sales or exchanges of property described in section 1231 (relating to
property used in the trade or business and involuntary conversions),
grouped by applicable holding periods, by applicable rate of tax under
section 1(h), and by any other classification that may be relevant in
determining the shareholder's tax liability;
(iii) Charitable contributions, grouped by the percentage
limitations of section 170(b), paid by the corporation within the
taxable year of the corporation;
(iv) The taxes described in section 901 that have been paid (or
accrued) by the corporation to foreign countries or to possessions of
the United States;
(v) Each of the corporation's separate items involved in the
determination of credits against tax allowable under part IV of
subchapter A (section 21 and following) of the Internal Revenue Code,
except for any credit allowed under section 34 (relating to certain
uses of gasoline and special fuels);
(vi) Each of the corporation's separate items of gains and losses
from wagering transactions (section 165(d)); soil and water
conservation expenditures (section 175); deduction under an election to
expense certain depreciable business expenses (section 179); medical,
dental, etc., expenses (section 213); the additional itemized
deductions for individuals provided in part VII of subchapter B
(section 212 and following) of the Internal Revenue Code; and any other
itemized deductions for which the limitations on itemized deductions
under sections 67 or 68 applies;
(vii) Any of the corporation's items of portfolio income or loss,
and expenses related thereto, as defined under section 469;
(viii) The corporation's tax-exempt income. For purposes of
subchapter S, tax-exempt income is income that is permanently
excludible from gross income in all circumstances in which the
applicable provision of the Internal Revenue Code applies. For example,
income that is excludible from gross income under section 101 (certain
death benefits) or section 103 (interest on state and local bonds) is
tax-exempt income, while income that is excludible from gross income
under section 108 (income from discharge of indebtedness) or section
109 (improvements by lessee on lessor's property) is not tax-exempt
income;
(ix) The corporation's adjustments described in sections 56 and 58,
and items of tax preference described in section 57; and
(x) Any item identified in guidance (including forms and
instructions) issued by the Commissioner as an item required to be
separately stated under this paragraph (a)(2).
(3) Nonseparately computed income or loss. Each shareholder must
take into account separately the shareholder's pro rata share of the
nonseparately computed income or loss of the S corporation. For this
purpose, nonseparately computed income or loss means the corporation's
gross income less the deductions allowed to the corporation under
chapter 1 of the Internal Revenue Code, determined by excluding any
item requiring separate computation under paragraph (a)(2) of this
section.
(4) Separate activities requirement. An S corporation must report,
and each shareholder must take into account in the shareholder's
return, the shareholder's pro rata share of an S corporation's items of
income, loss, deduction, or credit described in paragraphs (a)(2) and
(3) of this section for each of the corporation's activities as defined
in section 469 and the regulations thereunder.
(5) Aggregation of deductions or exclusions for purposes of
limitations--(i) In general. A shareholder aggregates the shareholder's
separate deductions or exclusions with the shareholder's pro rata share
of the S corporation's separately stated deductions or exclusions in
determining the amount of any deduction or exclusion allowable to the
shareholder under subtitle A of the Internal Revenue Code as to which a
limitation is imposed.
(ii) Example. The provisions of paragraph (a)(5)(i) of this section
are illustrated by the following example:
Example. In 1999, Corporation M, an S corporation, purchases and
places in service section 179 property costing $10,000. Corporation
M elects to expense the entire cost of the property. Shareholder A
owns 50 percent of the stock of Corporation M. Shareholder A's pro
rata share of this item after Corporation M applies the section
179(b) limitations is $5,000. Because the aggregate amount of
Shareholder A's pro rata share and separately acquired section 179
expense may not exceed $19,000 (the aggregate maximum cost that may
be taken into account under section 179(a) for the applicable
taxable year), Shareholder A may elect to expense up to $14,000 of
separately acquired section 179 property that is purchased and
placed in service in 1999, subject to the limitations of section
179(b).
(b) Character of items constituting pro rata share--(1) In general.
Except as provided in paragraph (b)(2) or (3) of this section, the
character of any item of income, loss, deduction, or credit described
in section 1366(a)(1)(A) or (B) and paragraph (a) of this section is
determined for the S corporation and retains that character in the
hands of the shareholder. For example, if an S corporation has capital
gain on the sale or exchange of a capital asset, a shareholder's pro
rata share of that gain will also be characterized as a capital gain
regardless of whether the shareholder is otherwise a dealer in that
type of property. Similarly, if an S corporation engages in an activity
that is not for profit (section 183), a shareholder's pro rata share of
the S corporation's deductions will be characterized as not for profit.
Also, if an S corporation makes a charitable contribution to an
organization qualifying under section 170(b)(1)(A), a shareholder's pro
rata share of the S corporation's charitable contribution will be
characterized as made to an organization qualifying under section
170(b)(1)(A).
(2) Exception for contribution of noncapital gain property. If an S
corporation is formed or availed of by any shareholder or group of
shareholders for a principal purpose of selling or exchanging
contributed property that in the hands of the shareholder or
shareholders would not have produced capital gain if sold or exchanged
by the shareholder or shareholders, then the gain on the sale or
exchange of the property recognized by the corporation is not treated
as a capital gain.
