[Federal Register Volume 64, Number 245 (Wednesday, December 22, 1999)]
[Rules and Regulations]
[Pages 71641-71652]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-32697]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
[TD 8852]
RIN 1545-AT52
Passthrough of Items of an S Corporation to its Shareholders
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to the
passthrough 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 regulations provide the public with
guidance needed to comply with the applicable law and will affect S
corporations and their shareholders.
DATES: Effective Date: These regulations are effective August 18, 1998.
Applicability Dates: For dates of applicability, see Sec. 1.1366-5,
Sec. 1.1367-3, and Sec. 1.1368-4, plus Transition Rule and Effective
Date under SUPPLEMENTARY INFORMATION.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations under
section 1366, Martin Schaffer, Deane M. Burke, or David Shulman (202)
622-3070; concerning the regulations under sections 1367 and 1368,
Brenda Stewart, (202) 622-3120.
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in these final regulations
has been reviewed and approved by the Office of Management and Budget
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507)
under control number 1545-1613. Responses to this collection of
information are mandatory.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid control number.
The burden for this requirement 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''.
Suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP,
Washington, DC 20224, and 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.
Books or records relating to this 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 amends 26 CFR part 1 to provide additional rules
under sections 1366, 1367, and 1368 relating to the passthrough 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.
On August 18, 1998, the IRS published in the Federal Register (63
FR 44181), a notice of proposed rulemaking (REG-209446-82) regarding
sections 1366, 1367, and 1368. Comments responding to the proposed
regulations were received. The public hearing was canceled because
there were no requests to speak. After considering the comments
received, the proposed regulations are adopted as amended by this
Treasury decision.
Explanation of Revisions and Summary of Comments
1. Aggregation of Deductions From an S Corporation With Deductions From
Other Sources
The proposed regulations provide that a shareholder of an S
corporation must aggregate its separate deductions and exclusions with
the shareholder's pro rata share of the S corporation's separately
stated deductions or exclusions in determining the allowable amount of
any deduction or exclusion that is subject to a limitation in the Code.
The proposed regulations provide an example of this rule for
property expensed under section 179. A commentator suggested that the
example implies that a shareholder must expense its pro rata share of
section 179 expense from the S corporation before it can expense any
separately acquired property.
The example is intended to illustrate that a shareholder may
expense only up to the amount allowable under section 179 in any given
year regardless of whether the property is owned individually or
through an S corporation. The example is not intended to imply that a
shareholder must elect to expense property held in an S corporation
before it can expense any separately acquired property. However, once
an S corporation elects to expense property under section 179, a
shareholder will generally elect to expense personal property only to
the extent the shareholder's pro rata share of the corporation's
section 179 expense does not exceed the shareholder's individual
limitation under section 179(b). Accordingly, no modifications have
been made to the example in the final regulations.
The commentator also requested that the final regulations provide
additional examples that illustrate the aggregation of the
shareholder's pro rata share of deductions and exclusions from an S
corporation with deductions and exclusions from other sources and the
operation of any limitations on those aggregated deductions and
exclusions. Specifically, the commentator requested that the final
regulations include an example in which the shareholder's aggregate
section 179 expenses from several passthrough sources exceeds the
maximum section 179 expense allowable. The allocation of the section
179 expense among the various sources is more appropriately addressed
in the regulations under section 179 and is beyond the scope of these
regulations. Accordingly, the final regulations do not adopt this
comment.
2. Recharacterization of Gains and Losses at the Shareholder Level
Generally, the items of an S corporation that are passed through,
and reported by, a shareholder are characterized at the corporate level
in the same manner that partnership items are characterized at the
partnership level.
However, the proposed regulations also contain exceptions to this
general rule 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 that in the hands of the shareholder or
shareholders would have produced a different character of 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.
Commentators suggested that, in the absence of a statutory
provision like section 724 in the partnership context,
[[Page 71642]]
the IRS lacked the authority to recharacterize gain or loss at the
shareholder level. Thus, the commentators asserted that the final
regulations should not adopt the recharacterization rules.
Alternatively, the commentators suggested limiting the
recharacterization rule to sales or exchanges occurring within a
specified time period.
