S Corporation Subsidiaries
Federal RegisterApr 22, 1998
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-251698-96]
RIN 1545-AU77
S Corporation Subsidiaries
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking.
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SUMMARY: This document contains proposed regulations relating to the
treatment of corporate subsidiaries of S corporations. The proposed
regulations interpret the rules added to the Internal Revenue Code by
section 1308 of the Small Business Job Protection Act of 1996. The
proposed regulations affect S corporations and their subsidiaries.
DATES: Written comments must be received by July 21, 1998.
ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-251698-96), room
5228, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered between the
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-251698-96), Courier's
Desk, Internal Revenue Service, 1111 Constitution Avenue, NW.,
Washington, DC. Alternatively, taxpayers may submit comments
electronically via the Internet by selecting the ``Tax Regs'' option on
the IRS Home Page, or by submitting comments directly to the IRS
Internet site at http://www.irs.ustreas.gov/prod/tax__regs/
comments.html.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Deanna L.
Walton, (202) 622-3050 (Subchapter S) or Lee A. Dean, (202) 622-7540
(Subchapter C); concerning submissions, Michael Slaughter, (202) 622-
7190 (not toll-free numbers).
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SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in this notice of proposed
rulemaking have been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)).
Comments on the 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, T:FP, Washington, DC 20224.
Comments on the collections of information should be received by June
22, 1998. Comments are specifically requested concerning: Whether the
proposed collections of information are necessary for the proper
performance of the functions of the Internal Revenue Service, including
whether the collections will have a practical utility;
The accuracy of the estimated burden associated with the proposed
collections of information (see below);
How the quality, utility, and clarity of the information to be
collected may be enhanced;
How the burden of complying with the proposed collections of
information may be minimized, including through the application of
automated collection techniques or other forms of information
technology; and
Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of services to provide information.
The collections of information in these proposed regulations are in
Secs. 1.1361-3(a)(1), 1.1361-3(b)(1), 1.1361-5(a)(2), and 1.1362-8. The
collections of information are required to determine the manner in
which a corporate subsidiary of an S corporation will be treated under
the Internal Revenue Code.
These collections of information are required to obtain a benefit.
The likely respondents and/or recordkeepers are small businesses or
organizations, businesses or other for-profit institutions, and farms.
Estimated total annual reporting/recordkeeping burden: 10,110
hours.
Estimated average annual burden per respondent/recordkeeper: 57
minutes.
Estimated number of respondents/recordkeepers: 10,660.
Estimated annual frequency of responses: On occasion.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Background
This document contains proposed amendments to the Income Tax
Regulations (26 CFR part 1) relating to S corporations and their
subsidiaries under sections 1361 and 1362 of the Internal Revenue Code
(Code). Section 1308 of the Small Business Job Protection Act of 1996,
Public Law 104-188, 110 Stat. 1755 (the Act), modified section 1361 of
the Code to permit an S corporation: (1) To own 80 percent or more of
the stock of a C corporation, and (2) to elect to treat a wholly owned
subsidiary as a qualified subchapter S subsidiary (QSSS). In Notice 97-
4 (1997-2 I.R.B. 24), the IRS announced its intention to issue
regulations under section 1308 of the Act and requested comments on
certain issues. Section 1601 of the Taxpayer Relief Act of 1997, Public
Law 105-34, 111 Stat. 788 (the 1997 Act), made a technical correction
to section 1361 to provide regulatory authority regarding the
consequences of an election to be a QSSS.
Explanation of Provisions
Overview
Prior law prohibited an S corporation from owning 80 percent or
more of the stock of another corporation. The Act repealed section
1362(b)(2)(A) of the Internal Revenue Code (Code), thereby allowing an
S corporation to own 80 percent or more of the stock of a C
corporation. The Act also added section 1504(b)(8) to the Code to
prevent an S corporation from joining in the filing of a consolidated
return with its affiliated C corporations. A C corporation subsidiary
of an S corporation, however, may file a consolidated return with its
affiliated C corporations. See H.R. Conf. Rep. No. 737, 104th Cong., 2d
Sess. 224 (1996).
New section 1361(b)(3)(B) defines the term qualified subchapter S
subsidiary as any domestic corporation that is not an ineligible
corporation if, (1) an S corporation holds 100 percent of the stock of
the corporation, and (2) that S corporation elects to treat the
subsidiary as a QSSS. Except as otherwise provided in regulations, a
corporation for which a QSSS election is made is not treated as a
separate corporation, and all assets, liabilities, and items of income,
deduction, and credit of the QSSS are treated as assets, liabilities,
and items of income, deduction, and credit of the parent S corporation.
The legislative history accompanying section 1361(b)(3) indicates that,
when the parent corporation makes the election, the subsidiary is
deemed to have liquidated under sections 332 and 337 immediately before
the election is effective. See S. Rep. No. 281, 104th Cong., 2d Sess.
53 (1996); H.R. Rep. No. 586, 104th Cong., 2d Sess. 89 (1996). However,
the legislative history accompanying the technical correction made by
the 1997 Act indicates that regulations may provide exceptions to that
general rule. See S. Rep. No. 33, 105th Cong., 1st Sess. 320 (1997).