(3) Exception for contribution of capital loss property. If an S
corporation is formed or availed of by any shareholder or group of
shareholders for a principal purpose of selling or exchanging
contributed property that in the hands of the shareholder or
shareholders would have produced capital loss if sold or exchanged by
the shareholder or shareholders, then the loss on the sale or exchange
of the property recognized by the corporation is treated as a capital
loss to the extent that, immediately before the contribution, the
adjusted basis of the property in the hands of the shareholder
[[Page 44187]]
or shareholders exceeded the fair market value of the property.
(c) Gross income of a shareholder--(1) In general. Where it is
necessary to determine the amount or character of the gross income of a
shareholder, the shareholder's gross income includes the shareholder's
pro rata share of the gross income of the S corporation. The
shareholder's pro rata share of the gross income of the S corporation
is the amount of gross income of the corporation used in deriving the
shareholder's pro rata share of S corporation taxable income or loss
(including items described in section 1366(a)(1) (A) or (B) and
paragraph (a) of this section). For example, a shareholder is required
to include the shareholder's pro rata share of S corporation gross
income in computing the shareholder's gross income for the purposes of
determining the necessity of filing a return (section 6012(a)) and the
shareholder's gross income derived from farming (sections 175 and
6654(i)).
(2) Gross income for substantial omission of items--(i) In general.
For purposes of determining the applicability of the 6-year period of
limitation on assessment and collection provided in section 6501(e)
(relating to omission of more than 25 percent of gross income), a
shareholder's gross income includes the shareholder's pro rata share of
S corporation gross income (as described in section 6501(e)(1)(A)(i)).
In this respect, the amount of S corporation gross income used in
deriving the shareholder's pro rata share of any item of S corporation
income, loss, deduction, or credit (as included or disclosed in the
shareholder's return) is considered as an amount of gross income stated
in the shareholder's return for purposes of section 6501(e).
(ii) Example. The following example illustrates the provisions of
paragraph (c)(2)(i) of this section:
Example. Shareholder A, an individual, owns 25 percent of the
stock of Corporation N, an S corporation that has $10,000 gross
income and $2,000 taxable income. A reports only $300 as A's pro
rata share of N's taxable income. A should have reported $500 as A's
pro rata share of taxable income, derived from $2,500 of N's gross
income. Because A's return included only $300 without a disclosure
meeting the requirements of section 6501(e)(1)(A)(ii) describing the
difference of $200, A is regarded as having reported on the return
only $1,500 ($300/$500 of $2,500) as gross income from N.
(d) Shareholders holding stock subject to community property laws.
If a shareholder holds S corporation stock that is community property,
then the shareholder's pro rata share of any item or items listed in
paragraphs (a)(2), (3), and (4) of this section with respect to that
stock is reported by the husband and wife in accordance with community
property rules.
(e) Net operating loss deduction of shareholder of S corporation.
For purposes of determining a net operating loss deduction under
section 172, a shareholder of an S corporation must take into account
the shareholder's pro rata share of items of income, loss, deduction,
or credit of the corporation. See section 1366(b) and paragraph (b) of
this section for rules on determining the character of the items. In
determining under section 172(d)(4) the nonbusiness deductions
allowable to a shareholder of an S corporation (arising from both
corporation sources and any other sources), the shareholder separately
takes into account the shareholder's pro rata share of the deductions
of the corporation that are not attributable to a trade or business and
combines this amount with the shareholder's nonbusiness deductions from
any other sources. The shareholder also separately takes into account
the shareholder's pro rata share of the gross income of the corporation
not derived from a trade or business and combines this amount with the
shareholder's nonbusiness income from all other sources. See section
172 and the regulations thereunder.
(f) Cross-reference. For rules relating to the consistent tax
treatment of subchapter S items, see section 6037(c).
Sec. 1.1366-2 Limitations on deduction of pass-through items of an S
corporation to its shareholders.
(a) In general--(1) Limitation on losses and deductions. The
aggregate amount of losses and deductions taken into account by a
shareholder under Sec. 1.1366-1(a)(2), (3), and (4) for any taxable
year of an S corporation cannot exceed the sum of--
(i) The adjusted basis of the shareholder's stock in the
corporation (as determined under paragraph (a)(3)(i) of this section);
and
(ii) The adjusted basis of any indebtedness of the corporation to
the shareholder (as determined under paragraph (a)(3)(ii) of this
section).
(2) Carryover of disallowance. A shareholder's aggregate amount of
losses and deductions for a taxable year in excess of the sum of the
adjusted basis of the shareholder's stock in an S corporation and of
any indebtedness of the S corporation to the shareholder is not allowed
for the taxable year. However, any disallowed loss or deduction is
treated as incurred by the corporation in the corporation's first
succeeding taxable year, and subsequent taxable years, with respect to
the shareholder to the extent that the shareholder's adjusted basis of
stock or indebtedness exceeds zero. For rules on determining the
adjusted bases of stock of an S corporation and indebtedness of the
corporation to the shareholder, see paragraphs (a)(3) (i) and (ii) of
this section.
