Definitions Under Subchapter S of the Internal Revenue Code

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 18

[PS-268-82]

RIN 1545-AE94

Definitions Under Subchapter S of the Internal Revenue Code

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations for S corporations

and their shareholders relating to the definitions and the special rule

provided in section 1377 of the Internal Revenue Code of 1986. The

proposed regulations reflect changes to the law made by the Subchapter

S Revision Act of 1982. The proposed regulations are necessary to

provide guidance needed by taxpayers to comply with the law.

DATES: Written comments and requests for a public hearing must be

received by October 10, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (PS-268-82), room 5228,

Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,

DC 20044. In the alternative, submissions may be hand delivered between

the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (PS-268-82),

Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,

Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Brian J.

O'Connor, (202) 622-3060; concerning submissions and the hearing,

Michael Slaughter, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

The collection of information contained in this notice of proposed

rulemaking has been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act (44 U.S.C.

3504(h)). Comments on the collections of information should be sent to

the Office of Management and Budget, Attn: Desk Officer for the

Department of the Treasury, Office of Information and Regulatory

Affairs, Washington, DC 20503, with copies to the Internal Revenue

Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC

20224.

A collection of information is required under Sec. 1.1377-1(b).

This information is required by the IRS to verify the event giving rise

to the making of an election under section 1377(a)(2) by an S

corporation. The likely respondents and/or recordkeepers will be S

corporations and shareholders of S corporations.

Estimated total annual reporting burden: 1,000 hours.

The estimated annual burden per respondent varies from .2 hour to

.5 hour, depending on individual circumstances, with an estimated

average of .25 hour.

Estimated number of respondents: 4,000.

Estimated annual frequency of responses: 1.

Background

This document proposes amendments to the Income Tax Regulations (26

CFR part 1) under section 1377 of the Internal Revenue Code (Code).

Section 18.1377-1 was issued by TD 7872 (48 FR 3590). The proposed

regulations would conform the regulations to the addition of section

1377 to the Code by section 2 of the Subchapter S Revision Act of 1982,

Pub. L. 97-354 (1982-2 C.B. 702, 710).

Explanation of Provisions

Shareholder's Pro Rata Share of Items of Income, Loss, Deduction, and

Credit

Section 1366(a)(1) requires a shareholder of an S corporation to

take into account the shareholder's pro rata share of the corporation's

items of income, loss, deduction, and credit. The proposed regulations

provide that, except in the case of an election under section

1377(a)(2), each shareholder's pro rata share of an item for a taxable

year is the sum of the amounts determined with respect to the

shareholder by assigning an equal portion of the item to each day of

the S corporation's taxable year, and then dividing that portion pro

rata among the shares outstanding on that day.

The proposed regulations contain several special rules for

determining a shareholder's pro rata share. First, solely for purposes

of determining a shareholder's pro rata share of an item, an S

corporation's taxable year does not include any day on which the

corporation has no shareholders. This rule ensures that the full amount

of all items of the S corporation will be allocated to the

corporation's shareholders. Second, a shareholder who disposes of stock

of an S corporation is treated as the shareholder for the day of the

disposition. Finally, a shareholder who dies is treated as the

shareholder for the day of the shareholder's death.

Election To Treat Taxable Year as Separate Taxable Years

Under section 1377(a)(2), if a shareholder's interest in an S

corporation is terminated during the taxable year and all persons who

are shareholders during the taxable year agree, the corporation may

elect (terminating election) to apply section 1377(a)(1) as if the

taxable year of the S corporation consisted of two taxable years, the

first of which ends on the date of the termination. The proposed

regulations provide rules concerning the time and manner of making a

terminating election and, therefore, it is proposed that Sec. 18.1377-1

(which provides temporary rules concerning the time and manner of

making a terminating election) be removed. The proposed regulations

also provide that the terminating election is irrevocable and is

effective only for the terminating event for which it is made.