Section 1361(b)(3)(C) provides that any QSSS that ceases to meet
the requirements of section 1361(b)(3)(B) will be treated as a new
corporation acquiring all of its assets (and assuming all of its
liabilities) immediately before the cessation from its S corporation
parent in exchange for the subsidiary's stock. Section 1361(b)(3)(D)
provides that a QSSS whose election has terminated (or a successor
corporation) may not make an S election or have a QSSS election made
with respect to it before its fifth taxable year that begins after the
first taxable year for which the termination is effective, unless the
Secretary consents to the election.
Under current and prior law, the S election of a corporation with
subchapter C corporation earnings and profits terminated if that S
corporation received passive investment income, including dividends, in
excess of 25 percent of gross receipts for three consecutive years.
Section 1362(d)(3)(E) modifies that general rule by excluding dividends
from passive investment income to the extent that the dividends are
attributable to the active conduct of a trade or business of a C
corporation in which the S corporation has an 80 percent or greater
ownership interest. Neither the Act nor the legislative history
provides rules for determining the attribution of dividends to an
active trade or business.
QSSS Formation
Under the proposed regulations, an S corporation makes a QSSS
election with respect to an eligible subsidiary by filing a form to be
developed by the IRS prior to the time these regulations become final.
This proposes to change the temporary election procedure provided in
Notice 97-4, which provides that a parent S corporation files a
completed Form 966, Corporate Dissolution and
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Liquidation (with some modifications), to make a QSSS election. Until
these proposed regulations are finalized, taxpayers should continue to
use the temporary election procedure in Notice 97-4 to make QSSS
elections.
The proposed regulations also provide that the effective date of a
QSSS election may be up to 2 months and 15 days prior to the day the
QSSS election is made. This is a slight change from the 75 day
retroactive period provided in Notice 97-4, but is consistent with the
general time period for making S elections. Unlike the S election,
however, a QSSS election does not need to be made within 2 months and
15 days of the beginning of a taxable year. A similar retroactive
period is provided for revocations of QSSS status. In addition, a
taxpayer may choose a prospective effective date for a QSSS election or
revocation, so long as the date selected is not more than 12 months
after the date the election or revocation is made.
The proposed regulations provide that, when an S corporation makes
a valid QSSS election with respect to a subsidiary, the subsidiary is
deemed to have liquidated into the parent. The tax treatment of this
liquidation, alone or in the context of any larger transaction (for
example, a transaction that also includes the acquisition of the
subsidiary's stock), is generally determined under all relevant
provisions of the Code and general principles of tax law, including the
step transaction doctrine. However, a special transition rule applies
to certain elections effective prior to the date that is 60 days after
publication of final regulations in the Federal Register. The
transition rule indicates the recognition of special concerns that may
have arisen as a result of transactions entered into by taxpayers
relying on the legislative history to the Act and without applying the
step transaction doctrine to the acquisition of the subsidiary's stock
followed by a QSSS election. The IRS requests comments concerning other
transactions occurring during the transitional period for which relief
from the effect of application of the step transaction doctrine may be
warranted.
Special rules may apply when a QSSS election is made following the
transfer of one S corporation's stock to another S corporation. For
example, if an S corporation acquires the stock of another S
corporation in a transaction in which the acquiring S corporation's
basis in the stock received is determined by reference to the
transferor's basis and makes a QSSS election with respect to the other
corporation effective on the day of acquisition, any losses disallowed
under section 1366(d) with respect to a former shareholder of the QSSS
will be available to that shareholder as a shareholder of the acquiring
S corporation. Furthermore, when stock in an S corporation is
transferred to another S corporation and a QSSS election is made with
respect to the subsidiary effective on the day of acquisition, the S
election of the former corporation terminates at the same moment as the
QSSS election becomes effective. This rule ensures that the former S
corporation is not treated as a C corporation for any period solely
because of the transfer.
Generally, the proposed regulations treat the liquidation as
occurring at the close of the day before the QSSS election is
effective. Under this rule, if a parent corporation makes an S election
effective on the same date as a QSSS election with respect to a
subsidiary, the deemed liquidation occurs at a time when the parent
corporation is still a C corporation. A QSSS election satisfies the
requirement of adopting a plan of liquidation under section 332.
Following the deemed liquidation, the QSSS is not treated as a
separate corporation (except as otherwise provided in the regulations),
and all assets, liabilities, and items of income, deduction, and credit
are treated as those of the S corporation. Accordingly, all such items
must be reported on the S corporation's return required to be filed
under section 6037. A special rule applies for the calculation of these
items where either an S corporation or its QSSS is a bank (as defined
in section 581). This special rule was first announced in Notice 97-5
(1997-2 I.R.B. 25). Until these proposed regulations are finalized,
taxpayers should continue to follow Notice 97-5.
QSSS Termination
The QSSS status of a corporation continues until it terminates. The
regulations specify the date of termination for specific terminating
events. Section 1361(b)(3)(D) provides that, if a QSSS election
terminates, the corporation is treated as a new corporation acquiring
all of its assets (and assuming all of its liabilities) from the S
corporation in exchange for stock of the new corporation immediately
before the termination. The tax treatment of this transaction or of a
larger transaction that includes this transaction will be determined
under the Code and general principles of tax law, including the step
transaction doctrine. Examples are provided to illustrate situations in
which the formation of the new corporation will qualify as a
nonrecognition transaction under section 351. The proposed regulations
also provide that, under certain circumstances, relief may be available
under the standards established under section 1362(f) for the
inadvertent termination of an S election.