(3) Basis limitation amount--(i) Stock portion. A shareholder
generally determines the adjusted basis of stock for purposes of
paragraphs (a)(1)(i) and (2) of this section (limiting losses and
deductions) by taking into account only increases in basis under
section 1367(a)(1) for the taxable year and decreases in basis under
section 1367(a)(2)(A), (D) and (E) (relating to distributions,
noncapital, nondeductible expenses, and certain oil and gas depletion
deductions) for the taxable year. In so determining this loss
limitation amount, the shareholder disregards decreases in basis under
section 1367(a)(2)(B) and (C) (for losses and deductions, including
losses and deductions previously disallowed) for the taxable year.
However, if the shareholder has in effect for the taxable year an
election under Sec. 1.1367-1(f) (proposed to be redesignated as
Sec. 1.1367-1(g)) to decrease basis by items of loss and deduction
prior to decreasing basis by noncapital, nondeductible expenses and
certain oil and gas depletion deductions, the shareholder also
disregards decreases in basis under section 1367(a)(2)(D) and (E). This
basis limitation amount for stock is determined at the time prescribed
under Sec. 1.1367-1(d)(1) for adjustments to the basis of stock.
(ii) Indebtedness portion. A shareholder determines the
shareholder's adjusted basis in indebtedness of the corporation for
purposes of paragraphs (a)(1)(ii) and (2) of this section (limiting
losses and deductions) without regard to any adjustment under section
1367(b)(2)(A) for the taxable year. This basis limitation amount for
indebtedness is determined at the time prescribed under Sec. 1.1367-
2(d)(1) for adjustments to the basis of indebtedness.
(4) Limitation on losses and deductions allocated to each item. If
a shareholder's pro rata share of the aggregate amount of losses and
deductions specified in Sec. 1.1366-1(a)(2), (3), and (4) exceeds the
sum of the adjusted basis of the shareholder's stock in the corporation
(determined in accordance with paragraph (a)(3)(i) of this section) and
the adjusted basis of any indebtedness of the corporation to the
shareholder (determined in
[[Page 44188]]
accordance with paragraph (a)(3)(ii) of this section), then the
limitation on losses and deductions under section 1366(d)(1) must be
allocated among the shareholder's pro rata share of each loss or
deduction. The amount of the limitation allocated to any loss or
deduction is an amount that bears the same ratio to the amount of the
limitation as the loss or deduction bears to the total of the losses
and deductions. For this purpose, the total of losses and deductions
for the taxable year is the sum of the shareholder's pro rata share of
losses and deductions for the taxable year, and the losses and
deductions disallowed and carried forward from prior years pursuant to
section 1366(d)(2).
(5) Nontransferability of losses and deductions. Any loss or
deduction disallowed under paragraph (a)(1) of this section is personal
to the shareholder and cannot in any manner be transferred to another
person. If a shareholder transfers some but not all of the
shareholder's stock in the corporation, the amount of any disallowed
loss or deduction under this section is not reduced and the transferee
does not acquire any portion of the disallowed loss or deduction. If a
shareholder transfers all of the shareholder's stock in the
corporation, any disallowed loss or deduction is permanently
disallowed.
(6) Basis of stock acquired by gift. For purposes of section
1366(d)(1)(A) and paragraphs (a)(1)(i) and (2) of this section, the
basis of stock in a corporation acquired by gift is the basis of the
stock that is used for purposes of determining loss.
(b) Special rules for carryover of disallowed losses and deductions
to post-termination transition period described in section 1377(b)--(1)
In general. If, for the last taxable year of a corporation for which it
was an S corporation, a loss or deduction was disallowed to a
shareholder by reason of the limitation in paragraph (a) of this
section, the loss or deduction is treated under section 1366(d)(3) as
incurred by that shareholder on the last day of any post-termination
transition period (within the meaning of section 1377(b)).
(2) Limitation on losses and deductions. The aggregate amount of
losses and deductions taken into account by a shareholder under
paragraph (b)(1) of this section cannot exceed the adjusted basis of
the shareholder's stock in the corporation determined at the close of
the last day of the post-termination transition period. For this
purpose, the adjusted basis of a shareholder's stock in the corporation
is determined at the close of the last day of the post-termination
transition period without regard to any reduction required under
paragraph (b)(4) of this section. If a shareholder disposes of a share
of stock prior to the close of the last day of the post-termination
transition period, the adjusted basis of that share is its basis as of
the close of the day of disposition. Any losses and deductions in
excess of a shareholder's adjusted stock basis are permanently
disallowed. For purposes of section 1366(d)(3)(B) and this paragraph
(b)(2), the basis of stock in a corporation acquired by gift is the
basis of the stock that is used for purposes of determining loss.
