Adjustment To Net Unrealized Built-in Gain

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9180]

RIN 1545-BC29

Adjustment To Net Unrealized Built-in Gain

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations under section 1374

that provide for an adjustment to the amount that may be subject to tax

under section 1374 in certain cases in which an S corporation acquires

assets from a C corporation in an acquisition to which section

1374(d)(8) applies. These final regulations provide guidance to certain

S corporations that acquire assets from a C corporation in a carryover

basis transaction.

DATES: Effective Date: These regulations are effective February 23,

2005.

Applicability Dates: For dates of applicability, see Sec. 1.1374-

10.

FOR FURTHER INFORMATION CONTACT: Jennifer D. Sledge, (202) 622-7750

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

This document contains amendments to Income Tax Regulations (26 CFR

part 1) under section 1374 of the Internal Revenue Code (Code),

relating to the tax imposed on certain recognized built-in gains of S

corporations. Section 1374 imposes a tax on an S corporation's net

recognized built-in gain attributable to assets that it held on the

date it converted from a C corporation to an S corporation for the 10-

year period beginning on the first day the corporation is an S

corporation and assets that it acquired from a C corporation in a

carryover basis transaction for the 10-year period beginning on the day

of the acquisition. A separate determination of the amount subject to

tax under section 1374 is required for those assets the S corporation

held on the date it converted to C status and each pool of assets the S

corporation acquired in a carryover basis transaction from a C

corporation. The total amount subject to tax under section 1374 for

each pool of assets is limited to that pool's net unrealized built-in

gain (NUBIG) on the date of the conversion or acquisition.

Under the current rules, if X, a C corporation, elects to be an S

corporation when it owns some or all of the stock of Y, a C

corporation, and Y subsequently transfers its assets to X in a

liquidation to which sections 332 and 337(a) apply or in a

reorganization described in section 368(a), the built-in gain or built-

in loss in Y's assets may be wholly or partially reflected twice: once

in the NUBIG attributable to the assets X owned on the date of its

conversion (including the Y stock) and a second time in the NUBIG

attributable to Y's former assets acquired by X in the liquidation of

Y. The IRS and Treasury Department recognize that continuing to reflect

the built-in gain or the built-in loss in the Y stock at the time of

X's conversion after the liquidation or reorganization is inconsistent

with the fact that such liquidation or reorganization has the effect of

eliminating that built-in gain or built-in loss. Therefore, on June 25,

2004, the IRS and Treasury Department published in the Federal Register

(69 FR 35544) a notice of proposed rulemaking (REG-131486-03) that

includes regulations proposing an adjustment to the NUBIG in these

cases. In particular, the proposed regulations generally provide that,

if an S corporation acquires assets of a C corporation in a carryover

basis transaction, some or all of the stock of the C corporation from

which such assets were acquired was taken into account in the

computation of NUBIG for a pool of assets of the S corporation, and

some or all of such stock is redeemed or canceled in such transaction,

then, subject to certain limitations, such NUBIG is adjusted to

eliminate any effect any built-in gain or built-in loss in the redeemed

or canceled stock had on the initial computation of NUBIG for that pool

of assets. These regulations are proposed to apply for taxable years

beginning after the date they are published as final regulations in the

Federal Register.

No public hearing was requested or held regarding the proposed

regulations. One written comment, however, was received. That comment

requested that the proposed regulations be made effective as soon as

possible.

These final regulations adopt the proposed regulations without

substantive change as final regulations. However, the final regulations

do modify the proposed effective date of the regulations. The final

regulations apply to section 1374(d)(8) transactions that occur in

taxable years beginning after February 23, 2005. The final regulations

also provide that an S corporation may apply the regulations to section

1374(d)(8) transactions that occur in taxable years beginning on or

before February 23, 2005, if the S corporation (and any predecessors or

successors) and all affected shareholders file original or amended

returns that are consistent with the regulations for taxable years of

the S corporation during the recognition period of the pool of assets

the NUBIG of which would be adjusted pursuant to the regulations that

are not closed as of the first date after February 23, 2005, that the S

corporation files an original or amended return.