Unlike the partnership rules, the recharacterization rules in the
proposed regulations are limited to transactions in which an S
corporation is used for a principal purpose of changing the character
of the gain or loss of contributed property. These rules are reasonable
approaches to remedying any improper attempts to utilize section
1366(b) to avoid tax. The length of time between the contribution of
the property to the S corporation and the S corporation's sale or
exchange of the property will be a factor considered in evaluating
whether the S corporation was availed of for a principal purpose of
changing the character of the gain or loss. However, the final
regulations do not adopt any particular time period. Thus, the final
regulations retain the recharacterization rules as proposed.
3. Gross Income Reporting Requirement
Section 1366(c), like section 702(c) in the partnership context,
provides for the passthrough 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
proposed regulations provide that a 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.
A commentator suggested that the rule in the proposed regulations
attempts to narrow the disclosure exception under section 6501(e) by
applying a pro rata concept with respect to a shareholder's gross
income. The commentator recommended that the final regulations not
adopt the gross income reporting rules or, alternatively, provide a de
minimis exception to the rule for certain shareholders who own minority
interests in an S corporation.
The rule in the proposed regulations parallels the rules for
determining the amount of gross income reported by a partner in a
partnership. See section 702(c); Sec. 1.702-1(c)(2). Accordingly, the
final regulations do not adopt this suggestion.
4. Carryover of Disallowed Losses Under Section 1366(d)
Section 1366(d) provides that a shareholder's disallowed losses and
deductions for any taxable year shall be treated as incurred by the
corporation in the succeeding taxable year with respect to that
shareholder. The proposed regulations provide that a shareholder's
losses and deductions disallowed under section 1366(d) are personal to
the shareholder and cannot in any manner be transferred to another
person. A commentator requested that the final regulations provide an
exception to this rule for transferees that have an identity of
investment interest or common basis with the transferor, such as when
stock is transferred incident to divorce under section 1041.
Under section 1366(d), the carryover of disallowed losses and
deductions is with respect to the shareholder whose investment limited
the items of loss or deduction. Thus, the carryover is not available to
a transferee who acquires the stock whether by sale, death, gift, or
otherwise. Accordingly, the final regulations retain the rule that
disallowed losses and deductions are nontransferable.
The proposed regulations also provide that if a shareholder
transfers all of the shareholder's stock in the corporation, any
disallowed loss or deduction is permanently disallowed. A commentator
suggested that the final regulations permit a former shareholder of an
S corporation who subsequently reacquires stock in the S corporation to
utilize the losses and deductions previously disallowed to the
shareholder.
Losses and deductions that are disallowed in any taxable year carry
over under section 1366(d) to the succeeding taxable year of the
corporation with respect to a particular shareholder. If a shareholder
completely terminates its interest in the corporation, the shareholder
will not be a shareholder in the succeeding taxable year of the
corporation and the disallowed losses would not carry over. There is no
statutory authority for the carryover of disallowed items if a
shareholder is not a shareholder in the year succeeding the
disallowance. The disallowed items of loss and deduction are amounts
that exceed the shareholder's economic investment in the corporation.
Once the shareholder terminates its interest in the corporation, it is
not necessary to preserve the shareholder's position in the
corporation. Thus, the final regulations do not adopt this
commentator's suggestion.
5. Basis in S Corporation Stock Received as a Gift
Section 1366(d)(1) limits the amount of corporate losses and
deductions that can pass through to, and be deducted by, a shareholder
to the shareholder's adjusted basis in the corporation's stock and debt
of the corporation to the shareholder.
The proposed regulations provide that, for purposes of section
1366(d)(1), a shareholder's basis in stock acquired by gift is the
basis of the stock used for purposes of determining loss under section
1015. Thus, if the fair market value of the stock exceeds the donor's
adjusted basis on the date of the gift, for purposes of section
1366(d)(1), the adjusted basis of the stock in the hands of the donee
is its adjusted basis in the hands of the donor. However, if the
donor's adjusted basis in the stock exceeds the stock's fair market
value on the date of the gift, for purposes of section 1366(d)(1), the
adjusted basis of the stock in the hands of the donee is the stock's
fair market value on the date of the gift.
One commentator argued that the basis for determining loss under
section 1015 is applicable only on the disposition of the gifted asset.
The basis for determining loss in section 1015 generally does not
affect the basis for depreciation or the deductibility of net expenses
arising out of the use or operation of the gifted asset.