(3) Limitation on losses and deductions allocated to each item. If
the aggregate amount of losses and deductions treated as incurred by
the shareholder under paragraph (b)(1) of this section exceeds the
adjusted basis of the shareholder's stock determined under paragraph
(b)(2) of this section, the limitation on losses and deductions under
section 1366(d)(3)(B) must be allocated among each loss or deduction.
The amount of the limitation allocated to each loss or deduction is an
amount that bears the same ratio to the amount of the limitation as the
amount of each loss or deduction bears to the total of all the losses
and deductions.
(4) Adjustment to the basis of stock. The shareholder's basis in
the stock of the corporation is reduced by the amount allowed as a
deduction by reason of this paragraph (b). For rules regarding
adjustments to the basis of a shareholder's stock in an S corporation,
see Sec. 1.1367-1.
(c) Carryover of disallowed losses and deductions in the case of
liquidations, reorganizations, and divisions--(1) Liquidations and
reorganizations. If a corporation acquires the assets of an S
corporation in a transaction to which section 381(a) applies, any loss
or deduction disallowed under paragraph (a) of this section with
respect to a shareholder of the distributor or transferor S corporation
is available to that shareholder as a shareholder of the acquiring
corporation. Thus, where the acquiring corporation is an S corporation,
a loss or deduction of a shareholder of the distributor or transferor S
corporation disallowed prior to or during the taxable year of the
transaction is treated as incurred by the acquiring S corporation with
respect to that shareholder if the shareholder is a shareholder of the
acquiring S corporation after the transaction. Where the acquiring
corporation is a C corporation, a post-termination transition period
arises the day after the last day that an S corporation was in
existence and the rules provided in paragraph (b) of this section apply
with respect to any shareholder of the acquired S corporation that is
also a shareholder of the acquiring C corporation after the
transaction. See the special rules under section 1377 for the
availability of the post-termination transition period if the acquiring
corporation is a C corporation.
(2) Corporate separations to which section 368(a)(1)(D) applies. If
an S corporation transfers a portion of its assets constituting an
active trade or business to another corporation in a transaction to
which section 368(a)(1)(D) applies, and immediately thereafter the
stock and securities of the controlled corporation are distributed in a
distribution or exchange to which section 355 (or so much of section
356 as relates to section 355) applies, any loss or deduction
disallowed under paragraph (a) of this section with respect to a
shareholder of the distributing S corporation immediately before the
transaction is allocated between the distributing corporation and the
controlled corporation with respect to the shareholder. The amount of
disallowed loss or deduction allocated to the distributing (or
controlled) corporation with respect to the shareholder is an amount
that bears the same ratio to each item of disallowed loss or deduction
as the value of the shareholder's stock in the distributing (or
controlled) corporation bears to the total value of the shareholder's
stock in the distributing and controlled corporations, in each case as
determined immediately after the distribution.
Sec. 1.1366-3 Treatment of family groups.
(a) In general. Under section 1366(e), if an individual, who is a
member of the family of one or more shareholders of an S corporation,
renders services for, or furnishes capital to, the corporation without
receiving reasonable compensation, the Commissioner shall prescribe
adjustments to those items taken into account by the individual and the
shareholders as may be necessary to reflect the value of the services
rendered or capital furnished. For these purposes, in determining the
reasonable value for services rendered, or capital furnished, to the
corporation, consideration will be given to all the facts and
circumstances, including the amount that ordinarily would be paid in
order to obtain comparable services or capital from a person (other
than a member of the family) who is not a shareholder in the
corporation. In addition, for purposes of section 1366(e), if a member
of the family of one
[[Page 44189]]
or more shareholders of the S corporation holds an interest in a pass-
through entity (e.g., a partnership, S corporation, trust, or estate),
that performs services for, or furnishes capital to, the S corporation
without receiving reasonable compensation, the Commissioner shall
prescribe adjustments to the pass-through entity and the corporation as
may be necessary to reflect the value of the services rendered or
capital furnished. For purposes of section 1366(e), the term family of
any shareholder includes only the shareholder's spouse, ancestors,
lineal descendants, and any trust for the primary benefit of any of
these persons.
(b) Examples. The provisions of this section may be illustrated by
the following examples:
Example 1. The stock of an S corporation is owned 50 percent by
F and 50 percent by T, the minor son of F. For the taxable year, the
corporation has items of taxable income equal to $70,000.
Compensation of $10,000 is paid by the corporation to F for services
rendered during the taxable year, and no compensation is paid to T,
who rendered no services. Based on all the relevant facts and
circumstances, reasonable compensation for the services rendered by
F would be $30,000. In the discretion of the Internal Revenue
Service, up to an additional $20,000 of the $70,000 of the
corporation's taxable income, for tax purposes, may be allocated to
F as compensation for services rendered. If the Service allocates
$20,000 of the corporation's taxable income to F as compensation for
services, taxable income of the corporation would be reduced by
$20,000 to $50,000, of which F and T each would be allocated
$25,000. F would have $30,000 of total compensation paid by the
corporation for services rendered.
Example 2. The stock of an S corporation is owned by A and B.
