Adjustments to Basis of Stock and Indebtedness to Shareholders of S Corporations and Treatment of Distributions by S Corporations to Shareholders

Federal RegisterJan 3, 1994

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8508]

RIN 1545-AE26

Adjustments to Basis of Stock and Indebtedness to Shareholders of

S Corporations and Treatment of Distributions by S Corporations to

Shareholders

AGENCY: Internal Revenue Service, Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations under section 1367 of

the Internal Revenue Code relating to adjustments to the basis of a

shareholder's stock in an S corporation and the basis of indebtedness

of an S corporation to a shareholder. This document also contains final

regulations under section 1368 of the Internal Revenue Code relating to

the treatment of distributions by an S corporation to its shareholders.

Changes to the applicable law were made by the Subchapter S Revision

Act of 1982, the Technical Corrections Act of 1982, the Tax Reform Act

of 1984, and the Tax Reform Act of 1986. The final regulations affect S

corporations and their shareholders and are necessary to provide them

with the guidance they need to comply with the applicable tax law.

EFFECTIVE DATE: These regulations are effective on January 1, 1994 and

apply to taxable years beginning on and after January 1, 1994.

FOR FURTHER INFORMATION CONTACT: Deane M. Burke (202) 622-3080 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations

have been reviewed and approved by the Office of Management and Budget

in accordance with the requirements of the Paperwork Reduction Act (44

U.S.C. 3504(h)) under control number 1545-1139. The estimated annual

burden per respondent varies from .05 to .2 hour, depending on

individual circumstances, with an estimated average of .1 hour.

These estimates are an approximation of the average time expected

to be necessary for a collection of information. They are based on such

information as is available to the Internal Revenue Service. Individual

respondents may require greater or less time, depending on their

particular circumstances.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be directed to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP,

Washington, DC 20224, and to the Office of Management and Budget,

Attention: Desk Officer for the Department of the Treasury, Office of

Information and Regulatory Affairs, Washington, DC 20503.

Background

This document amends 26 CFR part 1 that provides rules under

sections 1367 and 1368 of the Internal Revenue Code of 1986 (Code), as

amended. The amendments conform the regulations to amendments made to

sections 1367 and 1368 by sections 2 and 6 of the Subchapter S Revision

Act of 1982, section 305 of the Technical Corrections Act of 1982,

sections 721(d), (r), and (w) and 722(e)(2) of the Tax Reform Act of

1984, and section 1879(m)(1)(B) of the Tax Reform Act of 1986.

On June 9, 1992, the Federal Register published a notice of

proposed rulemaking (57 FR 24426) (the proposed regulations) concerning

adjustments to basis of stock and indebtedness to shareholders of S

corporations and treatment of distributions by S corporations to

shareholders. Because no one requested to testify, the Service

cancelled a public hearing scheduled for September 14, 1992. The

Service, however, received written comments on the proposed

regulations. After consideration of all of the comments, the proposed

regulations are adopted as revised by this Treasury decision.

Explanation of Provisions

The final regulations provide rules under section 1367 regarding

adjustments to the basis of a shareholder's stock in an S corporation

and the basis of indebtedness of an S corporation to a shareholder. The

final regulations also provide rules under section 1368 regarding the

treatment of distributions by an S corporation to its shareholders.

Except for modifications in response to the comments, which were

generally favorable, these final regulations generally provide the same

rules as the proposed regulations.

I. Adjustments to Basis of Stock

A. Separate Basis Approach

The proposed regulations provided a separate basis approach

(comparable to the basis of a shareholder in C corporation stock) for

determining adjustments to the basis of a shareholder's stock in an S

corporation. The proposed regulations also provided a spillover rule

that allowed a shareholder to apply losses and deductions in excess of

the basis of a share of stock to which such items are attributable

against the remaining bases of all other shares of stock owned by a

shareholder. The Service invited and received comments on whether

another approach such as an aggregate/average basis (comparable to the

basis of a partner in a partnership interest) should be used for

purposes of sections 1367, 1368, and 1012.

Commentators generally favored the separate basis approach with the

spillover rule in the proposed regulations. The final regulations

therefore retain this rule. In response to comments, the final

regulations clarify that the spillover rule applies to basis

adjustments for distributions to shareholders as well as to adjustments

for pro rata shares of passthrough items of losses or deductions.

B. Ordering Rule

Under the proposed regulations, adjustments are made to the basis

of a share of stock in the following order: (1) increases for income

items (including tax-exempt income) and The excess of deductions for

depletion over basis for non-oil and gas properties; (2) decreases for

noncapital, nondeductible expenses and certain oil and gas depletion

deductions; (3) decreases for items of loss or deduction; and (4)

decreases for distributions. The Service invited and received several

comments regarding the ordering rules.

Some commentators suggested that decreases to basis for

distributions should occur prior to decreases for any losses or

deductions, noncapital, nondeductible expenses, and oil and gas

depletion deductions. The legislative history on this issue is

contradictory. On the one hand, the committee reports state that the S

corporation rules for adjusting basis generally will be analogous to

those provided for partnerships (which adjust basis first for

distributions, then for losses and deductions). On the other hand, the

reports also state that ``income and loss for any corporate taxable

year will apply to adjust basis before the distribution rules apply for

that year.'' See H.R. Rep. No. 826, 97th Cong., 2d Sess. 17 (1982); S.

Rep. No. 640, 97th Cong., 2d Sess. 18 (1982). The language of the loss

limitation rule of section 1366(d)(1) suggests that losses are to be

applied against basis prior to distributions. Section 1366(d)(1)

provides that ``[t]he aggregate amount of losses and deductions taken

into account by a shareholder * * * for a taxable year shall not exceed

the sum of (A) the adjusted basis of the shareholder's stock in the S

corporation (determined with regard to [increases for income and

depletion items]), and (B) the shareholder's adjusted basis in any debt

of the S corporation * * * '' Because of the specific statement in the

legislative history, and the implication in section 1366(d)(1), the

Service and the Treasury Department believe that it is appropriate to

require adjustments for losses and deductions prior to adjustments for

distributions. Thus, the final regulations retain the ordering rule of

the proposed regulations.

Commentators also suggested that decreases to basis for items of

loss or deduction should occur prior to decreases for noncapital,

nondeductible expenses and oil and gas depletion deductions. In

response to the comments, the final regulations provide that decreases

for items of loss or deduction may precede decreases for noncapital,

nondeductible expenses and oil and gas depletion deductions if a

shareholder agrees that noncapital, nondeductible expenses in excess of

basis and certain oil and gas depletion deductions will reduce basis in

succeeding taxable years.

II. Adjustments to Debt Basis and Open Account Debt

The Service invited comments regarding the proper treatment of open

account debt (advances to an S corporation by a shareholder that are

not represented by separate written instruments and that are typically

treated as one account by the S corporation) for purposes of reducing

and restoring basis in indebtedness. In particular, the Service asked

for comments on whether it is appropriate to treat each advance as a

separate debt or all advances as a single debt. Several commentators

suggested that the final regulations should provide a rule treating

open account debt as a single debt for all advances by a shareholder.

In response to comments, and for reasons of administrative simplicity,

the final regulations provide that all open account debt held by a

shareholder is to be treated as a single debt for purposes of reducing

and restoring basis of debt.

III. Elections Under Section 1368

The proposed regulations provide that if a shareholder disposes of

20 percent or more of the corporation's issued shares of stock in one

or more transactions during any thirty-day period during the taxable

year of the corporation (qualifying disposition), the corporation may

elect to treat the taxable year as if it consists of separate taxable

years, the first of which ends on the date on which the shareholder

disposes of 20 percent or more of the corporation's issued stock. Some

commentators suggested that the election for qualifying dispositions of

stock should be expanded to include any 20 percent or greater

disposition of stock (whether by a sale or exchange, by a redemption

treated as an exchange, or by a stock issuance). In response to

comments, the final regulations modify the rule in the proposed

regulations to permit the election for other dispositions of an S

corporation's stock.

IV. Rules Relating to the Accumulated Adjustments Account

Under the final regulations, only S corporations with earnings and

profits must maintain an accumulated adjustments account (AAA) to

determine the tax effect of distributions during S years and the post-

termination transition period as defined in section 1377(b)(1). An S

corporation without earnings and profits does not need to maintain the

AAA in order to determine the tax effect of distributions.