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 also has been

determined that section 553(b) of the Administrative Procedure Act (5

U.S.C. chapter 5) does not apply to these regulations and, because the

regulations do not impose a collection of information on small

entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Therefore, a Regulatory Flexibility Analysis is not required.

Pursuant to section 7805(f) of the Code, this regulation was submitted

to the Chief Counsel for Advocacy of the Small Business Administration

for comment on their impact on small business.

Drafting Information

The principal author of these regulations is Jennifer D. Sledge of

the Office of Associate Chief Counsel (Corporate). Other personnel from

Treasury and the IRS participated in their development.

[[Page 8728]]

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

0

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0

Paragraph 1. The authority citation for part 1 continues to read, in

part, as follows:

Authority: 26 U.S.C. 7805 * * *

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Par. 2. Section 1.1374-3 is amended by:

0

1. Revising paragraph (b).

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2. Adding paragraph (c).

The revision and addition read as follows:

Sec. 1.1374-3 Net unrealized built-in gain.

* * * * *

(b) Adjustment to net unrealized built-in gain--(1) In general. If

section 1374(d)(8) applies to an S corporation's acquisition of assets,

some or all of the stock of the corporation from which such assets were

acquired was taken into account in the computation of the net

unrealized built-in gain for a pool of assets of the S corporation, and

some or all of such stock is redeemed or canceled in such transaction,

then, subject to the limitations of paragraph (b)(2) of this section,

such net unrealized built-in gain is adjusted to eliminate any effect

that any built-in gain or built-in loss in the redeemed or canceled

stock (other than stock with respect to which a loss under section 165

is claimed) had on the initial computation of net unrealized built-in

gain for that pool of assets. For purposes of this paragraph, stock

described in section 1374(d)(6) shall be treated as taken into account

in the computation of the net unrealized built-in gain for a pool of

assets of the S corporation.

(2) Limitations on adjustment--(i) Recognized built-in gain or

loss. Net unrealized built-in gain for a pool of assets of the S

corporation is only adjusted under paragraph (b)(1) of this section to

reflect built-in gain or built-in loss in the redeemed or canceled

stock that has not resulted in recognized built-in gain or recognized

built-in loss during the recognition period.

(ii) Anti-duplication rule. Paragraph (b)(1) of this section shall

not be applied to duplicate an adjustment to the net unrealized built-

in gain for a pool of assets made pursuant to paragraph (b)(1) of this

section.

(3) Effect of adjustment. Any adjustment to the net unrealized

built-in gain made pursuant to this paragraph (b) only affects

computations of the amount subject to tax under section 1374 for

taxable years that end on or after the date of the acquisition to which

section 1374(d)(8) applies.

(4) Pool of assets. For purposes of this section, a pool of assets

means--

(i) The assets held by the corporation on the first day it became

an S corporation, if the corporation was previously a C corporation; or

(ii) The assets the S corporation acquired from a C corporation in

a section 1374(d)(8) transaction.

(c) Examples. The following examples illustrate the rules of this

section:

Example 1. Computation of net unrealized built-in gain. (i)(A)

X, a calendar year C corporation using the cash method, elects to

become an S corporation on January 1, 1996. On December 31, 1995, X

has assets and liabilities as follows:

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Assets FMV Basis

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Factory.......................................... $500,000 $900,000

Accounts Receivable.............................. 300,000 0

Goodwill......................................... 250,000 0

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Total.......................................... 1,050,000 900,000

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Liabilities Amount

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Mortgage..................................................... $200,000

Accounts Payable............................................. 100,000

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Total...................................................... 300,000

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(B) Further, X must include a total of $60,000 in taxable income

in 1996, 1997, and 1998 under section 481(a).