The proposed regulations, however, apply the loss basis rule in
section 1015 not for purposes of determining the depreciable basis of a
gifted asset, but rather for purposes of determining the amount of
passthrough losses and deductions (including depreciation deductions
and operating losses) that are allowable to a shareholder under section
1366. The donee of loss stock cannot dispose of the stock and recognize
the loss inherent in the stock on the date of gift. If the donee could
use the donor's basis to take depreciation deductions and operating
losses of the S corporation, the donee in effect would realize the
benefit of the loss inherent in the stock.
Another commentator agreed that the basis for determining loss in
section 1015 ought to be the basis of gifted stock for purposes of
section 1366. Thus, the final regulations continue to provide that for
purposes of section 1366, the basis of stock acquired by gift is the
basis for determining loss under section 1015.
6. Allocation of Disallowed Losses in Certain Corporate Separations
The proposed regulations provide rules for the carryover of
disallowed
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losses and deductions in the case of certain corporate reorganizations.
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. The proposed regulations provide that 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.
A commentator suggested that the term value as used in the proposed
regulations is ambiguous and that the final regulations should
specifically state ``fair market value.'' The commentator also
recommended that because the computation of fair market value
introduces a host of valuation issues into the transaction, the final
regulations should permit an allocation of disallowed losses and
deductions based on the relative adjusted bases of the assets of the
distributing and controlled corporations. Finally, the commentator
requested that the final regulations allow S corporations to allocate
disallowed losses and deductions to the controlled or distributing
corporation based upon the source of those losses and deductions. The
final regulations permit shareholders to allocate disallowed losses and
deductions according to any reasonable method, including a method based
on the relative fair market value of the shareholder's stock in the
distributing and controlled corporations immediately after the
distribution, a method based on the relative adjusted bases of the
assets in the distributing and controlled corporations immediately
after the distribution, or, in the case of losses and deductions
clearly attributable to either the distributing or controlled
corporation, a method that allocates such losses and deductions
accordingly.
7. Allocation of Tax on Passive Investment Income Under Section
1366(f)(3)
Section 1366(f)(3) provides that if any tax is imposed under
section 1375 for a taxable year, each item of passive investment income
is reduced by an amount which bears the same ratio to the amount of the
tax as the amount of the item bears to the total passive investment
income for the taxable year.
A commentator requested guidance in the final regulations on
whether the allocation of any tax imposed under section 1375 is made
based on the total gross or total net passive investment income. Under
section 1375, the amount of excess passive investment income is
allocated to the items of passive investment income based on the net
passive investment income of the corporation. The allocation of the tax
imposed on the excess passive investment income should be similarly
allocated. Accordingly, the final regulations clarify that the
allocation of any tax under section 1375 is based on the total net
passive investment income for the taxable year.
8. Accrual of Charitable Contribution Deductions Under Section
170(a)(2)
The proposed regulations under section 1366 provide that each
shareholder must take into account the shareholder's pro rata share of
any charitable contributions paid by the corporation during the
corporation's taxable year. A commentator requested that the final
regulations clarify that separately stated items include charitable
contributions paid or deemed to be paid. The commentator suggested that
an accrual basis S corporation may elect under section 170(a)(2) to
treat charitable contributions as paid in the year prior to the year in
which the charitable contribution is actually paid.
Under section 1363(b), S corporations generally compute their
taxable income in the same manner as in the case of an individual.
However, S corporations are not permitted to take charitable
contribution deductions by virtue of the cross reference in section
1363(b)(2) to section 703(a)(2). Instead, the deductions for charitable
contributions pass through to the shareholders of the S corporation.
Individuals cannot make the election under section 170(a)(2). Treasury
and the Service believe that an S corporation also cannot make the
election under section 170(a)(2). Accordingly, the final regulations do
not adopt this suggestion.
9. Treatment of Section 108 Income
The regulations enumerate items of income (including tax-exempt
income), loss, deduction, or credit of an S corporation that must be
taken into account separately by each shareholder pursuant to section
1366(a)(1)(A). ``Tax-exempt income'' does not include income from
discharge of indebtedness excluded from income under section 108
because such income is not permanently excludible from income in all
circumstances in which section 108 applies. One commentator objected to
this treatment of section 108 income, arguing that such income is tax-
exempt and that application of section 108 at the S corporation level
pursuant to section 108(d)(7)(A) does not preclude the pass-through of
section 108 income. Another commentator, however, agreed with the
approach taken by the regulations.