Nevertheless, if an S corporation without earnings and profits engages

in certain transactions to which section 381(a) applies, such as a

merger into an S corporation with C corporation earnings and profits,

the S corporation must be able to calculate its AAA at the time of the

merger for purposes of determining the tax effect of post-merger

distributions.

A. Adjustments to AAA

One commentator suggested that adjustments to the AAA should mirror

the statutory scheme for adjustments to basis in stock under section

1367, at least in the context of dividend distributions. Under the

proposed regulations, a distribution taxed to a shareholder under

section 1368(b)(2) (because it exceeds a shareholder's stock basis)

reduces the AAA balance. The commentator recommended that the AAA

should be decreased only by the portion of a distribution to which

section 1368(b)(1) applies. In effect, under the commentator's

suggestion, adjustments to the AAA would mirror adjustments to a

shareholder's basis in stock and would limit reduction of the AAA to

nontaxable distributions.

Section 1368(e)(1)(A) provides that the AAA is adjusted in a manner

similar to basis in stock and S corporation debt, but does not require

that it mirror shareholder level adjustments to basis in stock and S

corporation debt. Furthermore, the rule in the proposed regulations is

more consistent with the fact that the AAA is a corporate level

account. The Service and the Treasury Department believe that the

commentator's approach would create unnecessary complexity and

uncertainty in the administration of the statute. The AAA is a

corporate level account and an S corporation, which does not generally

need to track a shareholder's basis in its stock, would need to

determine a shareholder's basis to adjust the AAA upon a distribution.

Therefore, the final regulations do not adopt this commentator's

suggested approach regarding adjustments to the AAA for distributions.

B. Redemption Distributions

Section 1368(e)(1)(B) provides that in the case of a redemption

distribution that is treated as an exchange of stock under section

302(a) or section 303(a) (redemption distribution), the corporation's

AAA is adjusted in an amount equal to the ratable share of the

corporation's AAA attributable to the redeemed stock. In the case of a

taxable year in which ordinary distributions and redemption

distributions occur, the proposed regulations require an S corporation

to determine the ratable share of the AAA attributable to redeemed

stock under the method used to determine the pro rata portion of total

earnings and profits attributable to shares redeemed in a C

corporation. See Rev. Rul. 74-338, 1974-2 C.B. 101, and Rev. Rul. 74-

339, 1974-2 C.B. 103. The Service invited and received comments

regarding alternative approaches that appropriately reduce the AAA in

the case of ordinary and redemption distributions.

While commentators generally acknowledged that the redemption rule

in the proposed regulations is workable, they suggested the rule is

unnecessarily complex. In response to comments, the final regulations

modify the redemption rule. Under the final regulations, adjustments to

the AAA are made first for passthrough items, second for ordinary

distributions, and third for redemption distributions. For redemption

distributions, an S corporation is required to adjust the AAA in an

amount equal to the ratable share of the AAA attributable to the

redeemed stock. The corporation also independently adjusts earnings and

profits under the normal rules for C corporations.

V. Effective Date and Transition Rule

The final regulations under sections 1367 and 1368 apply to taxable

years of the corporation beginning on or after January 1, 1994. For

taxable years beginning before January 1, 1994, both the adjustments to

the basis of a shareholder's stock and any indebtedness of the S

corporation to a shareholder and the treatment of distributions by the

S corporation to its shareholders must be determined in a reasonable

manner. For purposes of the preceding sentence, return positions

consistent with Secs. 1.1367-1, 1.1367-2, 1.1368-1, 1.1368-2, and

1.1368-3 (other than the deemed dividend election under Sec. 1.1368-

1(f)(3)) are reasonable.

Special Analysis

It has been determined that this Treasury decision is not a

significant regulatory action as defined in Executive Order 12866. It

has also been determined that section 553(b) of the Administrative

Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act

(5 U.S.C. chapter 6) do not apply to these regulations, and, therefore,

a Regulatory Flexibility Analysis is not required. Pursuant to section

7805(f) of the Internal Revenue Code, the notice of proposed rulemaking

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 author of these final regulations is Deane M. Burke

of the Office of Assistant Chief Counsel (Passthroughs and Special

Industries), Internal Revenue Service. However, other personnel from

the Internal Revenue Service and Treasury Department participated in

their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

the following citations in numerical order:

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

Section 1.1368-1(f) and (g) also issued under 26 U.S.C. 1377(c).

Section 1.1368-2(b) also issued under 26 U.S.C. 1368(c).

Par. 2. Sections 1.1367-0 through 1.1367-3 and 1.1368-0 through

1.1368-4 are added to read as follows:

Sec. 1.1367-0 Table of contents.

The following table of contents is provided to facilitate the use

of Secs. 1.1367-1 through 1.1367-3.

Sec. 1.1367-1 Adjustments to basis of shareholder's stock in an S

corporation.

(a) In general.

(1) Adjustments under section 1367.

(2) Applicability of other Internal Revenue Code provisions.

(b) Increase in basis of stock.

(1) In general.

(2) Amount of increase in basis of individual shares.

(1) In general.

(2) Noncapital, nondeductible expenses.

(3) Amount of decrease in basis of individual shares.

(d) Time at which adjustments to basis of stock are effective.

(1) In general.

(2) Adjustment for nontaxable item.

(3) Effect of election under section 1377(a)(2) or Sec. 1.1368-

1(g)(2).

(e) Ordering rules.

(f) Elective ordering rule.

(g) Examples.

Sec. 1.1367-2 Adjustments to basis of indebtedness to shareholder.

(a) In general.

(b) Reduction in basis of indebtedness.

(1) General rule.

(2) Termination of shareholder's interest in corporation during

taxable year.

(3) Multiple indebtedness.

(1) General rule.

(2) Multiple indebtedness.

(d) Time at which adjustments to basis of indebtedness are

effective.

(1) In general.

(2) Effect of election under section 1377(a)(2) or Sec. 1.1368-

1(g)(2).

(e) Examples.

Sec. 1.1367-3 Effective date and transition rule.

Sec. 1.1367-1 Adjustments to basis of shareholder's stock in an S

corporation.

(a) In general--(1) Adjustments under section 1367.

This section provides rules relating to adjustments required by

section 1367 to the basis of a shareholder's stock in an S corporation.

Paragraph (b) of this section provides rules concerning increases in

the basis of a shareholder's stock, and paragraph (c) of this section

provides rules concerning decreases in the basis of a shareholder's

stock.

(2) Applicability of other Internal Revenue Code provisions. In

addition to the adjustments required by section 1367 and this section,

the basis of stock is determined or adjusted under other applicable

provisions of the Internal Revenue Code.

(b) Increase in basis of stock--(1) In general. Except as provided

in Sec. 1.1367-2(c) (relating to restoration of basis of indebtedness

to the shareholder), the basis of a shareholder's stock in an S

corporation is increased by the sum of the items described in section

1367(a)(1). The increase in basis described in section 1367(a)(1)(C)

for the excess of the deduction for depletion over the basis of the

property subject to depletion does not include the depletion deduction

attributable to oil or gas property. See section 613(A)(c)(11).

(2) Amount of increase in basis of individual shares. The basis of

a shareholder's share of stock is increased by an amount equal to the

shareholder's pro rata portion of the items described in section

1367(a)(1) that is attributable to that share, determined on a per

share, per day basis in accordance with section 1377(a).

shareholder's stock in an S corporation is decreased (but not below

zero) by the sum of the items described in section 1367(a)(2).

(2) Noncapital, nondeductible expenses. For purposes of section

1367(a)(2)(D), expenses of the corporation not deductible in computing

its taxable income and not properly chargeable to a capital account

(noncapital, nondeductible expenses) are only those items for which no

loss or deduction is allowable and do not include items the deduction

for which is deferred to a later taxable year. Examples of noncapital,

nondeductible expenses include (but are not limited to) the following:

illegal bribes, kickbacks, and other payments not deductible under

section 162(c); fines and penalties not deductible under section

162(f); expenses and interest relating to tax-exempt income under

section 265; losses for which the deduction is disallowed under section

267(a)(1); the portion of meals and entertainment expenses disallowed

under section 274; and the two-thirds portion of treble damages paid

for violating antitrust laws not deductible under section 162.