(ii) If, on December 31, 1995, X sold all its assets to a third

party that assumed all its liabilities, X's amount realized would be

$1,050,000 ($750,000 cash received + $300,000 liabilities assumed =

$1,050,000). Thus, X's net unrealized built-in gain is determined as

follows:

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Amount realized........................................... $1,050,000

Deduction allowed (A/P)................................... (100,000)

Basis of X's assets....................................... (900,000)

Section 481 adjustments................................... 60,000

Net unrealized built-in gain.............................. 110,000

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Example 2. Adjustment to net unrealized built-in gain for built-

in gain in eliminated C corporation stock. (i) X, a calendar year C

corporation, elects to become an S corporation effective January 1,

2005. On that date, X's assets (the first pool of assets) have a net

unrealized built-in gain of $15,000. Among the assets in the first

pool of assets is all of the outstanding stock of Y, a C

corporation, with a fair market value of $33,000 and an adjusted

basis of $18,000. On March 1, 2009, X sells an asset that it owned

on January 1, 2005, and as a result has $10,000 of recognized built-

in gain. X has had no other recognized built-in gain or built-in

loss. X's taxable income limitation for 2009 is $50,000. Effective

June 1, 2009, X elects under section 1361 to treat Y as a qualified

subchapter S subsidiary (QSub). The election is treated as a

transfer of Y's assets to X in a liquidation to which sections 332

and 337(a) apply.

(ii) Under paragraph (b) of this section, the net unrealized

built in-gain of the first pool of assets is adjusted to account for

the elimination of the Y stock in the liquidation. The net

unrealized built-in gain of the first pool of assets, therefore, is

decreased by $15,000, the amount by which the fair market value of

the Y stock exceeded its adjusted basis as of January 1, 2005.

Accordingly, for taxable years ending after June 1, 2009, the net

unrealized built-in gain of the first pool of assets is $0.

(iii) Under Sec. 1.1374-2(a), X's net recognized built-in gain

for any taxable year equals the least of X's pre-limitation amount,

taxable income limitation, and net unrealized built-in gain

limitation. In 2009, X's pre-limitation amount is $10,000, X's

taxable income limitation is $50,000, and X's net unrealized built-

in gain limitation is $0. Because the net unrealized built-in gain

of the first pool of assets has been adjusted to $0, despite the

$10,000 of recognized built-in gain in 2009, X has $0 net recognized

built-in gain for the taxable year ending on December 31, 2009.

Example 3. Adjustment to net unrealized built-in gain for built-

in loss in eliminated C corporation stock. (i) X, a calendar year C

corporation, elects to become an S corporation effective January 1,

2005. On that date, X's assets (the first pool of assets) have a net

unrealized built-in gain of negative $5,000. Among the assets in the

first pool of assets is 10 percent of the outstanding stock of Y, a

C corporation, with a fair market value of $18,000 and an adjusted

basis of $33,000. On March 1, 2009, X sells an asset that it owned

on January 1, 2005, resulting in $8,000 of recognized built-in gain.

X has had no other recognized built-in gains or built-in losses. X's

taxable income limitation for 2009 is $50,000. On June 1, 2009, Y

transfers its assets to X in a reorganization under section

368(a)(1)(C).

(ii) Under paragraph (b) of this section, the net unrealized

built in-gain of the first pool of assets is adjusted to account for

the elimination of the Y stock in the reorganization. The net

unrealized built-in gain of the first pool of assets, therefore, is

increased by $15,000, the amount by which the adjusted basis of the

Y stock exceeded its fair market value as of January 1, 2005.

Accordingly, for taxable years ending after June 1, 2009, the net

unrealized built-in gain of the first pool of assets is $10,000.

(iii) Under Sec. 1.1374-2(a), X's net recognized built-in gain

for any taxable year equals the least of X's pre-limitation amount,

taxable income limitation, and net unrealized built-in gain

limitation. In 2009, X's pre-limitation amount is $8,000 and X's

taxable income limitation is $50,000. The net unrealized built-in

gain of the first pool of assets has been adjusted to $10,000, so

X's net unrealized built-in gain limitation is $10,000. X,

therefore, has $8,000 net recognized built-in gain for the taxable

year ending on December 31, 2009. X's net unrealized built-in gain

limitation for 2010 is $2,000.