Treasury and the Service continue to believe that 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 the specific rules that apply to the discharge of indebtedness
income of S corporations. Accordingly, the treatment of section 108
income is unchanged in the final regulations.
10. Adjustment to Basis of Stock
Section 1367(a) and Sec. 1.1367-1 of the proposed regulations
prescribe the order of 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.
A commentator suggested that the final regulations should provide
that life insurance premiums on policies owned by the S corporation do
not affect either a shareholder's basis in stock/debt or the
corporation's accumulated adjustments account (AAA). The commentator
further suggested that Sec. 1.1367-1(c)(2) (relating to noncapital,
nondeductible expenses) be amended to make special provision for
accounts receivable when debt is restored.
Because these comments relate to provisions in Sec. 1.1367-1 that
were not affected by the amendments contained in the proposed
regulations, the comments are not reflected in the final regulations.
11. Adjustments Required Before Determining Tax Effect of Distribution
Section 1.1368-2 of the proposed regulations 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 to the
shareholders for
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taxable years of the corporation beginning on or after August 18, 1998.
One commentator interpreted Sec. 1.1368-2(a)(5) of the proposed
regulations, which prescribes the order in which adjustments are made
to the AAA for purposes of determining the source of a distribution, as
providing that the AAA is adjusted in the same order as the adjustments
to the basis of a share of stock under Sec. 1.1367-1 of the proposed
regulations. The commentator stated that although the Small Business
Job Protection Act of 1996 (1996 Act) changed the order of the
adjustments to the basis of a share of stock, the 1996 Act did not
change the order of the adjustments to the AAA except in situations
involving a net negative adjustment (where the reductions in the
account for the taxable year exceed the increases for the taxable
year). When a net negative adjustment occurs, the AAA is adjusted to
take into account distributions before the AAA is adjusted to take into
account any net negative adjustment.
Consistent with the comment received, the final regulations make
clear that except in situations involving a net negative adjustment,
the order of adjustments to the AAA is not changed. Examples are added
to the final regulations to illustrate the effect of the 1996 Act on
the AAA ordering rules.
12. Transition Rule and Effective Date Sections 1367 and 1368
Sections 1.1367-3 and 1.1368-4 of the proposed regulations provide
that the amendments to the final regulations under section 1367 and
1368 apply only to taxable years of the corporation beginning on or
after August 18, 1998.
Commentators suggested that because the amendments to sections 1367
and 1368 under the 1996 Act are effective for taxable years beginning
after December 31, 1996, the final regulations should be effective, at
least on an elective basis, for the period beginning from the effective
date of the 1996 Act and ending on the effective date of the final
regulations.
Sections 1.1367-3 and 1.1368-4 of the final regulations reflect
this comment and provide that for taxable years beginning on or after
January 1, 1997, and before August 18, 1998, the adjustments to the
basis of a shareholder's stock and the treatment of distributions by an
S corporation, respectively, must be determined in a reasonable manner,
taking into account the statute and the legislative history. Return
positions consistent with the final regulations will be considered
reasonable.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 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, the notice of proposed rulemaking preceding these
regulations was submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on its impact on small
business.
Drafting Information. The principal authors of these final
regulations are Terri A. Belanger, Deane M. Burke, 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
26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Sections 1.1366-0 and 1.1366-1 are added, Sec. 1.1366-2 is
revised, and Secs. 1.1366-3 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 passthrough 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.
[[Page 71645]]
Sec. 1.1366-3 Treatment of family groups.
(a) In general.
(b) Examples.
Sec. 1.1366-4 Special rules limiting the passthrough of certain
items of an S corporation to its shareholders.
(a) Passthrough inapplicable to section 34 credit.
(b) Reduction in passthrough for tax imposed on built-in gains.
(c) Reduction in passthrough 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 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 in the regulations 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, a calendar year 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
[[Page 71646]]
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 (as defined in 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 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 A's pro rata share,
$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 passthrough 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
[[Page 71647]]
the S corporation to the shareholder is not allowed for the taxable
year. However, any disallowed loss or deduction retains its character
and is treated as incurred by the corporation in the corporation's
first succeeding taxable year, and subsequent taxable years, with
respect to the shareholder. 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(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 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 under section
1015(a).
(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 under
section 1015(a).