(3) Amount of decrease in basis of individual shares. The basis of

a shareholder's share of stock is decreased by an amount equal to the

shareholder's pro rata portion of the passthrough items and

distributions described in section 1367(a)(2) attributable to that

share, determined on a per share, per day basis in accordance with

section 1377(a). If the amount attributable to a share exceeds its

basis, the excess is applied to reduce (but not below zero) the

remaining bases of all other shares of stock in the corporation owned

by the shareholder in proportion to the remaining basis of each of

those shares.

(d) Time at which adjustments to basis of stock are effective--(1)

In general. The adjustments described in section 1367(a) to the basis

of a shareholder's stock are determined as of the close of the

corporation's taxable year, and the adjustments generally are effective

as of that date. However, if a shareholder disposes of stock during the

corporation's taxable year, the adjustments with respect to that stock

are effective immediately prior to the disposition.

(2) Adjustment for nontaxable item. An adjustment for a nontaxable

item is determined for the taxable year in which the item would have

been includible or deductible under the corporation's method of

accounting for federal income tax purposes if the item had been subject

to federal income taxation.

(3) Effect of election under section 1377(a)(2) or Sec. 1.1368-

1(g)(2). If an election under section 1377(a)(2) (to terminate the year

in the case of the termination of a shareholder's interest) or under

Sec. 1.1368-1(g)(2) (to terminate the year in the case of a qualifying

disposition) is made with respect to the taxable year of a corporation,

this paragraph (d) applies as if the taxable year consisted of separate

taxable years, the first of which ends at the close of the day on which

either the shareholder's interest is terminated or a qualifying

disposition occurs, whichever the case may be.

(e) Ordering rules. For any taxable year, except as provided in

paragraph (f) 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 noncapital, nondeductible

expenses described in section 1367(a)(2)(D) and the oil and gas

depletion deduction described in section 1367(a)(2)(E);

(3) Any decrease in basis attributable to items of loss or

deduction described in section 1367(a)(2) (B) and (C); and

(4) Any decrease in basis attributable to a distribution by the

corporation described in section 1367(a)(2)(A).

(f) Elective ordering rule. A shareholder may elect to decrease

basis under paragraph (e)(3) of this section prior to decreasing basis

under paragraph (e)(2) of this section. If a shareholder makes this

election, any amount described in paragraph (e)(2) of this section 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) of this section in the succeeding taxable year. A

shareholder makes the election under this paragraph by attaching a

statement to the shareholder's timely filed original or amended return

that states that the shareholder agrees to the carryover rule of the

preceding sentence. Once a shareholder makes an election under this

paragraph with respect to an S corporation, the shareholder must

continue to use the rules of this paragraph for that S corporation in

future taxable years unless the shareholder receives the permission of

the Commissioner.

(g) Examples. The following examples illustrate the principles of

Sec. 1.1367-1. In each example, the corporation is a calendar year S

corporation:

Example 1. Adjustments to basis of stock in general. (i) On

December 31, 1994, A owns a block of 50 shares of stock with an

adjusted basis per share of $6 in Corporation S. On December 31,

1994, 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 1995 taxable year. For S's 1995 taxable

year, A's pro rata share of the amount of the items described in

section 1367(a)(1)(A) (relating to increases in basis of stock) is

$300, and A's pro rata share of the amount of the items described in

section 1367(a)(2) (B) and (D) (relating to decreases in basis of

stock) is $500. S makes a distribution to A in the amount of $100

during 1995.

(ii) Pursuant to the ordering rules of paragraph (e) of this

section, A increases the basis of each share of stock by $3 ($300/

100 shares) and decreases the basis of each share of stock by $5

($500/100 shares). Then A reduces the basis of each share by $1

($100/100 shares) for the distribution. Thus, on January 1, 1996, A

has a basis of $3 per share in his original block of 50 shares

($6+$3-$5 -$1) and a basis of $5 per share in the second block of 50

shares ($8+$3-$5-$1).

Example 2. Adjustments attributable to basis of individual

shares of stock. (i) On December 31, 1993, B owns one share of S

corporation's 10 outstanding shares of stock. The basis of B's share

is $30. On July 2, 1994, B purchases from another shareholder two

shares for $25 each. During 1994, S corporation has no income or

deductions but incurs a loss of $365. Under section 1377(a)(1)(A)

and paragraph (c)(3) of this section, the amount of the loss

assigned to each day of S's taxable year is $1.00 ($365/365 days).

For each day, $.10 is allocated to each outstanding share ($1.00

amount of loss assigned to each day/10 shares).

(ii) B owned one share for 365 days and, therefore, reduces the

basis of that share by the amount of loss attributable to it, i.e.,

$36.50 ($.10 x 365 days). B owned two shares for 182 days and,

therefore, reduces the basis of each of those shares by the amount

of the loss attributable to each, i.e., $18.20 ($.10 x 182 days).

(iii) The bases of the shares are decreased as follows:

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Excess basis

Share Original basis Decrease Adjusted basis reduction

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No. 1............................... $30.00 $36.50 $0 $6.50

No. 2............................... 25.00 18.20 6.80 0

No. 3............................... 25.00 18.20 6.80 0

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Total remaining basis........... ................. ................. 13.60 .................

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(iv) Because the decrease in basis attributable to share No. 1

exceeds the basis of share No. 1 by $6.50 ($36.50 - $30.00), the

excess is applied to reduce the bases of shares No. 2 and No. 3 in

proportion to their remaining bases. Therefore, the bases of share

No. 2 and share No. 3 are each decreased by an additional $3.25

($6.50 x $6.80/$13.60). After this decrease, Share No. 1 has a

basis of zero, Share No. 2 has a basis of $3.55, and Share No. 3 has

a basis of $3.55.

Example 3. Effects of section 1377(a)(2) election and

distribution on basis of stock. (i) On January 1, 1994, individuals

B and C each own 50 of the 100 shares of issued and outstanding

stock of Corporation S. B's adjusted basis in each share of stock is

$120, and C's is $80. On June 30, 1994, S distributes $6,000 to B

and $6,000 to C. On June 30, 1994, B sells all of her S stock for

$10,000 to D. S elects under section 1377(a)(2) to treat its 1994

taxable year as consisting of two taxable years, the first of which

ends at the close of June 30, the date on which B terminates her

interest in S.

(ii) For the period January 1, 1994, through June 30, 1994, S

has nonseparately computed income of $6,000 and a separately stated

deduction item of $4,000. Therefore, on June 30, 1994, B and C,

pursuant to the ordering rules of paragraph (e) of this section,

increase the basis of each share by $60 ($6,000/100 shares) and

decrease the basis of each share by $40 ($4,000/100 shares). Then B

and C reduce the basis of each share by $120 ($12,000/100 shares)

for the distribution.

(iii) The basis of B's stock is reduced from $120 to $20 per

share ($120+$60-$40-$120). The basis of C's stock is reduced from

$80 to $0 per share ($80+$60-$40-$120). See section 1368 and

Sec. 1.1368-1 (c) and (d) for rules relating to the tax treatment of

the distributions.

(iv) Pursuant to paragraph (d)(3) of this section, the net

reduction in the basis of B's shares of the S stock required by

section 1367 and this section is effective immediately prior to B's

sale of her stock. Thus, B's basis for determining gain or loss on

the sale of the S stock is $20 per share, and B has a gain on the

sale of $180 ($200-$20) per share.

Sec. 1.1367-2 Adjustments to basis of indebtedness to shareholder.

(a) In general. This section provides rules relating to adjustments

required by subchapter S to the basis of indebtedness of an S

corporation to a shareholder. For purposes of this section, shareholder

advances not evidenced by separate written instruments and repayments

on the advances (open account debt) are treated as a single

indebtedness. The basis of indebtedness of the S corporation to a

shareholder is reduced as provided in paragraph (b) of this section and

restored as provided in paragraph (c) of this section.