Section 1361(b)(3)(D) provides that a corporation whose QSSS
election has terminated (or a successor corporation) may not make an S
election or have a QSSS election made with respect to it for five
taxable years following the termination without the consent of the
Secretary. The proposed regulations provide that, without requesting
the Secretary's consent, a corporation may make an election to be
treated as an S corporation or may have a QSSS election made with
respect to it before the expiration of the five-year period under
certain circumstances. Consent is not required if an otherwise valid S
election or QSSS election is made for the former QSSS (or its successor
corporation) effective immediately following the disposition of its
stock. Thus, the proposed regulations allow corporations to move freely
between QSSS and S corporation status, provided there is no intervening
period for which the corporation is treated as a C corporation.
C Corporation Subsidiaries
The proposed regulations also provide rules relating to certain C
corporation subsidiaries held by S corporations. Under section
1362(d)(3)(E), dividends received by an S corporation from a C
corporation in which the S corporation has an 80 percent or greater
ownership interest are not treated as passive investment income for
purposes of sections 1362 and 1375 to the extent the dividends are
attributable to the earnings and profits of the C corporation derived
from the active conduct of a trade or business. The proposed
regulations provide guidance for attributing dividends to the active
conduct of a trade or business. Special rules apply to dividends
distributed by the common parent of a consolidated group.
Under the proposed regulations, earnings and profits of a C
corporation derived from the active conduct of a trade or business are
the earnings and profits of the corporation derived from activities
that would not produce passive investment income under section
1362(d)(3) if the C corporation were an S corporation. The proposed
regulations provide a safe harbor under which the corporation may
determine the amount of the active earnings and profits by comparing
the corporation's gross receipts derived from non-passive
[[Page 19867]]
investment income-producing activities with the corporation's total
gross receipts in the year the earnings and profits are produced. If
less than 10 percent of the C corporation's earnings and profits for a
taxable year are derived from activities that would produce passive
investment income, all earnings and profits produced by the corporation
during the taxable year are considered active earnings and profits.
The proposed regulations also provide that a C corporation may
treat all earnings and profits accumulated by the corporation prior to
the time an S corporation held stock meeting the requirements of
section 1504(a)(2) as active earnings and profits in the same
proportion as the C corporation's active earnings and profits for the
three taxable years ending prior to the time when the S corporation
acquired 80 percent of the C corporation bear to the C corporation's
total earnings and profits for those three taxable years. Provisions
also address the allocation of distributions from current or
accumulated earnings and profits.
Proposed Effective Date
The regulations are proposed to be effective on the date that final
regulations are published in the Federal Register. However, the IRS is
considering whether certain provisions should be made retroactive. The
IRS requests comments concerning whether certain provisions should be
made effective for taxable years beginning on or after January 1, 1997.
Special Analyses
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. 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. It is
hereby certified that the collections of information contained in these
regulations will not have a significant economic impact on a
substantial number of small businesses. This certification is based on
the fact that the economic burden imposed on taxpayers by the
collections of information and recordkeeping requirements of these
regulations is insignificant. For example, the estimated average annual
burden per respondent is less than one hour. Furthermore, most
taxpayers will only have to respond to the requests for information
contained in Secs. 1.1361-3(b)(1) and 1.1361-5(a)(2) one time in the
life of the corporation. Therefore, a Regulatory Flexibility Analysis
under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not
required.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (preferably a
signed original and eight (8) copies) that are timely submitted to the
IRS. All comments will be available for public inspection and copying.
A public hearing will be scheduled in the Internal Revenue
Building, 1111 Constitution Avenue, NW., Washington, DC. The IRS
recognizes that persons outside the Washington, DC, area also may wish
to testify at the public hearing through teleconferencing. Requests to
include teleconferencing sites must be received by June 22, 1998. If
the IRS receives sufficient indications of interest to warrant
teleconferencing to a particular city, and if the IRS has
teleconferencing facilities available in that city on the date the
public hearing is to be scheduled, the IRS will try to accommodate the
requests.
The IRS will publish the time and date of the public hearing and
the locations of any teleconferencing sites in an announcement in the
Federal Register.
Drafting Information
The principal authors of these proposed regulations are Deanna L.
Walton, Office of the Assistant Chief Counsel (Passthroughs and Special
Industries); and Lee A. Dean, Office of the Assistant Chief Counsel
(Corporate). However, other personnel from the IRS and Treasury
Department participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Amend Sec. 1.1361-0 as follows:
1. Revise the introductory text.
2. Remove the entry for Sec. 1.1361-1(d)(3).
3. Add entries for Secs. 1.1361-2, 1.1361-3, 1.1361-4, .1361-5, and
1.1361-6.
The revisions and additions read as follows:
Section 1.1361-0 Table of Contents
This section lists captions contained in Secs. 1.1361-1, 1.1361-2,
1.1361-3, 1.1361-4, 1.1361-5, and 1.1361-6.
* * * * *
Section 1.1361-2 Definitions Relating to S Corporation
Subsidiaries
(a) In general.