The proposed regulations clarify that a terminating election may be

made only if a shareholder's entire interest as a shareholder in the S

corporation is terminated. A shareholder's entire interest as a

shareholder is terminated under the proposed regulations on the

occurrence of any event through which a shareholder's entire stock

ownership in the S corporation ceases, including a sale, exchange, or

other disposition of all of the stock held by the shareholder; a gift

under section 102(a) of all the shareholder's stock; a spousal transfer

under section 1041(a) of all the shareholder's stock; a redemption, as

defined in section 317(b), of all of the shareholder's stock,

regardless of the tax treatment of the redemption under section 302;

and the death of the shareholder. A shareholder's entire interest in an

S corporation is not terminated under the proposed regulations if the

shareholder retains ownership of any stock that would result in the

shareholder continuing to be considered a shareholder of the

corporation for purposes of section 1362(a)(2). Thus, in determining

whether a shareholder's entire interest in an S corporation has been

terminated, any options held by the shareholder (other than options

that are treated as stock under Sec. 1.1361-1(l)(4)(iii)) and any

interest in the S corporation held by the shareholder as a creditor,

employee, director, or in any other non-shareholder capacity are

disregarded.

The proposed regulations also describe the effects of a terminating

election. Under the proposed regulations, an S corporation that makes a

terminating election must treat its taxable year as two separate

taxable

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years for purposes of computing and allocating to each shareholder

items of income (including tax-exempt income), loss, deduction, and

credit; making adjustments to the accumulated adjustments account

(AAA), earnings and profits, and basis; and determining the tax effect

of a distribution to the shareholders. This treatment is required to

give full effect to treating the taxable year as two separate taxable

years. The proposed regulations also require the S corporation to

assign items of income, loss, deduction, and credit to each deemed

separate taxable year using the corporation's normal method of

accounting as determined under section 446(a). The proposed regulations

provide that a terminating election does not affect the due date of the

S corporation's tax return for the taxable year or the time when the

shareholders must include their pro rata allocations of items from the

S corporation. The proposed regulations also provide that a terminating

election by an S corporation that is a partner in a partnership is

treated as a sale or exchange of the corporation's entire interest in

the partnership for purposes of section 706(c) (closing of the

partnership's taxable year) if the taxable year of the partnership ends

after the shareholder's interest is terminated and within the full

taxable year of the S corporation for which the terminating election is

made. This rule conforms terminating elections with the rule for S

termination years. See Sec. 1.1362-3(c)(1).

The proposed regulations coordinate the application of the

terminating election under section 1377(a)(2) with the election under

section 1362(e)(3) (election to have items assigned to each short

taxable year of an S termination year under normal accounting rules

rather than pro rata) and the election under Sec. 1.1368-1(g)(2)

(election to terminate the taxable year when there is a qualifying

disposition). Under the proposed regulations, if a transfer results in

a termination of the shareholder's entire interest as a shareholder and

the transfer also constitutes a qualifying disposition under

Sec. 1.1368-1(g)(2)(i), the terminating election rules under these

proposed regulations take precedence and a qualifying disposition

election cannot be made. If a termination of a shareholder's entire

interest results in a termination under section 1362(d)(2) of the

corporation's election to be an S corporation, however, the proposed

regulations provide that the corporation may not make a terminating

election. When a corporation's election to be an S corporation

terminates, the portion of the corporation's taxable year ending at the

close of the day preceding the day for which the terminating event is

effective is treated as an S short year, and the remainder is treated

as a C short year. Thus, because the day upon which a terminating event

occurs is the first day of a C short year, as of that date there is no

S corporation taxable year that may be divided into two separate years

under section 1377(a)(2). Under section 1362(e)(2), the income or loss

for the entire S termination year is allocated on a pro rata basis

between the S and C short years. However, if the corporation makes an

election under section 1362(e)(3), the corporation allocates income and

loss to each short taxable year under the corporation's normal tax

accounting rules. Thus, when a corporation makes an election under

section 1362(e)(3), a shareholder of an S corporation may achieve a

result similar to the result of an election under section 1377(a)(2)

and these proposed regulations (which also require an allocation of

income and loss to each short taxable year under normal accounting

rules).