(b) Reduction in basis of indebtedness--(1) General rule. If, after

making the adjustments required by section 1367(a)(1) for any taxable

year of the S corporation, the amounts specified in section 1367(a)(2)

(B), (C), (D), and (E) (relating to losses, deductions, noncapital,

nondeductible expenses, and certain oil and gas depletion deductions)

exceed the basis of a shareholder's stock in the corporation, the

excess is applied to reduce (but not below zero) the basis of any

indebtedness of the S corporation to the shareholder held by the

shareholder at the close of the corporation's taxable year. Any such

indebtedness that has been satisfied by the corporation, or disposed of

or forgiven by the shareholder, during the taxable year, is not held by

the shareholder at the close of that year and is not subject to basis

reduction.

(2) Termination of shareholder's interest in corporation during

taxable year. If a shareholder terminates his or her interest in the

corporation during the taxable year, the rules of this paragraph (b)

are applied with respect to any indebtedness of the S corporation held

by the shareholder immediately prior to the termination of the

shareholder's interest in the corporation.

(3) Multiple indebtedness. If a shareholder holds more than one

indebtedness at the close of the corporation's taxable year or, if

applicable, immediately prior to the termination of the shareholder's

interest in the corporation, the reduction in basis is applied to each

indebtedness in the same proportion that the basis of each indebtedness

bears to the aggregate bases of the indebtedness to the shareholder.

year of an S corporation beginning after December 31, 1982, there has

been a reduction in the basis of an indebtedness of the S corporation

to a shareholder under section 1367(b)(2)(A), any net increase in any

subsequent taxable year of the corporation is applied to restore that

reduction. For purposes of this section, net increase with respect to a

shareholder means the amount by which the shareholder's pro rata share

of the items described in section 1367(a)(1) (relating to income items

and excess deduction for depletion) exceed the items described in

section 1367(a)(2) (relating to losses, deductions, noncapital,

nondeductible expenses, certain oil and gas depletion deductions, and

certain distributions) for the taxable year. These restoration rules

apply only to indebtedness held by a shareholder as of the beginning of

the taxable year in which the net increase arises. The reduction in

basis of indebtedness must be restored before any net increase is

applied to restore the basis of a shareholder's stock in an S

corporation. In no event may the shareholder's basis of indebtedness be

restored above the adjusted basis of the indebtedness under section

1016(a), excluding any adjustments under section 1016(a)(17) for prior

taxable years, determined as of the beginning of the taxable year in

which the net increase arises.

(2) Multiple indebtedness. If a shareholder holds more than one

indebtedness as of the beginning of a corporation's taxable year, any

net increase is applied first to restore the reduction of basis in any

indebtedness repaid (in whole or in part) in that taxable year to the

extent necessary to offset any gain that would otherwise be realized on

the repayment. Any remaining net increase is applied to restore each

outstanding indebtedness in proportion to the amount that the basis of

each outstanding indebtedness has been reduced under section

1367(b)(2)(A) and paragraph (b) of this section and not restored under

section 1367(b)(2)(B) and this paragraph (c).

(d) Time at which adjustments to basis of indebtedness are

effective--(1) In general. The amounts of the adjustments to basis of

indebtedness provided in section 1367(b)(2) and this section are

determined as of the close of the corporation's taxable year, and the

adjustments are generally effective as of the close of the

corporation's taxable year. However, if the shareholder is not a

shareholder in the corporation at that time, these adjustments are

effective immediately before the shareholder terminates his or her

interest in the corporation. If a debt is disposed of or repaid in

whole or in part before the close of the taxable year, the basis of

that indebtedness is restored under paragraph (c) of this section,

effective immediately before the disposition or the first repayment on

the debt during the taxable year.

(2) Effect of election under section 1377(a)(2) or Sec. 1.1368-

1(g)(2). If an election is made under section 1377(a)(2) (to terminate

the year in the case of the termination of a shareholder's interest) or

under Sec. 1.1368-1(g)(2) (to terminate the year in the case of a

qualifying disposition), this paragraph (d) applies as if the taxable

year consisted of separate taxable years, the first of which ends at

the close of the day on which the shareholder either terminates his or

her interest in the corporation or disposes of a substantial amount of

stock, whichever the case may be.

(e) Examples. The following examples illustrate the principles of

Sec. 1.1367-2. In each example, the corporation is a calendar year S

corporation. The lending transactions described in the examples do not

result in foregone interest (within the meaning of section 7872(e)(2)),

original issue discount (within the meaning of section 1273), or total

unstated interest (within the meaning of section 483(b)).

Example 1. Reduction in basis of indebtedness. (i) A has been

the sole shareholder in Corporation S since 1992. In 1993, A loans S

$1,000 (Debt No. 1), which is evidenced by a ten-year promissory

note in the face amount of $1,000. In 1996, A loans S $5,000 (Debt

No. 2), which is evidenced by a demand promissory note. On December

31, 1996, the basis of A's stock is zero; the basis of Debt No. 1

has been reduced under paragraph (b) of this section to $0; and the

basis of Debt No. 2 has been reduced to $1,000. On January 1, 1997,

A loans S $4,000 (Debt No. 3), which is evidenced by a demand

promissory note. For S's 1997 taxable year, the sum of the amounts

specified in section 1367(a)(1) (in this case, nonseparately

computed income and the excess deduction for depletion) is $6,000,

and the sum of the amounts specified in section 1367(a)(2) (B), (D),

and (E) (in this case, items of separately stated deductions and

losses, noncapital, nondeductible expenses, and certain oil and gas

depletion deductions--there is no nonseparately computed loss) is

$10,000. Corporation S makes no payments to A on any of the loans

during 1997.

(ii) The $4,000 excess of loss and deduction items is applied to

reduce the basis of each indebtedness in proportion to the basis of

that indebtedness over the aggregate bases of the indebtedness to

the shareholder (determined immediately before any adjustment under

section 1367(b)(2)(A) and paragraph (b) of this section is effective

for the taxable year). Thus, the basis of Debt No. 2 is reduced in

an amount equal to $800 ($4,000 (excess) x $1,000 (basis of Debt No.

2)/$5,000 (total basis of all debt)). Similarly, the basis in Debt

No. 3 is reduced in an amount equal to $3,200 ($4,000 x $4,000/

$5,000). Accordingly, on December 31, 1997, A's basis in his stock

is zero and his bases in the three debts are as follows:

----------------------------------------------------------------------------------------------------------------

1/1/96 12/31/96 1/1/97 12/31/97 1/1/98

Debt basis reduction basis reduction basis

----------------------------------------------------------------------------------------------------------------

No. 1................................................ $1,000 $1,000 $0 $0 $0

No. 2................................................ 5,000 4,000 1,000 800 200

No. 3................................................ ......... ........... 4,000 3,200 800

----------------------------------------------------------------------------------------------------------------

Example 2. Restoration of basis of indebtedness. (i) The facts

are the same as in Example 1. On July 1, 1998, S completely repays

Debt No. 3, and, for S's 1998 taxable year, the net increase (within

the meaning of paragraph (c) of this section) with respect to A

equals $4,500.

(ii) The net increase is applied first to restore the bases in

the debts held on January 1, 1998, before any of the net increase is

applied to increase A's basis in his shares of S stock. The net

increase is applied to restore first the reduction of basis in

indebtedness repaid in 1998. Any remaining net increase is applied

to restore the bases of the outstanding debts in proportion to the

amount that each of these outstanding debts have been reduced

previously under paragraph (b) of this section and have not been

restored. As of December 31, 1998, the total reduction in A's debts

held on January 1, 1998 equals $9,000. Thus, the basis of Debt No. 3

is restored by $3,200 (the amount of the previous reduction) to

$4,000. A's basis in Debt No. 3 is treated as restored immediately

before that debt is repaid. Accordingly, A does not realize any gain

on the repayment. The remaining net increase of $1,300

($4,500-$3,200) is applied to restore the bases of Debt No. 1 and

Debt No. 2. As of December 31, 1998, the total reduction in these

outstanding debts is $5,800 ($9,000-$3,200). The basis of Debt No. 1

is restored in an amount equal to $224 ($1,300 x $1,000/$5,800).