(b) Stock treated as held by S corporation.
(c) Examples.
Secton 1.1361-3 QSSS Election
(a) Time and manner of making election.
(1) In general.
(2) Time of making election.
(3) Effective date of election.
(4) Example.
(5) Extension of time for making a QSSS election.
(b) Revocation of QSSS election.
(1) Manner of revoking QSSS election.
(2) Effective date of revocation.
(3) Revocation after termination.
Section 1.1361-4 Effect of QSSS Election.
(a) Separate existence ignored.
(1) In general.
(2) Liquidation of subsidiary.
(3) Treatment of banks.
(i) In general.
(ii) Examples.
(4) Treatment of stock of QSSS.
(5) Transitional relief.
(i) General rule.
(ii) Examples.
(b) Timing of the liquidation.
(1) In general.
(2) Acquisitions.
(3) Coordination with section 338 election.
(c) Carryover of disallowed losses and deductions.
(d) Examples.
Section 1.1361-5 Termination of QSSS Election
(a) In general.
(1) Effective date.
(2) Information to be provided upon termination of QSSS election
by failure to qualify as a QSSS.
(3) Examples.
(b) Effect of termination of QSSS election.
(1) Formation of new corporation.
(2) Carryover of disallowed losses and deductions.
(3) Examples.
(c) Inadvertent terminations.
(d) Election after QSSS termination.
(1) In general.
(2) Exception.
(3) Examples.
Section 1.1361-6 Effective Date
Par. 3. Amend Sec. 1.1361-1 as follows:
1. Revise paragraph (b)(1)(i).
2. Remove paragraph (d)(1)(i).
3. Redesignate paragraphs (d)(1)(ii), (d)(1)(iii), (d)(1)(iv), and
(d)(1)(v) as paragraphs (d)(1)(i), (d)(1)(ii), (d)(1)(iii), and
(d)(1)(iv), respectively.
4. Revise newly designated paragraph (d)(1)(i).
[[Page 19868]]
5. Remove paragraph (d)(3).
6. Revise the first sentence of paragraph (e)(1).
The revisions read as follows:
Sec. 1.1361-1 S corporation defined.
* * * * *
(b) * * *
(1) * * *
(i) More than 75 shareholders (35 for taxable years beginning
before January 1, 1997);
* * * * *
(d) * * *
(1) * * *
(i) For taxable years beginning on or after January 1, 1997, a
financial institution that uses the reserve method of accounting for
bad debts described in section 585 (for taxable years beginning prior
to January 1, 1997, a financial institution to which section 585
applies (or would apply but for section 585(c)) or to which section 593
applies);
* * * * *
(e) * * *
(1) General rule. A corporation does not qualify as a small
business corporation if it has more than 75 shareholders (35 for
taxable years beginning prior to January 1, 1997). * * *
* * * * *
Par. 4. Add Secs. 1.1361-2, 1.1361-3, 1.1361-4, 1.1361-5, and
1.1361-6 to read as follows:
Sec. 1.1361-2 Definitions relating to S corporation subsidiaries.
(a) In general. The term qualified subchapter S subsidiary (QSSS)
means any domestic corporation that is not an ineligible corporation
(as defined in section 1361(b)(2) and the regulations thereunder), if--
(1) 100 percent of the stock of such corporation is held by an S
corporation; and
(2) The S corporation properly elects to treat the subsidiary as a
QSSS under Sec. 1.1361-3.
(b) Stock treated as held by S corporation. For purposes of
satisfying the 100 percent stock ownership requirement in section
1361(b)(3)(B)(i) and paragraph (a)(1) of this section, stock of a
corporation is treated as held by an S corporation if the S corporation
is the owner of that stock for federal income tax purposes.
(c) Examples. The following examples illustrate the application of
this section:
Example 1. X, an S corporation, owns 100 percent of Y, a
corporation for which a valid QSSS election is in effect for the
taxable year. Y owns 100 percent of Z, a corporation otherwise
eligible for QSSS status. X may elect to treat Z as a QSSS under
section 1361(b)(3)(B)(ii).
Example 2. Assume the same facts as in Example 1, except that Y
is a business entity that is disregarded as an entity separate from
its owner under Sec. 301.7701-2(c)(2) of this chapter. X may elect
to treat Z as a QSSS.
Example 3. Assume the same facts as in Example 1, except that Y
owns 50 percent of Z, and X owns the other 50 percent. X may elect
to treat Z as a QSSS.
Example 4. Assume the same facts as in Example 1, except that Y
is a C corporation. Although Y is a domestic corporation that is
otherwise eligible to be a QSSS, no QSSS election has been made for
Y. Thus, X is not treated as holding the stock of Z. Consequently, X
may not elect to treat Z as a QSSS.
Sec. 1.1361-3 QSSS election.
(a) Time and manner of making election--(1) In general. Except as
provided in section 1361(b)(3)(D) and Sec. 1.1361-5(d) (five-year
prohibition on re-election), an S corporation may elect to treat an
eligible subsidiary as a QSSS by filing a completed form to be
prescribed by the Internal Revenue Service. The election form must be
signed by a person authorized to sign the S corporation's return
required to be filed under section 6037 and must be submitted to the
service center where the subsidiary filed its most recent tax return
(if applicable). If an S corporation forms a subsidiary and makes a
valid QSSS election (effective upon the date of the subsidiary's
formation) for the subsidiary, the election should be submitted to the
service center where the S corporation filed its most recent return.