Post-Termination Transition Period

Section 1377(b) provides that the term post-termination transition

period (PTTP) for purposes of subchapter S of chapter 1 of the Code

means: (1) The period beginning on the day after the last day of the

corporation's last taxable year as an S corporation and ending on the

later of the day which is 1 year after such last day, or the due date

for filing the return for the last taxable year as an S corporation

(including extensions); and (2) the 120-day period beginning on the

date of a determination that the corporation's election under section

1362(a) had terminated for a previous taxable year. The PTTP is

relevant for purposes of section 1366(d)(3) (carryover of disallowed

losses after the last taxable year for which a corporation is an S

corporation) and section 1371(e) (distributions of money by a

corporation with respect to its stock after termination of S

corporation status).

The proposed regulations clarify that a PTTP arises following the

termination under section 1362(d) of a corporation's S election. For

example, a PTTP arises in the case of a C corporation that acquires the

assets of an S corporation in a transaction to which section 381(a)(2)

applies. However, if an S corporation acquires the assets of another S

corporation in a transaction to which section 381(a)(2) applies, a PTTP

does not arise. Instead, under Sec. 1.1368-2(d)(2), the acquiring S

corporation succeeds to and merges its AAA with the AAA of the

distributor or transferor S corporation.

The proposed regulations clarify that the last day of a

corporation's last taxable year as an S corporation is the last day of

the short S taxable year under section 1362(e)(1)(A) or the date of

transfer in the event that a C corporation acquires the assets of an S

corporation in a transaction to which section 381(a)(2) applies. The

proposed regulations also provide that the special treatment under

section 1371(e)(1) is available only to those shareholders who were

shareholders in the S corporation at the time of the termination.

The proposed regulations provide additional guidance on the

definition of a determination for purposes of ascertaining when a PTTP

begins under section 1377(b)(1)(B). Under the proposed regulations, a

determination includes a written agreement between an S corporation and

the Commissioner that the corporation failed to qualify as an S

corporation. The agreement must be signed by the appropriate district

director and an authorized officer of the corporation. In addition, if

there is no written agreement, a determination results from the

expiration of the period specified in section 6226 for filing a

petition for readjustment of a final S corporation administrative

adjustment finding that the corporation failed to qualify as an S

corporation, provided that no petition is filed prior to the expiration

of the period. For corporations not subject to the audit and assessment

provisions of subchapter C of chapter 63 of subtitle A (dealing with

the tax treatment of partnership items) a determination results from

the expiration of the period for filing a petition under section 6213

for the shareholder's taxable year for which the Commissioner has made

a finding that the corporation failed to qualify as an S corporation,

provided that no petition was timely filed before the expiration of the

period.

Effective Date

The regulations under section 1377 are proposed to apply to taxable

years of an S corporation beginning after the date of publication as

final regulations in the Federal Register.

Special Analysis

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 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) and the Regulatory

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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, this notice

of proposed rulemaking will be submitted to the Chief Counsel for

Advocacy of the Small Business Administration for comment on its impact

on small business.

Comments and Requests for a Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying. A public

hearing may be scheduled if requested in writing by a person that

timely submits written comments. If a public hearing is scheduled,

notice of the date, time, and place for the hearing will be published

in the Federal Register.

Drafting Information

The principal author of these regulations is Brian J. O'Connor,

Office of Assistant Chief Counsel (Passthroughs and Special

Industries). However, other personnel from the IRS and Treasury

Department participated in their development.

List of Subjects in 26 CFR Parts 1 and 18

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 18 are proposed to be amended as

follows:

PART 1--INCOME TAXES

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

an entry in numerical order to read as follows:

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

Section 1.1377-1 also issued under 26 U.S.C. 1377 (a)(2) and

(c).

Par. 2. Sections 1.1377-0, 1.1377-1, 1.1377-2, and 1.1377-3 are

added under the heading ``Small Business Corporations and Their

Shareholders'' to read as follows:

Sec. 1.1377-0 Table of contents.

The following table of contents is provided to facilitate the use

of Secs. 1.1377-1 through 1.1377-3:

Sec. 1.1377-1 Pro rata share.

(a) Computation of pro rata shares.

(1) In general.

(2) Special rules.

(i) Days without shareholders.

(ii) Determining shareholder for day of stock disposition.

(b) Election to terminate year.

(1) In general.

(2) Effect of the terminating election.

(i) In general.

(ii) Due date of S corporation return.