(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
[[Page 71648]]
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. Such allocation
shall be made according to any reasonable method, including a method
based on the relative fair market value of the shareholder's stock in
the distributing and controlled corporations immediately after the
distribution, a method based on the relative adjusted basis of the
assets in the distributing and controlled corporations immediately
after the distribution, or, in the case of losses and deductions
clearly attributable to either the distributing or controlled
corporation, any method that allocates such losses and deductions
accordingly.
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 or more shareholders of the S corporation holds an
interest in a passthrough 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 passthrough 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 Internal Revenue
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 passthrough of certain items
of an S corporation to its shareholders.
(a) Passthrough 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 passthrough 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 net
recognized built-in gains giving rise to the tax and attributing the
character of each net recognized built-in gain to the allocable portion
of the loss.
(c) Reduction in passthrough 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 net 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. 3. 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. 4. Section 1.1367-1 is amended as follows:
1. The paragraph 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.
[[Page 71649]]
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 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. 5. Sec. 1.1367-3 is revised to read as follows:
Sec. 1.1367-3 Effective date and transition rule.
Except for Sec. 1.1367-1(f), (h) Example 2 and Example 5, and (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), (h) Example
2 and Example 5, and (j) apply only to taxable years of the corporation
beginning on or after August 18, 1998. For taxable years beginning
before January 1, 1994, and taxable years beginning on or after January
1, 1997, and before August 18, 1998, the basis of a shareholder's stock
must be determined in a reasonable manner, taking into account the
statute and legislative history. Except for Sec. 1.1367-1(f), (h)
Example 2 and Example 5, and (j), return positions consistent with
Secs. 1.1367-1 and 1.1367-2 are reasonable for taxable years beginning
before January 1, 1994. Return positions consistent with Sec. 1.1367-
1(f), (h) Example 2 and Example 5, and (j) are reasonable for taxable
years beginning on or after January 1, 1997, and before August 18,
1998.
Par. 6. 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 (2) are added.
[[Page 71650]]
2. The entry for Sec. 1.1368-2(a)(4) is revised.
3. An entry for Sec. 1.1368-2(a)(5) is added.
4. The entry for Sec. 1.1368-2(d) is revised.
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) * * *
(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. 7. 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
includible 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 net
negative adjustment (as defined in section 1368(e)(1)(C)(ii)) for the
taxable year shall not be taken into account.
* * * * *
Par. 8. Section 1.1368-2 is amended as follows:
1. Paragraphs (a)(1) and (a)(3)(ii), and the paragraph heading and
introductory text of paragraph (a)(4) are revised.
2. Paragraph (a)(5) is added.
3. The paragraph 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) * * *
(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 S 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)(i) of this section for
the taxable year;
(ii) The AAA is decreased under paragraph (a)(3)(i) of this section
(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)(iii) of this section;
(iii) The AAA is decreased (but not below zero) by any portion of
an ordinary distribution to which section 1368(b) or (c)(1) applies;
(iv) The AAA is decreased by any net negative adjustment (as
defined in section 1368(e)(1)(C)(ii)); 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. 9. Section 1368-3 is amended as follows:
1. The heading for Example 1 is revised.
2. Example 3 through Example 6 are redesignated as Example 6
through Example 9, respectively.
3. Example 2 is redesignated as Example 3.
[[Page 71651]]
4. The heading for newly redesignated Example 3 is revised.
5. New Example 2, Example 4, and Example 5 are added.
The revisions and additions 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. The balance in Corporation S's AAA is $100. 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.
Example 3. Distributions by S corporations with C corporation
earnings and profits for taxable years beginning before January 1,
1997. * * *
Example 4. Distributions by S corporations with earnings and
profits and no net negative adjustment for taxable years beginning
on or after August 18, 1998. (i) Corporation S, an S corporation,
has accumulated earnings and profits of $1,000 and a balance in the
AAA of $2,000 on January 1, 2001. S's sole shareholder B holds 100
shares of stock with a basis of $20 per share as of January 1, 2001.
On April 1, 2001, S makes a distribution of $1,500 to B. B's pro
rata share of the income earned by S during 2001 is $2,000 and B's
pro rata share of S's losses is $1,500. For the taxable year ending
December 31, 2001, S does not have a net negative adjustment as
defined in section 1368(e)(1)(C). S does not make the election under
section 1368(e)(3) and Sec. 1.1368-1(f)(2) to distribute its
earnings and profits before its AAA.