Similarly, the basis in Debt No. 2 is restored in an amount equal to

$1,076 ($1,300 x $4,800/$5,800). On December 31, 1998, A's basis in

his S stock is zero and his bases in the two remaining debts are as

follows:

------------------------------------------------------------------------

Original Amount Amount 12/31/98

basis reduced 1/1/98 basis restored basis

------------------------------------------------------------------------

$1,000....... $1,000 $0 $224 $224

5,000........ 4,800 200 1,076 1,276

------------------------------------------------------------------------

Example 3. Full restoration of basis in indebtedness when debt

is repaid in part during the taxable year. (i) C has been a

shareholder in Corporation S since 1992. In 1997, C loans S $1,000.

S issues its note to C in the amount of $1,000, of which $950 is

payable on March 1, 1998, and $50 is payable on March 1, 1999. On

December 31, 1997, C's basis in all her shares of S stock is zero

and her basis in the note has been reduced under paragraph (b) of

this section to $900. For 1998, the net increase (within the meaning

of paragraph (c) of this section) with respect to C is $300.

(ii) Because C's basis of indebtedness was reduced in a prior

taxable year under Sec. 1.1367-2(b), the net increase for 1998 is

applied to restore this reduction. The restored basis cannot exceed

the adjusted basis of the debt as of the beginning of the first day

of 1998, excluding prior adjustments under section 1367, or $1,000.

Therefore, $100 of the $300 net increase is applied to restore the

basis of the debt from $900 to $1,000 effective immediately before

the repayment on March 1, 1998. The remaining net increase of $200

increases C's basis in her stock.

Example 4. Determination of net increase--distribution in excess

of increase in basis. (i) D has been the sole shareholder in

Corporation S since 1990. On January 1, 1996, D loans S $10,000 in

return for a note from S in the amount of $10,000 of which $5,000 is

payable on each of January 1, 2000, and January 1, 2001. On December

31, 1997, the basis of D's shares of S stock is zero, and his basis

in the note has been reduced under paragraph (b) of this section to

$8,000. During 1998, the sum of the items under section 1367(a)(1)

(relating to increases in basis of stock) with respect to D equals

$10,000 (in this case, nonseparately computed income), and the sum

of the items under section 1367(a)(2)(B), (C), (D), and (E)

(relating to decreases in basis of stock) with respect to D equals

$0. During 1998, S also makes distributions to D totaling $11,000.

This distribution is an item that reduces basis of stock under

section 1367(a)(2)(A) and must be taken into account for purposes of

determining whether there is a net increase for the taxable year.

Thus, for 1998, there is no net increase with respect to D because

the amount of the items provided in section 1367(a)(1) do not exceed

the amount of the items provided in section 1367(a)(2).

(ii) Because there is no net increase with respect to D for

1998, none of the 1997 reduction in D's basis in the indebtedness is

restored. The $10,000 increase in basis under section 1367(a)(1) is

applied to increase D's basis in his S stock. Under section

1367(a)(2)(A), the $11,000 distribution with respect to D's stock

reduces D's basis in his shares of S stock to $0. See section 1368

and Sec. 1.1368-1 (c) and (d) for the tax treatment of the $1,000

distribution in excess of D's basis.

Example 5. Distributions less than increase in basis. (i) The

facts are the same as in Example 4, except that in 1998 S makes

distributions to D totaling $8,000. On these facts, for 1998, there

is a net increase with respect to D of $2,000 (the amount by which

the items provided in section 1367(a)(1) exceed the amount of the

items provided in section 1367(a)(2)).

(ii) Because there is a net increase of $2,000 with respect to D

for 1998, $2,000 of the $10,000 increase in basis under section

1367(a)(1) is first applied to restore D's basis in the indebtedness

to $10,000 ($8,000 + $2,000). Accordingly, on December 31, 1998, D

has a basis in his shares of S stock of $0 ($0 + $8,000 (increase in

basis remaining after restoring basis in indebtedness)--$8,000

(distribution)) and a basis in the note of $10,000.

Sec. 1.1367-3 Effective date and transition rule.

Sections 1.1367-1 and 1.1367-2 apply to taxable years of a

corporation beginning on or after January 1, 1994. For taxable years

beginning before January 1, 1994, the adjustments to the basis of a

shareholder's stock and the basis of indebtedness of an S corporation

to a shareholder must be determined in a reasonable manner, taking into

account the statute and the legislative history. Return positions

consistent with Secs. 1.1367-1 and 1.1367-2 are reasonable.

Sec. 1.1368-0 Table of contents.

The following table of contents is provided to facilitate the use

of Secs. 1.1368-1 through 1.1368-4.

Sec. 1.1368-1 Distributions by S corporations.

(a) In general.

(b) Date distribution made.

(d) S corporation with earnings and profits.

(1) General treatment of distribution.

(2) Previously taxed income.

(e) Certain adjustments taken into account.

(f) Elections relating to source of distributions.

(1) In general.

(2) Election to distribute earnings and profits first.

(i) In general.

(ii) Previously taxed income.

(iii) Corporation with subchapter C and subchapter S earnings

and profits.

(3) Election to make a deemed dividend.

(4) Election to forego previously taxed income.

(5) Time and manner of making elections.

(i) For earnings and profits.

(ii) For previously taxed income and deemed dividends.

(iii) Corporate statement regarding elections.

(iv) Irrevocable elections.

(g) Special rules.

(1) Election to terminate year under section 1377 or

Sec. 1.1368-1(g)(2).

(2) Election in case of a qualifying disposition.

(i) In general.

(ii) Effect of the election.

(iii) Time and manner of making election.

Sec. 1.1368-2 Accumulated adjustments account (AAA).

(a) Accumulated adjustments account.

(1) In general.

(2) Increases to the AAA.

(3) Decreases to the AAA.

(i) In general.

(ii) Extent of allowable reduction.

(iii) Decrease to the AAA for distributions.

(4) Ordering rules for the AAA.

(b) Distributions in excess of the AAA.

(1) In general.

(2) Amount of the AAA allocated to each distribution.

(1) In general.

(2) Allocating the AAA to loss property.

(d) Adjustment in the case of redemptions, reorganizations, and

divisions.

(1) Redemptions.

(i) General rule.

(ii) Special rule for years in which a corporation makes both

ordinary and redemption distributions.

(iii) Adjustments to earnings and profits.

(2) Reorganizations.

(3) Corporate separations to which section 368(a)(1)(D) applies.

(e) Election to terminate year under section 1377(a)(2) or

Sec. 1.1368-1(g)(2).

Sec. 1.1368-3 Examples.

Sec. 1.1368-4 Effective date and transition rule.

Sec. 1.1368-1 Distributions by S corporations.

(a) In general. This section provides rules for distributions made

by an S corporation with respect to its stock which, but for section

1368(a) and this section, would be subject to section 301(c) and other

rules of the Internal Revenue Code that characterize a distribution as

a dividend.

(b) Date distribution made. For purposes of section 1368, a

distribution is taken into account on the date the corporation makes

the distribution, regardless of when the distribution is treated as

received by the shareholder.

by an S corporation that has no 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(b).

(d) S corporation with earnings and profits--(l) 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)(1), (2), and (3).

See section 316 and Sec. 1.316-2 for provisions relating to the

allocation of earnings and profits among distributions.

(2) Previously taxed income. This paragraph (d)(2) applies to

distributions by a corporation that has both accumulated earnings and

profits and previously taxed income (within the meaning of section

1375(d)(2), as in effect prior to its amendment by the Subchapter S

Revision Act of 1982, and the regulations thereunder) with respect to

one or more shareholders. In the case of such a distribution, that

portion remaining after the application of section 1368(c)(1) (relating

to distributions from the accumulated adjustments account (AAA) as

defined in Sec. 1.1368-2(a)) is treated in the manner provided in

section 1368(b) (relating to S corporations without earnings and

profits) to the extent that portion is a distribution of money and does

not exceed the shareholder's net share immediately before the

distribution of the corporation's previously taxed income. The AAA and

the earnings and profits of the corporation are not decreased by that

portion of the distribution. Any distribution remaining after the

application of this paragraph (d)(2) is treated in the manner provided

in section 1368(c)(2) and (3).

(e) Certain adjustments taken into account. Paragraphs (c) and (d)

of this section are applied only after taking into account--

(1) 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

(2) 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.

(f) Elections relating to source of distributions--(1) In general.