(iii) Taxable year of inclusion by shareholder.

(iv) S Corporation that is a partner in a partnership.

(3) Determination of whether an S shareholder's entire interest

has terminated.

(4) Time and manner of making terminating election.

(i) In general.

(ii) Shareholders required to consent.

(iii) More than one terminating election.

(c) Examples.

Sec. 1.1377-2 Post-termination transition period.

(a) In general.

(b) When a post-termination transition period arises.

(c) Last day of last taxable year.

(d) Determination defined.

(e) Time of determination.

(1) Court decision.

(2) Closing agreement.

(3) Written agreement.

(4) Implied agreement.

Sec. 1.1377-3 Effective date.

Sec. 1.1377-1 Pro rata share.

(a) Computation of pro rata shares--(1) In general. For purposes of

subchapter S of chapter 1 of the Code and this section, each

shareholder's pro rata share of any S corporation item described in

section 1366(a) for any taxable year is the sum of the amounts

determined with respect to the shareholder by assigning an equal

portion of the item to each day of the S corporation's taxable year,

and then dividing that portion pro rata among the shares outstanding on

that day. See paragraph (b) of this section for rules pertaining to the

computation of each shareholder's pro rata share when an election is

made under section 1377(a)(2) to treat the taxable year of an S

corporation as if it consisted of two taxable years in the case of a

termination of a shareholder's entire interest in the corporation.

(2) Special rules--(i) Days without shareholders. Solely for

purposes of determining a shareholder's pro rata share of an item for a

taxable year under section 1377(a) and this section, an S corporation's

taxable year does not include any day on which the corporation has no

shareholders.

(ii) Determining shareholder for day of stock disposition. A

shareholder who disposes of stock in an S corporation is treated as the

shareholder for the day of the disposition. A shareholder who dies is

treated as the shareholder for the day of the shareholder's death.

(b) Election to terminate year--(1) In general. If a shareholder's

entire interest in an S corporation is terminated during the S

corporation's taxable year and all persons who are shareholders during

the taxable year agree (as prescribed in paragraph (b)(4) of this

section), the S corporation may elect under section 1377(a)(2) and this

paragraph (b) (terminating election) to treat its taxable year as if it

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

close of the day on which the shareholder's entire interest in the S

corporation is terminated. If the event resulting in the termination of

the shareholder's entire interest also constitutes a qualifying

disposition as described in Sec. 1.1368-1(g)(2), the election under

Sec. 1.1368-1(g)(2) cannot be made. An S corporation may not make a

terminating election if the cessation of a shareholder's interest

occurs in a transaction which results in a termination under section

1362(d)(2) of the corporation's election to be an S corporation. (See

section 1362(e)(3) for an election to have items assigned to each short

taxable year under normal tax accounting rules in the case of a

termination of a corporation's election to be an S corporation.) A

terminating election is irrevocable and is effective only for the

terminating event for which it is made.

(2) Effect of the terminating election--(i) In general. An S

corporation that makes a terminating election for a taxable year must

treat the taxable year as separate taxable years for purposes of

allocating items of income (including tax-exempt income), loss,

deduction, and credit; making adjustments to the accumulated

adjustments account, earnings and profits, and basis; and determining

the tax effect of a distribution to the shareholders. An S corporation

that makes a terminating election must assign items of income

(including tax-exempt income), loss, deduction, and credit to each

deemed separate taxable year using its normal method of accounting as

determined under section 446(a).

(ii) Due date of S corporation return. A terminating election does

not affect the due date of the S corporation's return required to be

filed under section 6037(a) for a taxable year (determined without

regard to a terminating election).

(iii) Taxable year of inclusion by shareholder. A terminating

election does not affect the taxable year in which a shareholder

(including any shareholder whose entire interest in the corporation has

terminated during the

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corporation's taxable year) must take into account the shareholder's

pro rata share of the S corporation's items of income, loss, deduction,

and credit.

(iv) S corporation that is a partner in a partnership. A

terminating election by an S corporation that is a partner in a

partnership is treated as a sale or exchange of the corporation's

entire interest in the partnership for purposes of section 706(c)

(relating to closing the partnership taxable year), if the taxable year

of the partnership ends after the shareholder's interest is terminated

and within the taxable year of the S corporation (determined without

regard to any terminating election) for which the terminating election

is made.