For the taxable year, the corporation has paid compensation to a
partnership that rendered services to the corporation during the
taxable year. The spouse of A is a partner in that partnership.
Consequently, if based on all the relevant facts and circumstances
the partnership did not receive reasonable compensation for the
services rendered to the corporation, the Internal Revenue Service,
in its discretion, may make adjustments to those items taken into
account by the partnership and the corporation as may be necessary
to reflect the value of the services rendered.
Sec. 1.1366-4 Special rules limiting the pass through of certain items
of an S corporation to its shareholders.
(a) Pass through inapplicable to section 34 credit. Section 1.1366-
1(a) does not apply to any credit allowable under section 34 (relating
to certain uses of gasoline and special fuels).
(b) Reduction in pass through for tax imposed on built-in gains.
For purposes of Sec. 1.1366-1(a), if for any taxable year of the S
corporation a tax is imposed on the corporation under section 1374, the
amount of the tax imposed is treated as a loss sustained by the S
corporation during the taxable year. The character of the deemed loss
is determined by allocating the loss proportionately among the
recognized built-in gain items giving rise to the tax and attributing
the character of each recognized built-in gain item to the allocable
portion of the loss.
(c) Reduction in pass through for tax imposed on excess net passive
income. For purposes of Sec. 1.1366-1(a), if for any taxable year of
the S corporation a tax is imposed on the corporation under section
1375, each item of passive investment income shall be reduced by an
amount that bears the same ratio to the amount of the tax as the amount
of the item bears to the total passive investment income for that
taxable year.
Sec. 1.1366-5 Effective date.
Sections 1.1366-1 through 1.1366-4 apply to taxable years of an S
corporation beginning on or after August 18, 1998.
Par. 4. Section 1.1367-0 is amended in the table as follows:
1. The entries for Sec. 1.1367-1 (e) through (g) are revised.
2. The entries for Sec. 1.1367-1 (h) through (j) are added.
The additions and revisions read as follows:
Sec. 1.1367-0 Table of contents.
* * * * *
Sec. 1.1367-1 Adjustments to basis of shareholder's stock in an S
corporation.
* * * * *
(e) Ordering rules for taxable years beginning before January 1,
1997.
(f) Ordering rules for taxable years beginning on or after August
18, 1998.
(g) Elective ordering rule.
(h) Examples.
(i) [Reserved]
(j) Adjustments for items of income in respect of a decedent.
* * * * *
Par. 5. Section 1.1367-1 is amended as follows:
1. The heading and introductory text of paragraph (e) are revised.
2. Paragraphs (f) and (g) are redesignated as paragraphs (g) and
(h), respectively.
3. New paragraph (f) is added.
4. The first and second sentences of newly designated paragraph (g)
are revised.
5. Newly designated paragraph (h) is amended as follows:
a. The heading for Example 1 is revised.
b. Example 2 and Example 3 are redesignated as Example 3 and
Example 4, respectively.
c. New Example 2 is added.
d. The heading of newly designated Example 4 is revised.
e. Example 5 is added.
6. Paragraph (i) is added and reserved and paragraph (j) is added.
The additions and revisions read as follows:
Sec. 1.1367-1 Adjustments to basis of shareholder's stock in an S
corporation.
* * * * *
(e) Ordering rules for taxable years beginning before January 1,
1997. For any taxable year of a corporation beginning before January 1,
1997, except as provided in paragraph (g) of this section, the
adjustments required by section 1367(a) are made in the following
order--
* * * * *
(f) Ordering rules for taxable years beginning on or after August
18, 1998. For any taxable year of a corporation beginning on or after
August 18, 1998, except as provided in paragraph (g) of this section,
the adjustments required by section 1367(a) are made in the following
order--
(1) Any increase in basis attributable to the income items
described in section 1367(a)(1) (A) and (B), and the excess of the
deductions for depletion described in section 1367(a)(1)(C);
(2) Any decrease in basis attributable to a distribution by the
corporation described in section 1367(a)(2)(A);
(3) Any decrease in basis attributable to noncapital, nondeductible
expenses described in section 1367(a)(2)(D), and the oil and gas
depletion deduction described in section 1367(a)(2)(E); and
(4) Any decrease in basis attributable to items of loss or
deduction described in section 1367(a)(2) (B) and (C).