An S corporation may modify the application of paragraphs (c) and (d)

of this section by electing (pursuant to paragraph (f)(5) of this

section)--

(i) To distribute earnings and profits first as described in

paragraph (f)(2) of this section;

(ii) To make a deemed dividend as described in paragraph (f)(3) of

this section; or

(iii) To forego previously taxed income as described in paragraph

(f)(4) of this section.

(2) Election to distribute earnings and profits first--(i) In

general. An S corporation with accumulated earnings and profits may

elect under this paragraph (f)(2) for any taxable year to distribute

earnings and profits first as provided in section 1368(e)(3). Except as

provided in paragraph (f)(2)(ii) of this section, distributions made by

an S corporation making this election are treated as made first from

earnings and profits under section 1368(c)(2) and second from the AAA

under section 1368(c)(1). Any remaining portion of the distribution is

treated in the manner provided in section 1368(b). This election is

effective for all distributions made during the year for which the

election is made.

(ii) Previously taxed income. If a corporation to which paragraph

(d)(2) of this section (relating to corporations with previously taxed

income) applies makes the election provided in this paragraph (f)(2)

for the taxable year, and does not make the election to forego

previously taxed income under paragraph (f)(4) of this section,

distributions by the S corporation during the taxable year are treated

as made first, from previously taxed income under paragraph (d)(2) of

this section; second, from earnings and profits under section

1368(c)(2); and third, from the AAA under section 1368(c)(1). Any

portion of a distribution remaining after the previously taxed income,

earnings and profits, and the AAA are exhausted is treated in the

manner provided in section 1368(b).

(iii) Corporation with subchapter C and subchapter S earnings and

profits. If an S corporation that makes the election provided in this

paragraph (f)(2) has both subchapter C earnings and profits (as defined

in section 1362(d)(3)(B)) and subchapter S earnings and profits in a

taxable year of the corporation in which the distribution is made, the

distribution is treated as made first from subchapter C earnings and

profits, and second from subchapter S earnings and profits. Subchapter

S earnings and profits are earnings and profits accumulated in a

taxable year beginning before January 1, 1983 (or in the case of a

qualified casualty insurance electing small business corporation or a

qualified oil corporation, earnings and profits accumulated in any

taxable year), for which an election under subchapter S of chapter 1 of

the Internal Revenue Code was in effect.

(3) Election to make a deemed dividend. An S corporation may elect

under this paragraph (f)(3) to distribute all or part of its subchapter

C earnings and profits through a deemed dividend. If an S corporation

makes the election provided in this paragraph (f)(3), the S corporation

will be considered to have made the election provided in paragraph

(f)(2) of this section (relating to the election to distribute earnings

and profits first). The amount of the deemed dividend may not exceed

the subchapter C earnings and profits of the corporation on the last

day of the taxable year, reduced by any actual distributions of

subchapter C earnings and profits made during the taxable year. The

amount of the deemed dividend is considered, for all purposes of the

Internal Revenue Code, as if it were distributed in money to the

shareholders in proportion to their stock ownership, received by the

shareholders, and immediately contributed by the shareholders to the

corporation, all on the last day of the corporation's taxable year.

(4) Election to forego previously taxed income. An S corporation

may elect to forego distributions of previously taxed income. If such

an election is made, paragraph (d)(2) of this section (relating to

corporations with previously taxed income) does not apply to any

distribution made during the taxable year. Thus, distributions by a

corporation that makes the election to forego previously taxed income

for a taxable year under this paragraph (f)(4) and does not make the

election to distribute earnings and profits first under paragraph

(f)(2) of this section are treated in the manner provided in section

1368(c) (relating to distributions by corporations with earnings and

profits). Distributions by a corporation that makes both the election

to distribute earnings and profits first under paragraph (f)(2) of this

section and the election to forego previously taxed income under this

paragraph (f)(4), are treated in the manner provided in paragraph

(f)(2)(i) of this section.

(5) Time and manner of making elections--(i) For earnings and

profits. If an election is made under paragraph (f)(2) of this section

to distribute earnings and profits first, see section 1368(e)(3)

regarding the consent required by shareholders.

(ii) For previously taxed income and deemed dividends. If an

election is made to forego previously taxed income under paragraph

(f)(4) of this section or to make a deemed dividend under paragraph

(f)(3) of this section, consent by each ``affected shareholder,'' as

defined in section 1368(e)(3)(B), is required.

(iii) Corporate statement regarding elections. A corporation makes

an election for a taxable year under this paragraph (f) by attaching a

statement to a timely filed original or amended return required to be

filed under section 6037 for that taxable year. In the statement, the

corporation must identify the election it is making under Sec. 1.1368-

1(f) and must state that each shareholder consents to the election. An

officer of the corporation must sign under penalties of perjury the

statement on behalf of the corporation. A statement of election to make

a deemed dividend under this paragraph must include the amount of the

deemed dividend that is distributed to each shareholder.

(iv) Irrevocable elections. The elections under this paragraph (f)

are irrevocable and are effective only for the taxable year for which

they are made. In applying the preceding sentence to elections under

this paragraph (f), an election to terminate the taxable year under

section 1377(a)(2) or Sec. 1.1368-1(g)(2) is disregarded.

(g) Special rules--(1) Election to terminate year under section

1377 or Sec. 1.1368-1(g)(2). If an election is made under section

1377(a)(2) (to terminate the year when a shareholder terminates his or

her interest in the corporation) or under paragraph (g)(2) of this

section (to terminate the year when there is a qualifying disposition),

this section applies as if the taxable year consisted of separate

taxable years, the first of which ends at the close of the day on which

the shareholder terminates his or her interest in the corporation or on

which there is a qualifying disposition of stock, whichever the case

may be.

(2) Election in case of a qualifying disposition-- (i) In general.

In the case of a qualifying disposition, a corporation may elect under

this paragraph (g)(2)(i) to treat the year as if it consisted of

separate taxable years, the first of which ends at the close of the day

on which the qualifying disposition occurs. A qualifying disposition

is--

(A) A disposition by a shareholder of 20 percent or more of the

outstanding stock of the corporation in one or more transactions during

any thirty-day period during the corporation's taxable year;

(B) A redemption treated as an exchange under section 302(a) or

section 303(a) of 20 percent or more of the outstanding stock of the

corporation from a shareholder in one or more transactions during any

thirty-day period during the corporation's taxable year; or

percent of the previously outstanding stock to one or more new

shareholders during any thirty-day period during the corporation's

taxable year.

(ii) Effect of the election. A corporation making an election under

paragraph (g)(2)(i) of this section must treat the taxable year as

separate taxable years for purposes of allocating items of income and

loss; making adjustments to the AAA, earnings and profits, and basis;

and determining the tax effect of distributions under section 1368(b)

and (c). An election made under paragraph (g)(2)(i) of this section may

be made upon the occurrence of any qualifying disposition. Dispositions

of stock that are taken into account as part of a qualifying

disposition are not taken into account in determining whether a

subsequent qualifying disposition has been made.

(iii) Time and manner of making election. A corporation makes an

election under paragraph (g)(2)(i) of this section for a taxable year

by attaching a statement to a timely filed original or amended return

required to be filed under section 6037 for a taxable year (without

regard to the election under paragraph (g)(2)(i) of this section). In

the statement, the corporation must state that it is electing for the

taxable year under Sec. 1.1368-1(g)(2)(i) to treat the taxable year as

if it consisted of separate taxable years. The corporation also must

set forth facts in the statement relating to the qualifying disposition

(e.g., sale, gift, stock issuance, or redemption), and state that each

shareholder who held stock in the corporation during the taxable year

(without regard to the election under paragraph (g)(2)(i) of this

section) consents to this election. An officer of the corporation must

sign under penalties of perjury the statement on behalf of the

corporation. For purposes of this election, a shareholder of the

corporation for the taxable year is a shareholder as described in

section 1362(a)(2). A single election statement may be filed for all

elections made under paragraph (g)(2)(i) of this section for the

taxable year. An election made under paragraph (g)(2)(i) of this

section is irrevocable.

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, reorganizations, and corporate separations, see paragraph

(d) of this section.