(2) Time of making election. A QSSS election may be made by the S
corporation parent at any time during the taxable year.
(3) Effective date of election. A QSSS election will be effective
on the date specified on the election form or on the date the election
form is filed if no date is specified. The effective date specified on
the form can not be more than 2 months and 15 days prior to the date of
filing and can not be more than 12 months after the date of filing. For
this purpose, the definition of the term ``month'' found in
Sec. 1.1362-6(a)(2)(ii)(C) applies. If an election form specifies an
effective date more than 2 months and 15 days prior to the date on
which the election form is filed, it will be effective 2 months and 15
days prior to the date it is filed. If an election form specifies an
effective date more than 12 months after the date on which the election
is filed, it will be effective 12 months after the date it is filed.
The corporation for which the QSSS election is made must meet all the
requirements of section 1361(b)(3)(B) at the time the election is made
and for all periods for which the election is to be effective.
(4) Example. The following example illustrates the application of
paragraph (a)(3) of this section:
Example. X has been a calendar year S corporation engaged in a
trade or business for several years. X acquires the stock of Y, a
calendar year C corporation, on April 1, 1998. On August 10, 1998, X
makes an election to treat Y as a QSSS. Unless otherwise specified
on the election form, the election will be effective as of August
10, 1998. If specified on the election form, the election may be
effective on some other date that is not more than 2 months and 15
days prior to August 10, 1998, and not more than 12 months after
August 10, 1998.
(5) Extension of time for making a QSSS election. An extension of
time to make a QSSS election may be available under the procedures
applicable under Secs. 301.9100-1 and 301.9100-3 of this chapter.
(b) Revocation of QSSS election--(1) Manner of revoking QSSS
election. An S corporation may revoke a QSSS election under section
1361 by filing a statement with the service center where the S
corporation's most recent tax return was properly filed. The revocation
statement must include the names, addresses, and taxpayer
identification numbers of both the parent S corporation and the QSSS.
The statement must be signed by a person authorized to sign the S
corporation's return required to be filed under section 6037.
(2) Effective date of revocation. The revocation of a QSSS election
is effective on the date specified on the revocation statement or on
the date the revocation statement is filed if no date is specified. The
effective date specified on the revocation statement can not be more
than 2 months and 15 days prior to the date on which the revocation
statement is filed and can not be more than 12 months after the date on
which the revocation statement is filed. If a revocation statement
specifies an effective date more than 2 months and 15 days prior to the
date on which the statement is filed, it will be effective 2 months and
15 days prior to the date it is filed. If a revocation statement
specifies an effective date more than 12 months after the date on which
the statement is filed, it will be effective 12 months after the date
it is filed.
(3) Revocation after termination. A revocation may not be made
after the occurrence of an event that renders the subsidiary ineligible
for QSSS status under section 1361(b)(3)(B).
Sec. 1.1361-4 Effect of QSSS election.
(a) Separate existence ignored--(1) In general. Except as otherwise
provided in paragraph (a)(3) of this section, for federal tax
purposes--
[[Page 19869]]
(i) A corporation which is a QSSS shall not be treated as a
separate corporation; and
(ii) All assets, liabilities, and items of income, deduction, and
credit of a QSSS shall be treated as assets, liabilities, and items of
income, deduction, and credit of the S corporation.
(2) Liquidation of subsidiary. If an S corporation makes a valid
QSSS election with respect to a subsidiary, the subsidiary is deemed to
have liquidated into the S corporation. Except as provided in paragraph
(a)(5) of this section, the tax treatment of the liquidation or of a
larger transaction that includes the liquidation will be determined
under the Internal Revenue Code and general principles of tax law,
including the step transaction doctrine. Thus, for example, if an S
corporation forms a subsidiary and makes a valid QSSS election
(effective upon the date of the subsidiary's formation) for the
subsidiary, there will be no deemed liquidation of the new subsidiary.
Instead, the corporation will be deemed to be a QSSS from its
inception. For purposes of section 332, the making of a QSSS election
satisfies the requirement of adopting a plan of liquidation.
(3) Treatment of banks--(i) In general. If an S corporation is a
bank, or if an S corporation makes a valid QSSS election for a
subsidiary that is a bank, any special rules applicable to banks under
the Internal Revenue Code continue to apply separately to the bank
parent or bank subsidiary as if the deemed liquidation of any QSSS
under paragraph (a)(2) of this section had not occurred. For any QSSS
that is a bank, however, all assets, liabilities, and items of income,
deduction, and credit of the QSSS, as determined in accordance with the
special bank rules, are treated as assets, liabilities, and items of
income, deduction, and credit of the S corporation. For purposes of
this paragraph (a)(3)(i), the term ``bank'' has the same meaning as in
section 581.