(3) Determination of whether an S shareholder's entire interest has

terminated. For purposes of section 1377(a)(2) and paragraph (b) of

this section, a shareholder's entire interest in an S corporation is

terminated on the occurrence of any event through which a shareholder's

entire stock ownership in the S corporation ceases, including a sale,

exchange, or other disposition of all of the stock held by the

shareholder; a gift under section 102(a) of all the shareholder's

stock; a spousal transfer under section 1041(a) of all the

shareholder's stock; a redemption, as defined in section 317(b), of all

the shareholder's stock, regardless of the tax treatment of the

redemption under section 302; and the death of the shareholder. A

shareholder's entire interest in an S corporation is not terminated if

the shareholder retains ownership of any stock that would result in the

shareholder continuing to be considered a shareholder of the

corporation for purposes of section 1362(a)(2). Thus, in determining

whether a shareholder's entire interest in an S corporation has been

terminated, any options held by the shareholder (other than options

that are treated as stock under Sec. 1.1361-1(l)(4)(iii)) and any

interest held by the shareholder as a creditor, employee, director, or

in any other non-shareholder capacity are disregarded. (See

Sec. 1.1361-1(l)(4)(iii) for circumstances under which an option is

treated as stock of the corporation and, therefore, the holder of the

option is treated as owning a stock interest in the corporation.)

(4) Time and manner of making terminating election--(i) In general.

An S corporation makes a terminating election by attaching a statement

to its timely filed original or amended return required to be filed

under section 6037(a) (that is, a Form 1120S) for the taxable year

during which a shareholder's entire interest is terminated. A single

election statement may be filed by the S corporation for all

terminating elections for the taxable year. The election statement must

include--

(A) A declaration by the S corporation that it is electing under

section 1377(a)(2) and Sec. 1.1377-1(b) to treat the taxable year as if

it consisted of two separate taxable years;

(B) Information setting forth when and how the shareholder's entire

interest was terminated (for example, a sale or gift);

(C) The signature on behalf of the S corporation of an authorized

officer of the corporation under penalties of perjury; and

(D) A notice of consent, signed by each person who is a shareholder

in the S corporation during the taxable year (determined without regard

to the terminating election), including any shareholder whose entire

interest terminates during the taxable year, in which each shareholder

consents to the S corporation making the terminating election.

(ii) Shareholders required to consent. For purposes of paragraph

(b)(4)(i)(D) of this section, a shareholder of the S corporation for

the taxable year is a shareholder as described in section 1362(a)(2).

For example, the person who under Sec. 1.1362-6(b)(2) must consent to a

corporation's S election in certain special cases is the person who

must consent to the terminating election. In addition, an executor or

administrator of an estate of a deceased shareholder may consent to the

terminating election on behalf of the deceased shareholder.

(iii) More than one terminating election. A shareholder whose

entire interest in an S corporation is terminated in an event for which

a terminating election was made is not required to consent to a

terminating election made with respect to a subsequent termination

within the same taxable year of the entire interest of another

shareholder.

(c) Examples. The following examples illustrate the provisions of

this section.

Example 1. General rule. (i) On January 2, 1997, X, a calendar

year corporation, is incorporated. On January 4, 1997, X acquires

assets. On January 6, 1997, X issues 100 shares of common stock to

each of A and B and files an election to be an S corporation

effective for its 1997 taxable year. During its 1997 taxable year, X

has nonseparately computed income (as defined in section 1366(a)(2))

of $720,000.

(ii) Each shareholder's pro rata share of X's nonseparately

computed income for 1997 is determined by assigning an equal portion

of the income to each day of X's taxable year on which X had

shareholders. In the present case, there are only 360 days on which

X had shareholders because X had no shareholders until January 6,

1997. Thus, $2,000 of nonseparately computed income is assigned to

each day that X had shareholders ($720,000/360 days=$2,000 per day).

The amount assigned to each day is multiplied by the percentage of

shares held by the shareholder on that day. Because A and B each

owned 50 percent of the shares of stock outstanding on each day that

X had shareholders, each shareholder's daily pro rata share of X's

nonseparately computed income is $1,000 ($2,000 per day x 50%).