(ii) The AAA is increased from $2,000 to $4,000 for the $2,000
of income earned during the 2001 taxable year. The AAA is decreased
from $4,000 to $2,500 for the $1,500 of losses. The AAA is decreased
from $2,500 to $1,000 for the portion of the distribution ($1,500)
to B that does not exceed the AAA.
(iii) As of December 31, 2001, B's basis in his stock is $10
($20 + $20 ($2,000 income/100 shares)--$15 ($1,500 distribution/100
shares)--$15 ($1,500 loss/100 shares).
Example 5. Distributions by S corporations with earnings and
profits and net negative adjustment for taxable years beginning on
or after August 18, 1998. (i) Corporation S, an S corporation, has
accumulated earnings and profits of $1,000 and a balance in the AAA
of $2,000 on January 1, 2001. S's sole shareholder B holds 100
shares of stock with a basis of $20 per share as of January 1, 2001.
On April 1, 2001, S makes a distribution of $2,000 to B. B's pro
rata share of the income earned by S during 2001 is $2,000 and B's
pro rata share of S's losses is $3,500. For the taxable year ending
December 31, 2001, S has a net negative adjustment as defined in
section 1368(e)(1)(C). S does not make the election under section
1368(e)(3) and Sec. 1.1368-1(f)(2) to distribute its earnings and
profits before its AAA.
(ii) The AAA is increased from $2,000 to $4,000 for the $2,000
of income earned during the 2001 taxable year. Because under section
1368(e)(1)(C)(ii) and Sec. 1.1368-2(a)(ii), the net negative
adjustment is not taken into account, the AAA is decreased from
$4,000 to $2,000 for the portion of the losses ($2,000) that does
not exceed the income earned during the 2001 taxable year. The AAA
is reduced from $2,000 to zero for the portion of the distribution
to B ($2,000) that does not exceed the AAA. The AAA is decreased
from zero to a negative $1,500 for the portion of the $3,500 of loss
that exceeds the $2,000 of income earned during the 2001 taxable
year.
(iii) Under Sec. 1.1367-1(c)(1), the basis of a shareholder's
share in an S corporation stock may not be reduced below zero.
Accordingly, as of December 31, 2001, B's basis per share in his
stock is zero ($20 + $20 income--$20 distribution--$35 loss).
Pursuant to section 1366(d)(2), the $15 of loss in excess of B'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 B.
* * * * *
Par. 10. Sec. 1.1368-4 is revised 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 1.1368-3
Example 2, Example 4, and Example 5, 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. Section 1.1368-1(e)(2), Sec. 1.1368-2(a)(5), and
Sec. 1.1368-3 Example 2, Example 4, and Example 5 apply only to taxable
years of the corporation beginning on or after August 18, 1998. For
taxable years beginning before January 1, 1994, and taxable years
beginning on or after January 1, 1997, and before August 18, 1998, the
treatment of distributions by an S corporation to its shareholders must
be determined in a reasonable manner, taking into account the statute
and legislative history. Except with regard to the deemed dividend rule
under Sec. 1.1368-1(f)(3), Sec. 1.1368-1(e)(2), Sec. 1.1368-2(a)(5),
and Sec. 1.1368-3 Example 2, Example 4, and Example 5, return positions
consistent with Secs. 1.1368-1, 1.1368-2, and 1.1368-3 are reasonable
for taxable years beginning before January 1, 1994. Return positions
consistent with Secs. 1.1368-1(e)(2), 1.1368-2(a)(5), and 1.1368-3
Example 2, Example 4, and Example 5 are reasonable for taxable years
beginning on or after January 1, 1997, and before August 18, 1998.
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 11. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Par. 12. In Sec. 602.101, paragraph (b) is amended by adding an
entry for 1.1366-1 to the table to read as follows:
Sec. 602.101 OMB Control numbers.
* * * * *
(b) * * *
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control No.
------------------------------------------------------------------------
* * * * *
1.1366-1................................................... 1545-1613
* * * * *
------------------------------------------------------------------------
[[Page 71652]]
Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
Approved: December 13, 1999.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury.
[FR Doc. 99-32697 Filed 12-21-99; 8:45 am]
BILLING CODE 4830-01-U