(2) Increases to the AAA. The AAA is increased for the taxable year

of the corporation by the sum of the following items with respect to

the corporation for the taxable year:

(i) The items of income described in section 1366(a)(1)(A) other

than income that is exempt from tax;

(ii) Any nonseparately computed income determined under section

1366(a)(1)(B); and

(iii) The excess of the deductions for depletion over the basis of

property subject to depletion unless the property is an oil or gas

property the basis of which has been allocated to shareholders under

section 613A(c)(11).

(3) Decreases to the AAA--(i) In general. The AAA is decreased for

the taxable year of the corporation by the sum of the following items

with respect to the corporation for the taxable year--

(A) The items of loss or deduction described in section

1366(a)(1)(A);

(B) Any nonseparately computed loss determined under section

1366(a)(1)(B);

taxable income and not properly chargeable to a capital account, other

than--

(1) Federal taxes attributable to any taxable year in which the

corporation was a C corporation; and

(2) Expenses related to income that is exempt from tax; and

(D) The sum of the shareholders' deductions for depletion for any

oil or gas property held by the corporation described in section

1367(a)(2)(E).

(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(f)

(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 or 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(f) (or in which the loss or

deduction is otherwise allowed to the shareholder), no further

adjustment is made to the AAA.

(iii) Decrease to the AAA for distributions. The AAA is decreased

(but not below zero) by any portion of a distribution to which section

1368(b) or (c)(1) applies.

(4) Ordering Rules for the AAA. For any taxable year, the

adjustments to the AAA are made in the following order:

(i) The AAA is increased under paragraph (a)(2) of this section

before it is decreased under paragraph (a)(3) of this section for the

taxable year;

(ii) The AAA is decreased under paragraph (a)(3)(i) of this section

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;

and

(iv) The AAA is adjusted (whether negative or positive) for

redemption distributions under paragraph (d)(1) of this section.

(b) Distributions in excess of the AAA--(1) In general. A portion

of the AAA (determined under paragraph (b)(2) of this section) is

allocated to each of the distributions made for the taxable year if--

(i) An S corporation makes more than one distribution of property

with respect to its stock during the taxable year of the corporation

(including an S short year as defined under section 1362(e)(1)(A));

(ii) The AAA has a positive balance at the close of the year; and

(iii) The sum of the distributions made during the corporation's

taxable year exceeds the balance of the AAA at the close of the year.

(2) Amount of the AAA allocated to each distribution. The amount of

the AAA allocated to each distribution is determined by multiplying the

balance of the AAA at the close of the current taxable year by a

fraction, the numerator of which is the amount of the distribution and

the denominator of which is the amount of all distributions made during

the taxable year. For purposes of this paragraph (b)(2), the term all

distributions made during the taxable year does not include any

distribution treated as from earnings and profits or previously taxed

income pursuant to an election made under section 1368(e)(3) and

Sec. 1.1368-1(f)(2). See paragraph (d)(1) of this section for rules

relating to the adjustments to the AAA for redemptions and

distributions in the year of a redemption.

amount of the AAA allocated to a distribution under this section must

be further allocated (under paragraph (c)(2) of this section) if the

distribution--

(i) Consists of property the adjusted basis of which exceeds its

fair market value on the date of the distribution and money;

(ii) Is a distribution to which Sec. 1.1368-1(d)(1) applies; and

(iii) Exceeds the amount of the corporation's AAA properly

allocable to that distribution.

(2) Allocating the AAA to loss property. The amount of the AAA

allocated to the property other than money is equal to the amount of

the AAA allocated to the distribution multiplied by a fraction, the

numerator of which is the fair market value of the property other than

money on the date of distribution and the denominator of which is the

amount of the distribution. The amount of the AAA allocated to the

money is equal to the amount of the AAA allocated to the distribution

reduced by the amount of the AAA allocated to the property other than

money.

(d) Adjustment in the case of redemptions, reorganizations, and

divisions--(l) Redemptions--(i) General Rule. In the case of a

redemption distribution by an S corporation that is treated as an

exchange under section 302(a) or section 303(a) (a redemption

distribution), the AAA of the corporation is adjusted in an amount

equal to the ratable share of the corporation's AAA (whether negative

or positive) attributable to the redeemed stock as of the date of the

redemption.

(ii) Special rule for years in which a corporation makes both

ordinary and redemption distributions. In any year in which a

corporation makes one or more distributions to which section 1368(a)

applies (ordinary distributions) and makes one or more redemption

distributions, the AAA of the corporation is adjusted first for any

ordinary distributions and then for any redemption distributions.

(iii) Adjustments to earnings and profits. Earnings and profits are

adjusted under section 312 independently of any adjustments made to the

AAA.

(2) Reorganizations. An S corporation acquiring the assets of

another S corporation in a transaction to which section 381(a)(2)

applies will succeed to and merge its AAA (whether positive or

negative) with the AAA (whether positive or negative) of the

distributor or transferor S corporation as of the close of the date of

distribution or transfer. Thus, the AAA of the acquiring corporation

after the transaction is the sum of the AAAs of the corporations prior

to the transaction.

(3) Corporate separations to which section 368(a)(l)(D) applies. If

an S corporation with accumulated earnings and profits transfers a part

of its assets constituting an active trade or business to another

corporation in a transaction to which section 368(a)(l)(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, the AAA of the distributing corporation immediately before the

transaction is allocated between the distributing corporation and the

controlled corporation in a manner similar to the manner in which the

earnings and profits of the distributing corporation are allocated

under section 312 (h). See Sec. 1.312-10(a).

(e) Election to terminate year under section 1377(a)(2) or

Sec. 1.1368-1(g)(2). If an election is made under section 1377(a)(2)

(to terminate the year in the case of termination of a shareholder's

interest) or Sec. 1.1368-1(g)(2) (to terminate the year in the case of

a qualifying disposition), this section applies as if the taxable year

consisted of separate taxable years, the first of which ends at the

close of the day on which the shareholder terminated his or her

interest in the corporation or makes a substantial disposition of

stock, whichever the case may be.

Sec. 1.1368-3 Examples.

The principles of Secs. 1.1368-1 and 1.1368-2 are illustrated by

the examples below. In each example Corporation S is a calendar year

corporation:

Example 1. Distributions by S corporations without C corporation

earnings and profits. (i) Corporation S, an S corporation, has no

earnings and profits as of January 1, 1996, the first day of its

1996 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,

1996, S makes a distribution of $38 to A. For S's 1996 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 and A's

pro rata share of the amount of the items described in section

1367(a)(2) (B) through (D) (relating to decreases in basis of stock

for items other than distributions) is $26.

(ii) Under section 1368(d)(1) and Sec. 1.1368-1(e)(1), the

adjustments to the bases of A's stock in S described in section 1367

are made before the distribution rules of section 1368 are applied.

Thus, A's basis per share in the stock is $3.40 ($1 + [($50-$26) /

10 shares]) 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). However, A only has a basis of $3.40 in each share, and

basis may not be reduced below zero. Therefore, the basis of each

share of his stock is reduced by $3.40 to zero, and the remaining

$4.00 of the distribution ([$3.80-$3.40] x 10 shares) is treated as

gain from the sale or exchange of property. As of January 1, 1997, A

has a basis of $0 in his shares of S stock.

Example 2. Distributions by S corporations with C corporation

earnings and profits. (i) Corporation S properly elects to be an S

corporation beginning January 1, 1997, and as of that date has

accumulated earnings and profits of $30. B, an individual and sole

shareholder of Corporation S, has 10 shares of S stock with a basis

of $12 per share. In addition, B lends $30 to S evidenced by a

demand note.

(ii) During 1997, S has a nonseparately computed loss of $150. S

makes no distributions to B during 1997. Under section 1366(d)(1), B

is allowed a loss equal to $150, the amount equal to the sum of B's

bases in his shares of stock and his basis in the debt. Under

section 1367, the loss reduces B's adjusted basis in his stock and

debt to $0. Under Sec. 1.1368-2(a)(3), S's AAA as of December 31,

1997, has a deficit of $150 as a result of S's loss for the year.