(g) Elective ordering rule. A shareholder may elect to decrease
basis under paragraph (e)(3) or (f)(4) of this section, whichever
applies, prior to decreasing basis under paragraph (e)(2) or (f)(3) of
this section, whichever applies. If a shareholder makes this election,
any amount described in paragraph (e)(2) or (f)(3) of this section,
whichever applies, that is in excess of the shareholder's basis in
stock and indebtedness is treated, solely for purposes of this section,
as an amount described in paragraph (e)(2) or (f)(3) of this section,
whichever applies, in the succeeding taxable year. * * *
(h) * * *
Example 1. Adjustments to basis of stock for taxable years
beginning before January 1, 1997. * * *
Example 2. Adjustments to basis of stock for taxable years
beginning on or after August 18, 1998. (i) On December 31, 2001, A
owns a block of 50 shares of stock with an adjusted
[[Page 44190]]
basis per share of $6 in Corporation S. On December 31, 2001, A
purchases for $400 an additional block of 50 shares of stock with an
adjusted basis of $8 per share. Thus, A holds 100 shares of stock
for each day of the 2002 taxable year. For S's 2002 taxable year,
A's pro rata share of the amount of items described in section
1367(a)(1)(A) (relating to increases in basis of stock) is $300, A's
pro rata share of the amount of the items described in section
1367(a)(2)(B) (relating to decreases in basis of stock attributable
to items of loss and deduction) is $300, and A's pro rata share of
the amount of the items described in section 1367(a)(2)(D) (relating
to decreases in basis of stock attributable to noncapital,
nondeductible expenses) is $200. S makes a distribution to A in the
amount of $100 during 2002.
(ii) Pursuant to the ordering rules of paragraph (f) of this
section, A first increases the basis of each share of stock by $3
($300/100 shares) and then decreases the basis of each share by $1
($100/100 shares) for the distribution. A next decreases the basis
of each share by $2 ($200/100 shares) for the noncapital,
nondeductible expenses and then decreases the basis of each share by
$3 ($300/100 shares) for the items of loss. Thus, on January 1,
2003, A has a basis of $3 per share in the original block of 50
shares ($6 + $3 -$1 -$2 -$3) and a basis of $5 per share in the
second block of 100 shares ($8 + $3 -$1 -$2 -$3).
* * * * *
Example 4. Effects of section 1377(a)(2) election and
distribution on basis of stock for taxable years beginning before
January 1, 1997. * * *
Example 5. Effects of section 1377(a)(2) election and
distribution on basis of stock for taxable years beginning on or
after August 18, 1998. (i) The facts are the same as in Example 4,
except that all of the events occur in 2001 rather than in 1994 and
except as follows: On June 30, 2001, B sells 25 shares of her stock
for $5,000 to D and 25 shares back to Corporation S for $5,000.
Under section 1377(a)(2)(B) and Sec. 1.1377-1(b)(2), B and C are
affected shareholders because B has transferred shares to
Corporation S. Pursuant to section 1377(a)(2)(A) and Sec. 1.1377-
1(b)(1), B and C, the affected shareholders, and Corporation S agree
to treat the taxable year 2001 as if it consisted of two separate
taxable years for all affected shareholders for the purposes set
forth in Sec. 1.1377-1(b)(3)(i).
(ii) On June 30, 2001, B and C, pursuant to the ordering rules
of paragraph (f)(1) of this section, increase the basis of each
share by $60 ($6,000/100 shares) for the nonseparately computed
income. Then B and C reduce the basis of each share by $120
($12,000/100 shares) for the distribution. Finally, B and C decrease
the basis of each share by $40 ($4,000/100 shares) for the
separately stated deduction item.
(iii) The basis of the stock of B is reduced from $120 to $20
per share ($120 + $60 - $120 - $40). Prior to accounting for the
separately stated deduction item, the basis of the stock of C is
reduced from $80 to $20 ($80 + $60 - $120). Finally, because the
period from January 1 through June 30, 2001 is treated under
Sec. 1.1377-1(b)(3)(i) as a separate taxable year for purposes of
making adjustments to the basis of stock, under section 1366(d) and
Sec. 1.1366-2(a)(2), C may deduct only $20 per share of the
remaining $40 of the separately stated deduction item, and the basis
of the stock of C is reduced from $20 per share to $0 per share.
Under section 1366 and Sec. 1.1366-2(a)(2), C's remaining separately
stated deduction item of $20 per share is treated as having been
incurred in the first succeeding taxable year of Corporation S,
which, for this purpose, begins on July 1, 2001.
(i) [Reserved]
(j) Adjustments for items of income in respect of a decedent. The
basis determined under section 1014 of any stock in an S corporation is
reduced by the portion of the value of the stock that is attributable
to items constituting income in respect of a decedent. For the
determination of items realized by an S corporation constituting income
in respect of a decedent, see sections 1367(b)(4)(A) and 691 and
applicable regulations thereunder. For the determination of the
allowance of a deduction for the amount of estate tax attributable to
income in respect of a decedent, see section 691(c) and applicable
regulations thereunder.
Par. 6. The first sentence of Sec. 1.1367-3 is removed and two
sentences are added in its place to read as follows:
Sec. 1.1367-3 Effective date and transition rule.
Except for Sec. 1.1367-1(f), Example 2 and Example 5 of
Sec. 1.1367-1(h), and Sec. 1.1367-1(j), Secs. 1.1367-1 and 1.1367-2
apply to taxable years of the corporation beginning on or after January
1, 1994. Section 1.1367-1(f), Example 2 and Example 5 of Sec. 1.1367-
1(h), and Sec. 1.1367-1(j) apply only to taxable years of the
corporation beginning on or after August 18, 1998. * * *
Par. 7. Section 1.1368-0 is amended in the table as follows:
1. The entry for Sec. 1.1368-1(e) is revised and entries for
Sec. 1.1368-1 (e)(1) and (e)(2) are added.