(ii) Examples. The following examples illustrate the application of
this paragraph (a)(3):
Example 1. X, an S corporation, is a bank as defined in section
581. X owns 100 percent of Y and Z, corporations for which valid
QSSS elections are in effect. Y is a bank as defined in section 581,
and Z is not a financial institution. Pursuant to paragraph
(a)(3)(i) of this section, any special rules applicable to banks
under the Internal Revenue Code continue to apply separately to X
and Y and do not apply to Z. Thus, for example, section 265(b),
which provides special rules for interest expense deductions of
banks, applies separately to X and Y. That is, X and Y each must
make a separate determination under section 265(b) of interest
expense allocable to tax-exempt interest, and no deduction is
allowed for that interest expense.
Example 2. X, an S corporation, is a bank holding company and
thus is not a bank as defined in section 581. X owns 100 percent of
Y, a corporation for which a valid QSSS election is in effect. Y is
a bank as defined in section 581. Pursuant to paragraph (a)(3)(i) of
this section, any special rules applicable to banks under the
Internal Revenue Code continue to apply to Y and do not apply to X.
However, all of Y's assets, liabilities, and items of income,
deduction, and credit, as determined in accordance with the special
bank rules, are treated as those of X. Thus, for example, section
582(c), which provides special rules for sales and exchanges of debt
by banks, applies only to sales and exchanges by Y. However, any
gain or loss on such a transaction by Y that is considered ordinary
income or ordinary loss pursuant to section 582(c) is treated as
ordinary income or ordinary loss of X.
(4) Treatment of stock of QSSS. Except for purposes of section
1361(b)(3)(B)(i) and Sec. 1.1361-2(a)(1), the stock of a QSSS shall be
disregarded for all federal tax purposes.
(5) Transitional relief--(i) General rule. If an S corporation and
another corporation (the related corporation) are persons specified in
section 267(b) prior to an acquisition by the S corporation of some or
all of the stock of the related corporation followed by a QSSS election
for the related corporation, the step transaction doctrine will not
apply to determine the tax consequences of the acquisition. This
paragraph (a)(5) shall apply to QSSS elections effective prior to the
date that is 60 days after publication of final regulations in the
Federal Register.
(ii) Examples. The following examples illustrate the application of
this paragraph (a)(5):
Example 1. Individual A owns 100 percent of the stock of X, an S
corporation. X owns 79 percent of the stock of Y, a solvent
corporation, and A owns the remaining 21 percent. On May 4, 1998, A
contributes its Y stock to X in exchange for X stock. X makes a QSSS
election with respect to Y effective immediately following the
transfer. The liquidation described in paragraph (a)(2) of this
section is respected as an independent step separate from the stock
acquisition, and the tax consequences of the liquidation are
determined under sections 332 and 337. The contribution by A of the
Y stock qualifies under section 351, and no gain or loss is
recognized by A, X, or Y.
Example 2. Individual A owns 100 percent of the stock of two
solvent S corporations, X and Y. On May 4, 1998, A contributes the
stock of Y to X. X makes a QSSS election with respect to Y
immediately following the transfer. The liquidation described in
paragraph (a)(2) of this section is respected as an independent step
separate from the stock acquisition, and the tax consequences of the
liquidation are determined under sections 332 and 337. The
contribution by A of the Y stock to X qualifies under section 351,
and no gain or loss is recognized by A, X, or Y. Y is not treated as
a C corporation for any period solely because of the transfer of its
stock to X, an ineligible shareholder. See Sec. 1.1362-2(b)(4).
(b) Timing of the liquidation--(1) In general. Except as otherwise
provided in paragraphs (b)(2) or (b)(3) of this section, the
liquidation described in paragraph (a)(2) of this section occurs at the
close of the day before the QSSS election is effective. Thus, for
example, if a C corporation elects to be treated as an S corporation
and makes a QSSS election (effective the same date as the S election)
with respect to a subsidiary, the liquidation occurs immediately before
the S election becomes effective, while the S electing parent is still
a C corporation.
(2) Acquisitions. If an S corporation does not own 100 percent of
the stock of the subsidiary on the day before the QSSS election is
effective, the liquidation described in paragraph (a)(2) of this
section occurs immediately after the time at which the S corporation
first owns 100 percent of the stock.
(3) Coordination with section 338 election. An S corporation that
makes a qualified stock purchase of a target may make an election under
section 338 with respect to the acquisition if it meets the
requirements for the election, and may make a QSSS election with
respect to the target. If an S corporation makes an election under
section 338 with respect to a subsidiary acquired in a qualified stock
purchase, a QSSS election made with respect to that subsidiary is not
effective before the day after the acquisition date (within the meaning
of section 338(h)(2)). If the QSSS election is effective on the day
after the acquisition date, the liquidation under paragraph (a)(2) of
this section occurs immediately after the deemed asset purchase by the
new target corporation under section 338. If an S corporation makes an
election under section 338 (without a section 338(h)(10) election) with
respect to a target, the target must file a final or deemed sale return
as a C corporation reflecting the deemed sale. See Sec. 1.338-1(e).
(c) Carryover of disallowed losses and deductions. If an S
corporation (S1) acquires the stock of another S corporation (S2) in a
transaction in which the basis of the S2 stock is determined in whole
or in part by reference to the transferor's basis, and S1 makes a QSSS
election with respect to S2 effective on the day of the acquisition,
any loss or deduction disallowed under section 1366(d) with respect to
a former shareholder of S2 is
[[Page 19870]]
available to that shareholder as a shareholder of S1. Thus, a loss or
deduction of a shareholder of S2 disallowed prior to or during the
taxable year of the transaction is treated as incurred by S1 with
respect to that shareholder if the shareholder is a shareholder of S1
after the transaction.