Finally, the amounts of each shareholder's daily pro rata shares are

aggregated to produce the shareholder's pro rata share of X's

nonseparately computed income for 1997. During 1997, A and B each

held X stock for 360 days. Thus, each shareholder's pro rata share

of X's nonseparately computed income for 1997 is $360,000 ($1,000

per day x 360 days).

Example 2. Shareholder's pro rata share in the case of a partial

disposition of stock. (i) X, a newly incorporated calendar year

corporation, issues 100 shares of common stock on January 6, 1997,

to each of A and B and files an election to be an S corporation for

its 1997 taxable year. On July 24, 1997, B sells 50 shares of X

stock to C. Thus, in 1997, A owned 50 percent of the outstanding

shares of X on each day of X's 1997 taxable year on which X had

shareholders, B owned 50 percent on each day from January 6, 1997,

to July 24, 1997 (200 days), and 25 percent from July 25, 1997, to

December 31, 1997 (160 days), and C owned 25 percent from July 25,

1997, to December 31, 1997 (160 days).

(ii) Because B's entire interest in X is not terminated when B

sells 50 shares to C on July 24, 1997, X cannot make a terminating

election under section 1377(a)(2) and paragraph (b) of this section

for B's sale of 50 shares to C. Although B's sale of 50 shares to C

is a qualifying disposition under Sec. 1.1368-1(g)(2)(i), X does not

make an election to terminate its taxable year under Sec. 1.1368-

1(g)(2). During its 1997 taxable year, X has nonseparately computed

income of $720,000.

(iii) For each day in X's 1997 taxable year, A's daily pro rata

share of X's nonseparately computed income is $1,000 ($720,000/360

days x 50%). Thus, A's pro rata share of X's nonseparately computed

income for 1997 is $360,000 ($1,000 x 360 days). B's daily pro rata

share of X's nonseparately computed income is $1,000 ($720,000/

360 x 50%) for the first 200 days of X's taxable year on which X has

shareholders, and $500 ($720,000/360 x 25%) for the following 160

days in 1997. Thus, B's pro rata share of X's nonseparately computed

income for 1997 is $280,000 (($1,000 x 200 days) + ($500 x 160

days)). C's daily pro rata share of X's nonseparately computed

income is $500 ($720,000/360 x 25%) for 160 days in 1997. Thus, C's

pro rata share of X's nonseparately computed income for 1997 is

$80,000 ($500 x 160 days).

Example 3. Shareholder's pro rata share when an S corporation

makes a terminating election under section 1377(a)(2). (i) On

January 6, 1997, X, a newly incorporated calendar year corporation,

issues 100 shares of common stock to each of A and B and files an

election to be treated as an S corporation for its 1997 taxable

year. On July 24, 1997,

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B sells B's entire 100 shares of X corporation stock to C. During its

1997 taxable year, X has nonseparately computed income of $720,000.

X makes an election under section 1377(a)(2) and paragraph (b) of

this section for the termination of B's entire interest arising from

B's sale of 100 shares to C. As a result of the election, each

shareholder's pro rata share is determined as if X's taxable year

consisted of two separate taxable years, the first of which ends on

July 24, 1997, the date B's entire interest in X terminates.

(ii) Under X's normal method of accounting, $200,000 of the

$720,000 of nonseparately computed income is allocable to the period

of January 6, 1997, through July 24, 1997 (the first deemed taxable

year), and the remaining $520,000 is allocable to the period of July

25, 1997, through December 31, 1997 (the second deemed taxable

year).

(iii) The pro rata share of the $200,000 of nonseparately

computed income for each of A and B for the first deemed taxable

year is determined by assigning the $200,000 of nonseparately

computed income to each day of the first deemed taxable year

($200,000/200 days=$1,000 per day). Thus, for each day of the first

deemed taxable year, $1,000 is allocated between A and B based on

their proportionate stock ownership. Because A and B each held 50%

of X's authorized and issued shares on each day of the first deemed

taxable year, the daily pro rata share for each of A and B for each

day of the first deemed taxable year is $500 ($1,000 per day x 50%).