2. The entries for Sec. 1.1368-2 (a)(4) and (d) are revised.
3. An entry for Sec. 1.1368-2(a)(5) is added.
The additions and revisions read as follows:
Sec. 1.1368-0 Table of contents.
* * * * *
Sec. 1.1368-1 Distributions by S corporations.
* * * * *
(e) Certain adjustments taken into account.
(1) Taxable years beginning before January 1, 1997.
(2) Taxable years beginning on or after August 18, 1998.
* * * * *
Sec. 1.1368-2 Accumulated adjustments account (AAA).
(a) Accumulated adjustments account.
* * * * *
(4) Ordering rules for the AAA for taxable years beginning
before January 1, 1997.
(5) Ordering rules for the AAA for taxable years beginning on or
after August 18, 1998.
* * * * *
(d) Adjustment in the case of redemptions, liquidations,
reorganizations, and divisions.
* * * * *
Par. 8. Section 1.1368-1 is amended by revising paragraphs (d)(1)
and (e) to read as follows:
Sec. 1.1368-1 Distributions by S corporations.
* * * * *
(d) S corporation with earnings and profits--(1) General treatment
of distribution. Except as provided in paragraph (d)(2) of this
section, a distribution made with respect to its stock by an S
corporation that has accumulated earnings and profits as of the end of
the taxable year of the S corporation in which the distribution is made
is treated in the manner provided in section 1368(c). See section 316
and Sec. 1.316-2 for provisions relating to the allocation of earnings
and profits among distributions.
* * * * *
(e) Certain adjustments taken into account--(1) Taxable years
beginning before January 1, 1997. For any taxable year of the
corporation beginning before January 1, 1997, paragraphs (c) and (d) of
this section are applied only after taking into account--
(i) The adjustments to the basis of the shares of a shareholder's
stock described in section 1367 (without regard to section
1367(a)(2)(A) (relating to decreases attributable to distributions not
includable in income)) for the S corporation's taxable year; and
(ii) The adjustments to the AAA required by section 1368(e)(1)(A)
(but without regard to the adjustments for distributions under
Sec. 1.1368-2(a)(3)(iii)) for the S corporation's taxable year.
(2) Taxable years beginning on or after August 18, 1998. For any
taxable year of the corporation beginning on or after August 18, 1998,
paragraphs (c) and (d) of this section are applied only after taking
into account--
(i) The adjustments to the basis of the shares of a shareholder's
stock described in section 1367(a)(1) (relating to increases in basis
of stock) for the S corporation's taxable year; and
(ii) The adjustments to the AAA required by section 1368(e)(1)(A)
(but without regard to the adjustments for distributions under
Sec. 1.1368-2(a)(3)(iii)) for the S corporation's taxable year. Any
[[Page 44191]]
net negative adjustment (as defined in section 1368(e)(1)(C)(ii)) for
the taxable year shall not be taken into account.
* * * * *
Par. 9. Section 1.1368-2 is amended as follows:
1. Paragraphs (a)(1) and (a)(3)(ii) and the heading and
introductory text of paragraph (a)(4) are revised.
2. Paragraph (a)(5) is added.
3. The heading for paragraph (d) is revised.
The additions and revisions read as follows:
Sec. 1.1368-2 Accumulated adjustments account (AAA).
(a) Accumulated adjustments account--(1) In general. The
accumulated adjustments account is an account of the S corporation and
is not apportioned among shareholders. The AAA is relevant for all
taxable years beginning on or after January 1, 1983, for which the
corporation is an S corporation. On the first day of the first year for
which the corporation is an S corporation, the balance of the AAA is
zero. The AAA is increased in the manner provided in paragraph (a)(2)
of this section and is decreased in the manner provided in paragraph
(a)(3) of this section. For the adjustments to the AAA in the case of
redemptions, liquidations, reorganizations, and corporate separations,
see paragraph (d) of this section.
* * * * *
(3) Decreases to the AAA * * *
(ii) Extent of allowable reduction. The AAA may be decreased under
paragraph (a)(3)(i) of this section below zero. The AAA is decreased by
noncapital, nondeductible expenses under paragraph (a)(3)(i)(C) of this
section even though a portion of the noncapital, nondeductible expenses
is not taken into account by a shareholder under Sec. 1.1367-1(g)
(relating to the elective ordering rule). The AAA is also decreased by
the entire amount of any loss or deduction even though a portion of the
loss or deduction is not taken into account by a shareholder under
section 1366(d)(1) or is otherwise not currently deductible under the
Internal Revenue Code. However, in any subsequent taxable year in which
the loss, deduction, or noncapital, nondeductible expense is treated as
incurred by the corporation with respect to the shareholder under
section 1366(d)(2) or Sec. 1.1367-1(g) (or in which the loss or
deduction is otherwise allowed to the shareholder), no further
adjustment is made to the AAA.