(d) Examples. The following examples illustrate the application of
this section:
Example 1. X, an S corporation, owns 100 percent of the stock of
Y, a C corporation. On June 2, 1998, X makes a valid QSSS election
for Y, effective June 2, 1998. Assume that, under general principles
of tax law, including the step transaction doctrine, X's acquisition
of the Y stock and the subsequent QSSS election would not be treated
as related. The liquidation described in paragraph (a)(2) of this
section occurs at the close of the day on June 1, 1998, the day
before the QSSS election is effective, and the plan of liquidation
is considered adopted on that date. Y's taxable year and separate
existence for federal tax purposes end at the close of June 1, 1998.
Example 2. X, a C corporation, owns 100 percent of the stock of
Y, another C corporation. On December 31, 1998, X makes an election
under section 1362 to be treated as an S corporation and a valid
QSSS election for Y, both effective January 1, 1999. Assume that,
under general principles of tax law, including the step transaction
doctrine, X's acquisition of the Y stock and the subsequent QSSS
election would not be treated as related. The liquidation described
in paragraph (a)(2) of this section occurs at the close of December
31, 1998, the day before the QSSS election is effective. The QSSS
election for Y is effective on the same day that X's S election is
effective, and the deemed liquidation is treated as occurring before
the S election is effective, when X is still a C corporation. Y's
taxable year ends at the close of December 31, 1998. See
Sec. 1.381(b)-1.
Example 3. On June 1, 1998, X, an S corporation, acquires 100
percent of the stock of Y, an existing S corporation, for cash in a
transaction meeting the requirements of a qualified stock purchase
(QSP) under section 338. X immediately makes a QSSS election for Y
effective June 2, 1998, and also makes a joint election under
section 338(h)(10) with the shareholder of Y. Under section 338(a)
and Sec. 1.338(h)(10)-1, Y is treated as having sold all of its
assets at the close of the acquisition date, June 1, 1998. Y is
treated as a new corporation which purchased all of those assets as
of the beginning of June 2, 1998, the day after the acquisition
date. Section 338(a)(2). The QSSS election is effective on June 2,
1998, and the liquidation under paragraph (a)(2) of this section
occurs immediately after the deemed asset purchase by the new
corporation.
Example 4. X, an S corporation, owns 100 percent of Y, a
corporation for which a QSSS election is in effect. On May 12, 1998,
a date on which the QSSS election is in effect, X issues Y a $10,000
note under state law that matures in ten years with a market rate of
interest. Y is not treated as a separate corporation, and X's
issuance of the note to Y on May 12, 1998, is disregarded for
federal tax purposes.
Example 5. X, an S corporation, owns 100 percent of the stock of
Y, a C corporation. At a time when Y is indebted to X in an amount
which exceeds the fair market value of Y's assets, X makes a QSSS
election effective on the date it is filed with respect to Y. The
liquidation described in paragraph (a)(2) of this section does not
qualify under sections 332 and 337 and, thus, Y recognizes gain or
loss on the assets distributed, subject to the limitations of
section 267.
Sec. 1.1361-5 Termination of QSSS election.
(a) In general--(1) Effective date. The termination of a QSSS
election is effective--
(i) On the effective date contained in the revocation statement if
a QSSS election is revoked under Sec. 1.1361-3(b);
(ii) At the close of the last day of the parent's last taxable year
as an S corporation if the parent's S election terminates under
Sec. 1.1362-2; or
(iii) At the close of the day on which an event (other than an
event described in paragraph (a)(1)(ii) of this section) occurs that
renders the subsidiary ineligible for QSSS status under section
1361(b)(3)(B).
(2) Information to be provided upon termination of QSSS election by
failure to qualify as a QSSS. If a QSSS election terminates because an
event renders the subsidiary ineligible for QSSS status, the S
corporation must attach to its return for the taxable year in which the
termination occurs a notification that a QSSS election has terminated,
the date of the termination, and the names, addresses, and employer
identification numbers of both the parent corporation and the QSSS.
(3) Examples. The following examples illustrate the application of
this paragraph (a):
Example 1. Termination because parent's S election terminates.
X, an S corporation, owns 100 percent of Y. A QSSS election is in
effect with respect to Y for 1998. Effective on January 1, 1999, X
revokes its S election. Because X is no longer an S corporation, Y
no longer qualifies as a QSSS at the close of December 31, 1998.
Example 2. Termination due to transfer of QSSS stock. X, an S
corporation, owns 100 percent of Y. A QSSS election is in effect
with respect to Y for 1998. On December 10, 1998, X sells one share
of Y stock to A, an individual. Because X no longer owns 100 percent
of the stock of Y, Y no longer qualifies as a QSSS. Accordingly, the
QSSS election made with respect to Y terminates at the close of
December 10, 1998.
Example 3. No termination on stock transfer between QSSS and
parent. X, an S corporation, owns 100 percent of the stock of Y and
Y owns 100 percent of the stock of Z. QSSS elections are in effect
with respect to both Y and Z. Y transfers all of its Z stock to X.