Thus, each shareholder's pro rata share of the $200,000 of

nonseparately computed income for the first deemed taxable year is

$100,000 ($500 per day x 200 days). A and B must report these

amounts for their respective taxable years with or within which X's

full taxable year ends (December 31, 1997).

(iv) The pro rata share of the $520,000 of nonseparately

computed income for each of A and C for the second deemed taxable

year is determined by assigning the $520,000 of nonseparately

computed income to each day of the second deemed taxable year

($520,000/160 days=$3,250 per day). Thus, for each day of the second

deemed taxable year, $3,250 is allocated between A and C based on

their proportionate ownership. Because A and C each held 50% of X's

authorized and issued shares on each day of the second deemed

taxable year, the daily pro rata shares for each of A and C for each

day of the second deemed taxable year is $1,625 ($3,250 per

day x 50%). Therefore, each shareholder's pro rata share of the

$520,000 nonseparately computed income is $260,000 ($1,625 per

day x 160 days). A and C must report these amounts for their

respective taxable years with or within which X's full taxable year

ends (December 31, 1997).

Example 4. Interaction between the terminating election under

section 1377(a)(2) and section 1362(e). (i) On January 1, 1997, X, a

calendar year S corporation, has two shareholders, A and B, owning

60 shares and 40 shares, respectively. On June 29, 1997, B sells B's

40 shares to C. On July 20, 1997, C sells C's 40 shares to P, a

partnership, causing a termination under section 1362(d)(2) of X's

election to be an S corporation. X makes an election under section

1377(a)(2) and paragraph (b) of this section with regard to the

termination of B's entire interest on June 29, 1997. Because the

termination on July 20, 1997, of C's entire interest results in a

termination of X's election to be an S corporation, X cannot make a

terminating election under section 1377(a)(2) and paragraph (b) of

this section with regard to C's sale of 40 shares to P. However, X

makes an election under section 1362(e)(3) to assign items to each

short taxable year of the S termination year under X's normal method

of accounting. X has nonseparately computed income of $530,000 for

its 1997 taxable year.

(ii) As a result of the election under section 1362(e)(3), the

portion of X's taxable year ending at the close of the day prior to

the termination of X's S corporation election (January 1, 1997,

through July 19, 1997) is treated as a short taxable year for which

X is an S corporation, and the portion of the year beginning on the

day the termination is effective (July 20, 1997, through December

31, 1997) is treated as a short taxable year for which X is a C

corporation. Under X's normal method of accounting, $200,000 of the

$530,000 of X's taxable income is allocable to the S short year and

the remaining $330,000 is allocable to the C short year. Of the

$200,000 allocable to the S short year, $90,000 is allocable to the

first deemed taxable year (January 1, 1997, through June 29, 1997)

(180 days), and $110,000 is allocable to the second deemed taxable

year (June 30, 1997, through July 19, 1997) (20 days) under X's

normal method of accounting.

(iii) Each shareholder's pro rata share of X's income for the

first deemed taxable year within the S short year is determined as

follows. Because A owns 60% of the stock outstanding during the

first deemed taxable year, A's pro rata share for that period is

$54,000 ($90,000/180 days in the period x 60% x 180 days). B's pro

rata share for that period, reflecting B's 40% ownership, is $36,000

($90,000/180 days in the period x 40% x 180 days). A and B must

report these amounts for their respective taxable years with or

within which the S termination year ends (December 31, 1997).

(iv) Each shareholder's pro rata share of X's income for the

second deemed taxable year within the S short year is determined as

follows. Because A owns 60% of the stock outstanding during the

second deemed taxable year, A's pro rata share for that period is

$66,000 ($110,000/20 days in the period x 60% x 20 days). C's pro

rata share for that period, reflecting C's 40% ownership, is $44,000

($110,000/20 days in the period x 40% x 20 days). A and C must

report these amounts for their respective taxable years with or

within which the S termination year ends (December 31, 1997).

Sec. 1.1377-2 Post-termination transition period.