* * * * *
(4) Ordering rules for the AAA for taxable years beginning before
January 1, 1997. For any taxable year beginning before January 1, 1997,
the adjustments to the AAA are made in the following order--
* * * * *
(5) Ordering rules for the AAA for taxable years beginning on or
after August 18, 1998. For any taxable year of the corporation
beginning on or after August 18, 1998, the adjustments to the AAA are
made in the following order--
(i) The AAA is increased under paragraph (a)(2) of this section
before it is decreased under paragraph (a)(3) of this section for the
taxable year;
(ii) The AAA is decreased (but not below zero) by any portion of an
ordinary distribution to which section 1368(b) or (c)(1) applies
(without taking into account any net negative adjustment (as defined in
section 1368(e)(1)(C)(ii)) before it is decreased under paragraph
(a)(3)(i) of this section;
(iii) The AAA is decreased under paragraph (a)(3)(i)(C) and (D) of
this section before it is decreased under paragraph (a)(3)(i)(A) and
(B) of this section;
(iv) The AAA is decreased under paragraph (a)(3)(i)(A) and (B) of
this section; and
(v) The AAA is adjusted (whether negative or positive) for
redemption distributions under paragraph (d)(1) of this section.
* * * * *
(d) Adjustment in the case of redemptions, liquidations,
reorganizations, and divisions * * *
* * * * *
Par. 10. Section 1.1368-3 is amended as follows:
1. The heading for Example 1 is revised.
2. Example 2 through Example 6 are redesignated as Example 3
through Example 7, respectively.
3. New Example 2 is added.
The revision and addition read as follows:
Sec. 1.1368-3 Examples.
* * * * *
Example 1. Distributions by S corporations without C corporation
earnings and profits for taxable years beginning before January 1,
1997. * * *
Example 2. Distributions by S corporations without earnings and
profits for taxable years beginning on or after August 18, 1998. (i)
Corporation S, an S corporation, has no earnings and profits as of
January 1, 2001, the first day of its 2001 taxable year. S's sole
shareholder, A, holds 10 shares of S stock with a basis of $1 per
share as of that date. On March 1, 2001, S makes a distribution of
$38 to A. For S's 2001 taxable year, A's pro rata share of the
amount of the items described in section 1367(a)(1) (relating to
increases in basis of stock) is $50. A's pro rata share of the
amount of the items described in sections 1367(a)(2)(B) through (D)
(relating to decreases in basis of stock for items other than
distributions) is $26, $20 of which is attributable to items
described in section 1367(a)(2)(B) and (C) and $6 of which is
attributable to items described in section 1367(a)(2)(D) (relating
to decreases in basis attributable to noncapital, nondeductible
expenses).
(ii) Under section 1368(d)(1) and Sec. 1.1368-1(e)(1) and (2),
the adjustments to the basis of A's stock in S described in sections
1367(a)(1) are made before the distribution rules of section 1368
are applied. Thus, A's basis per share in the stock is $6.00 ($1 +
[$50/10]) before taking into account the distribution. Under section
1367(a)(2)(A), the basis of A's stock is decreased by distributions
to A that are not includible in A's income. Under Sec. 1.1367-
1(c)(3), the amount of the distribution that is attributable to each
share of A's stock is $3.80 ($38 distribution/10 shares). Thus, A's
basis per share in the stock is $2.20 ($6.00--$3.80), after taking
into account the distribution. Under section 1367(a)(2)(D), the
basis of each share of A's stock in S after taking into account the
distribution, $2.20, is decreased by $.60 ($6 noncapital,
nondeductible expenses/10). Thus, A's basis per share after taking
into account the nondeductible, noncapital expenses is $1.60. Under
section 1367(a)(2)(B) and (C), A's basis per share is further
decreased by $2 ($20 items described in section 1367(a)(2)(B) and
(C)/10 shares). However, basis may not be reduced below zero.
Therefore, the basis of each share of A's stock is reduced to zero.
As of January 1, 2002, A has a basis of $0 in his shares of S stock.
Pursuant to section 1366(d)(2), the $.40 of loss in excess of A's
basis in each of his shares of S stock is treated as incurred by the
corporation in the succeeding taxable year with respect to A.
* * * * *
Par. 11. The first sentence of Sec. 1.1368-4 is removed and two
sentences are added in its place to read as follows:
Sec. 1.1368-4 Effective date and transition rule.
Except for Secs. 1.1368-1(e)(2), 1.1368-2(a)(5), and Example 2 of
Sec. 1.1368-3, Secs. 1.1368-1, 1.1368-2, and 1.1368-3 apply to taxable
years of the corporation beginning on or after January 1, 1994.
Sections 1.1368-1(e)(2), 1.1368-2(a)(5) and Example 2 of Sec. 1.1368-3
apply only to taxable years of the corporation beginning on or after
August 18, 1998. * * *
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
[FR Doc. 98-21639 Filed 8-17-98; 8:45 am]
BILLING CODE 4830-01-U