[[Page 8729]]

Example 4. Adjustment to net unrealized built-in gain in case of

prior gain recognition. (i) X, a calendar year C corporation, elects

to become an S corporation effective January 1, 2005. On that date,

X's assets (the first pool of assets) have a net unrealized built-in

gain of $30,000. Among the assets in the first pool of assets is all

of the outstanding stock of Y, a C corporation, with a fair market

value of $45,000 and an adjusted basis of $10,000. Y has no current

or accumulated earnings and profits. On April 1, 2007, Y distributes

$18,000 to X, $8,000 of which is treated as gain to X from the sale

or exchange of property under section 301(c)(3). That $8,000 is

recognized built-in gain to X under section 1374(d)(3), and results

in $8,000 of net recognized built-in gain to X for 2007. X's net

unrealized built-in gain limitation for 2008 is $22,000. On June 1,

2009, Y transfers its assets to X in a liquidation to which sections

332 and 337(a) apply.

(ii) Under paragraph (b) of this section, the net unrealized

built in-gain of the first pool of assets is adjusted to account for

the elimination of the Y stock in the liquidation. The net

unrealized built-in gain of that pool of assets, however, can only

be adjusted to reflect the amount of built-in gain that was inherent

in the Y stock on January 1, 2005 that has not resulted in

recognized built-in gain during the recognition period. In this

case, therefore, the net unrealized built-in gain of the first pool

of assets cannot be reduced by more than $27,000 ($35,000, the

amount by which the fair market value of the Y stock exceeded its

adjusted basis as of January 1, 2005, minus $8,000, the recognized

built-in gain with respect to the stock during the recognition

period). Accordingly, for taxable years ending after June 1, 2009,

the net unrealized built-in gain of the first pool of assets is

$3,000. The net unrealized built-in gain limitation for 2009 is $0.

0

Par. 3. Paragraph (a) of Sec. 1.1374-10 is revised to read as follows:

Sec. 1.1374-10 Effective date and additional rules.

(a) In general. Sections 1.1374-1 through 1.1374-9, other than

Sec. 1.1374-3(b) and (c) Examples 2 through 4, apply for taxable years

ending on or after December 27, 1994, but only in cases where the S

corporation's return for the taxable year is filed pursuant to an S

election or a section 1374(d)(8) transaction occurring on or after

December 27, 1994. Section 1.1374-3(b) and (c) Examples 2 through 4

apply to section 1374(d)(8) transactions that occur in taxable years

beginning after February 23, 2005. In addition, an S corporation may

apply Sec. 1.1374-3(b) and (c) Examples 2 through 4 to section

1374(d)(8) transactions that occur in taxable years beginning on or

before February 23, 2005, if the S corporation (and any predecessors or

successors) and all affected shareholders file original or amended

returns that are consistent with these provisions for taxable years of

the S corporation during the recognition period of the pool of assets

the net unrealized built-in gain of which would be adjusted pursuant to

those provisions that are not closed as of the first date after

February 23, 2005, that the S corporation files an original or amended

return. For purposes of this section, affected shareholders means all

shareholders who received distributive shares of S corporation items in

such taxable years. However, the Commissioner may, in appropriate

circumstances, permit taxpayers to apply these provisions even if all

affected shareholders cannot file consistent returns. In addition, for

this purpose, a predecessor of an S corporation is a corporation that

transfers its assets to the S corporation in a transaction to which

section 381 applies. A successor of an S corporation is a corporation

to which the S corporation transfers its assets in a transaction to

which section 381 applies.

* * * * *

Mark E. Matthews,

Deputy Commissioner for Services and Enforcement.

Approved: February 14, 2005.

Eric Solomon,

Acting Deputy Assistant Secretary of the Treasury.

FR Doc. 05-3462 Filed 2-22-05; 8:45 am]

BILLING CODE 4830-01-P