(a) In general. For purposes of subchapter S of chapter 1 of the

Code and this section, the term post-termination transition period

means--

(1) The period beginning on the day after the last day of the

corporation's last taxable year as an S corporation and ending on the

later of--

(i) The day which is 1 year after such last day; or

(ii) The due date for filing the return for the last taxable year

as an S corporation (including extensions); and

(2) The 120-day period beginning on the date of a determination

that the corporation's election under section 1362(a) had terminated

for a previous taxable year.

(b) When a post-termination transition period arises. A post-

termination transition period arises following the termination under

section 1362(d) of a corporation's S election. For example, a post-

termination transition period arises if a C corporation acquires the

assets of an S corporation in a transaction to which section 381(a)(2)

applies. However, if an S corporation acquires the assets of another S

corporation in a transaction to which section 381(a)(2) applies, a

post-termination transition period does not arise. (See Sec. 1.1368-

2(d)(2) for the treatment of the acquisition of the assets of an S

corporation by another S corporation in a transaction to which section

381(a)(2) applies.) The special treatment under section 1371(e)(1) of

distributions of money by a corporation with respect to its stock

during the post-termination transition period is available only to

those shareholders who were shareholders in the S corporation at the

time of the termination.

(c) Last day of last taxable year. For purposes of section

1377(b)(1)(A) and paragraph (a)(1) of this section, the last day of a

corporation's last taxable year as an S corporation is--

(1) The last day of the short S taxable year under section

1362(e)(1)(A); or

(2) The date of transfer (within the meaning of section 381(a)(2))

in the event that a C corporation acquires the assets of an S

corporation in a transaction to which section 381(a)(2) applies.

(d) Determination defined. For purposes of section 1377(b)(1)(B)

and paragraph (a)(2) of this section, the term determination means--

(1) A court decision rendered by a court of competent jurisdiction;

(2) A closing agreement entered into between the Secretary and the

taxpayer pursuant to section 7121;

(3) A written agreement between the corporation and the

Commissioner (including a statement acknowledging that the

corporation's election to be an S corporation terminated under section

1362(d)) that the corporation failed to qualify as an S corporation;

(4) For a corporation subject to the audit and assessment

provisions of subchapter C of chapter 63 of subtitle A,

[[Page 35887]]

the expiration of the period specified in section 6226 for filing a

petition for readjustment of a final S corporation administrative

adjustment finding that the corporation failed to qualify as an S

corporation, provided that no petition was timely filed before the

expiration of the period; and

(5) For a corporation not subject to the audit and assessment

provisions of subchapter C of chapter 63 of subtitle A, the expiration

of the period for filing a petition under section 6213 for the

shareholder's taxable year for which the Commissioner has made a

finding that the corporation failed to qualify as an S corporation,

provided that no petition was timely filed before the expiration of the

period.

(e) Time of determination--(1) Court decision. A court decision

becomes a determination on the date the decision becomes final under

rules applicable to the court rendering the decision.

(2) Closing agreement. A closing agreement becomes a determination

on the date of its approval by the Commissioner.

(3) Written agreement. A written agreement described in paragraph

(d)(3) of this section becomes a determination when it is signed by the

district director having jurisdiction over the corporation (or by

another Service official to whom authority to sign the agreement is

delegated) and by an officer of the corporation authorized to sign on

its behalf. Neither the request for a written agreement nor the terms

of the written agreement suspend the running of any statute of

limitations.

(4) Implied agreement. A determination under paragraph (d)(4) or

(d)(5) of this section becomes effective on the day after the date of

expiration of the period specified under section 6226 or 6213,

respectively.

Sec. 1.1377-3 Effective date.

Sections 1.1377-1 and 1.1377-2 apply to taxable years of an S

corporation beginning after [the date of publication as final

regulations in the Federal Register].

PART 18--TEMPORARY INCOME TAX REGULATIONS UNDER THE SUBCHAPTER S

REVISION ACT OF 1982

Par. 3. The authority citation for part 18 continues to read as

follows:

Authority: 26 U.S.C. 7805 sec. (6)(c)(3)(B)(iii) of the

Subchapter S Revision Act of 1982.

Sec. 18.1377-1 [Removed]

Par. 4. Section 18.1377-1 is removed.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 95-16653 Filed 7-11-95; 8:45 am]

BILLING CODE 4830-01-U