(iii) For 1998, S has $220 of separately stated income and

distributes $110 to B. The balance in the AAA (negative $150 from

1997) is increased by $220 for S's income for the year and decreased

to $0 for the portion of the distribution that is treated as being

from the AAA ($70). Under Sec. 1.1367-2(c), B's net increase is

$150, determined by reducing the $220 of income by the $70 of the

distribution not includible in income by B. Thus, B's basis in the

debt is fully restored to $30, and B's basis in S stock (before

accounting for the distribution) is increased from zero to $19 per

share ([$220-$30 applied to the debt] / 10). Thirty dollars of the

distribution is considered a dividend to the extent of S's $30 of

earnings and profits, and the remaining $10 of the distribution

reduces B's basis in the S stock. Thus, B's basis in the S stock as

of December 31, 1998, is $11 per share ($19-[$70 AAA distribution /

10]--[10 distribution treated as a reduction in basis / 10]). The

balance in the AAA is $0, S's earnings and profits are $0, and B's

basis in the loan is $30.

Example 3. Election in case of disposition of substantial amount

of stock. (i) Corporation S, an S corporation, has earnings and

profits of $3,000 and a balance in the AAA of $1,000 on January 1,

1997. C, an individual and the sole shareholder of Corporation S,

has 100 shares of S stock with a basis of $10 per share. On July 3,

1997, C sells 50 shares of his S stock to D, an individual, for

$250. For 1997, S has taxable income of $1,000, of which $500 was

earned on or before July 3, 1997, and $500 earned after July 3,

1997. During its 1997 taxable year, S distributes $1,000 to C on

February 1 and $1,000 to each of C and D on August 1. 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. S makes the

election under Sec. 1.1368-1(g)(2) to treat its taxable year as if

it consisted of separate taxable years, the first of which ends at

the close of July 3, 1997, the date of the qualifying disposition.

(ii) Under section Sec. 1.1368-1(g)(2), for the period ending on

July 3, 1997, S's AAA is $500 ($1,000 (AAA as of January 1, 1997) +

$500 (income earned from January 1, 1997 through July 3, 1997)--

$1,000 (distribution made on February 1, 1997)). C's bases in his

shares of stock is decreased to $5 per share ($10 (original basis) +

$5 (increase per share for income)--$10 (decrease per share for

distribution)).

(iii) The AAA is adjusted at the end of the taxable year for the

period July 4 through December 31, 1997. It is increased from $500

(AAA as of the close of July 3, 1997) to $1,000 for the income

earned during this period and is decreased by $1,000, the portion of

the distribution ($2,000 in total) made to C and D on August 1 that

does not exceed the AAA. The $1,000 portion of the distribution that

remains after the AAA is reduced to zero is attributable to earnings

and profits. Therefore C and D each have a dividend of $500, which

does not affect their basis or S's AAA. The earnings and profits

account is reduced from $3,000 to $2,000.

(iv) As of December 31, 1997, C and D have bases in their shares

of stock of zero ($5 (basis as of July 4)+$5 ($500 income/100

shares)--$10 ($1,000 distribution/100 shares)). C and D each will

report $500 as dividend income, which does not affect their basis or

S's AAA.

Example 4. Election to distribute earnings and profits first.

(i) Corporation S has been a calendar year C corporation since 1975.

For 1982, S elects for the first time to be taxed under subchapter

S, and during 1982 has $60 of earnings and profits. As of December

31, 1995, S has an AAA of $10 and earnings and profits of $160,

consisting of $100 of subchapter C earnings and profits and $60 of

subchapter S earnings and profits. For 1996, S has $200 of taxable

income and the AAA is increased to $210 (before taking distributions

into account). During 1996, S distributes $240 to its shareholders.

With its 1996 tax return, S properly elects under section 1368(e)(3)

and Sec. 1.1368-1(f)(2) to distribute its earnings and profits

before its AAA.

(ii) Because S elected to distribute its earnings and profits

before its AAA, the first $100 of the distribution is characterized

as a distribution from subchapter C earnings and profits; the next

$60 of the distribution is characterized as a distribution from

subchapter S earnings and profits. Because $160 of the distribution

is from earnings and profits, the shareholders of S have a $160

dividend. The remaining $80 of the distribution is a distribution

from S's AAA and is treated by the shareholders as a return of

capital or gain from the sale or exchange of property, as

appropriate, under Sec. 1.1368-1(d)(1). S's AAA, as of December 31,

1996, equals $130 ($210-$80).

Example 5. Distributions in excess of the AAA. (i) On January 1,

1995, Corporation S has $40 of earnings and profits and a balance in

the AAA of $100. S has two shareholders, E and F, each of whom own

50 shares of S's stock. For 1995, S has taxable income of $50, which

increases the AAA to $150 as of December 31, 1995 (before taking

into account distributions made during 1995). On February 1, 1995, S

distributes $60 to each shareholder. On September 1, 1995, S

distributes $30 to each shareholder. 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 sum of the distributions exceed S's AAA. Therefore,

under Sec. 1.1368-2(b), a portion of S's $150 balance in the AAA as

of December 31, 1995, is allocated to each of the February 1 and

September 1 distributions based on the respective sizes of the

distributions. Accordingly, S must allocate $100 ($150 (AAA) x ($120

(February 1 distribution)/$180 (the sum of the distributions))) of

the AAA to the February 1 distribution, and $50 ($150 x ($60/$180))

to the September 1 distribution. The portions of the distributions

to which the AAA is allocated are treated by the shareholder as a

return of capital or gain from the sale or exchange of property, as

appropriate. The remainder of the two distributions is treated as a

dividend to the extent that it does not exceed S's earnings and

profits. E and F must each report $10 of dividend income for the

February 1 distribution. For the September 1 distribution, E and F

must each report $5 of dividend income.

Example 6. Ordinary and redemption distributions in the same

taxable year. (i) On January 1, 1995, Corporation S, an S

corporation, has $20 of earnings and profits and a balance in the

AAA of $10. S has two shareholders, G and H, each of whom owns 50

shares of S's stock. For 1995, S has taxable income of $16, which

increases the AAA to $26 as of December 31, 1995 (before taking into

account distributions made during 1995). On February 1, 1995, S

distributes $10 to each shareholder. On December 31, 1995, S redeems

for $13 all of shareholder G's stock in a redemption that is treated

as a sale or exchange under section 302(a).

(ii) The sum of the ordinary distributions does not exceed S's

AAA. Therefore, S must reduce the $26 balance in the AAA by $20 for

the February 1 ordinary distribution. The portions of the

distribution by which the AAA is reduced are treated by the

shareholders as a return of capital or gain from the sale or

exchange of property. S must adjust the remaining AAA, $6, in an

amount equal to the ratable share of the remaining AAA attributable

to the redeemed stock, or $3 (50% x $6).

(iii) S also must adjust the earnings and profits of $20 in an

amount equal to the ratable share of the earnings and profits

attributable to the redeemed stock. Therefore, S adjusts the

earnings and profits by $10 (50% x $20), the ratable share of the

earnings and profits attributable to the redeemed stock.

Sec. 1.1368-4 Effective date and transition rule.

Sections 1.1368-1, 1.1368-2, and 1.1368-3 apply to taxable years of

a corporation beginning on or after January 1, 1994. For taxable years

beginning before January 1, 1994, the treatment of distributions by an

S corporation to its shareholders must be determined in a reasonable

manner, taking into account the statute and the legislative history.

Except with regard to the deemed dividend rule under Sec. 1.1368-

1(f)(3), return positions consistent with Secs. 1.1368-1, 1.1368-2, and

1.1368-3 are reasonable.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 12. The authority citation for part 602 continues to read:

Authority: 26 U.S.C. 7805.

Par. 13. Section 602.101(c) is amended by adding the following

entries in numerical order to the table to read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *

------------------------------------------------------------------------

Current OMB

CFR part or section where identified control Number

------------------------------------------------------------------------

* * * * *

1.1367-1(f).......................................... 1545-1139

1.1368-1(f)(2)....................................... 1545-1139

1.1368-1(f)(3)....................................... 1545-1139

1.1368-1(f)(4)....................................... 1545-1139

1.1368-1(g)(2)....................................... 1545-1139

* * * * *

------------------------------------------------------------------------

Margaret Milner Richarson,

Commissioner of Internal Revenue.

Approved: December 21, 1993.

Leslie Samuels,

Assistant Secretary of the Treasury (Tax Policy).

[FR Doc. 93-31928 Filed 12-30-93; 8:45 am]

BILLING CODE 4830-01-U

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.