Because X is treated as owning the stock of Z both before and after
the transfer of stock solely for purposes of determining whether the
requirements of section 1361(b)(3)(B)(i) and Sec. 1.1361-2(a)(1)
have been satisfied, the transfer of Z stock does not terminate Z's
QSSS election. Because the stock of Z is disregarded for all other
federal tax purposes, no gain is recognized under section 311.
(b) Effect of termination of QSSS election--(1) Formation of new
corporation. If a QSSS election terminates under paragraph (a) of this
section, the former QSSS is treated as a new corporation acquiring all
of its assets (and assuming all of its liabilities) immediately before
the termination from the S corporation parent in exchange for stock of
the new corporation. The tax treatment of this transaction or of a
larger transaction that includes this transaction will be determined
under the Internal Revenue Code and general principles of tax law,
including the step transaction doctrine.
(2) Carryover of disallowed losses and deductions. If a QSSS
terminates because the S corporation distributes the QSSS stock to some
or all of the S corporation's shareholders in a transaction to which
section 368(a)(1)(D) applies by reason of section 355 (or so much of
section 356 as relates to section 355), any loss or deduction
disallowed under section 1366(d) with respect to a shareholder of the S
corporation immediately before the distribution is allocated between
the S corporation and the former QSSS with respect to the shareholder.
The amount of the disallowed loss or deduction allocated to the S
corporation is an amount that bears the same ratio to each item of
disallowed loss or deduction as the value of the shareholder's stock in
the S corporation bears to the total value of the shareholder's stock
in both the S corporation and the former QSSS, in each case as
determined immediately after the distribution.
(3) Examples. The following examples illustrate the application of
this paragraph (b):
Example 1. X, an S corporation, owns 100 percent of the stock of
Y, a corporation for which a QSSS election is in effect. X sells 21
percent of the Y stock to Z, an unrelated corporation, for cash,
thereby terminating the QSSS election. Y is treated as a new
corporation acquiring all of its assets (and assuming all of its
liabilities) in exchange for Y stock immediately before the
termination from the S corporation. The deemed exchange by X of
assets for Y stock does not qualify under section 351 because X is
not in control of Y within the meaning of section 368(c) immediately
after the transfer as a result of the sale of stock to Z. Therefore,
X must recognize gain, if any, on the assets transferred to Y in
exchange for its stock. X's losses, if any, on the assets
transferred are subject to the limitations of section 267.
[[Page 19871]]
Example 2. Assume the same facts as in Example 1, except that,
instead of purchasing Y stock, Z contributes to Y an operating asset
in exchange for 21 percent of the Y stock. Y is treated as a new
corporation acquiring all of its assets (and assuming all of its
liabilities) in exchange for Y stock immediately before the
termination. Because X and Z are co-transferors that control the
transferee immediately after the transfer, the transaction qualifies
under section 351.
Example 3. X, an S corporation, owns 100 percent of the stock of
Y, a corporation for which a QSSS election is in effect. X
distributes all of the Y stock pro rata to its shareholders, and the
distribution terminates the QSSS election. The transaction can
qualify as a distribution to which sections 368(a)(1)(D) and 355
apply if the transaction otherwise satisfies the requirements of
those sections.
Example 4. X, an S corporation, owns 100 percent of the stock of
Y, a corporation for which a QSSS election is in effect. X
subsequently revokes the QSSS election. Y is treated as a new
corporation acquiring all of its assets (and assuming all of its
liabilities) immediately before the revocation from its S
corporation parent in a deemed exchange for Y stock. On a subsequent
date, X sells 21 percent of the stock of Y to Z, an unrelated
corporation, for cash. Assume that under general principles of tax
law including the step transaction doctrine, the sale is not taken
into account in determining whether X is in control of Y immediately
after the deemed exchange of assets for stock. The deemed exchange
by X of assets for Y stock and the deemed assumption by Y of its
liabilities qualify under section 351 because, for purposes of that
section, X is in control of Y within the meaning of section 368(c)
immediately after the transfer.
(c) Inadvertent terminations. Relief from the consequences of an
inadvertent termination of a QSSS election may be available under the
standards established by the Commissioner for the inadvertent
termination of an S election under Sec. 1.1362-4.
(d) Election after QSSS termination--(1) In general. Absent the
Commissioner's consent, and except as provided in paragraph (d)(2) of
this section, a corporation whose QSSS election has terminated under
paragraph (a) of this section (or a successor corporation as defined in
Sec. 1.1362-5(b)) may not make an S election under section 1362 or have
a QSSS election under section 1361(b)(3)(B)(ii) made with respect to it
for five taxable years (as described in section 1361(b)(3)(D)). The
Commissioner may permit an S election by the corporation or a new QSSS
election with respect to the corporation before the 5-year period
expires. The corporation requesting consent to make the election has
the burden of establishing that, under the relevant facts and
circumstances, the Commissioner should consent to a new election.
(2) Exception. If a corporation's QSSS election terminates by
reason of a disposition of the corporation's stock, the corporation
may, without requesting the Commissioner's consent, make an S election
or have a QSSS election made with respect to it before the expiration
of the five-year period described in section 1361(b)(3)(D) and
paragraph (d)(1) of this section, provided that--
(i) Immediately following the disposition of its stock, the
corporation (or its successor corporation) is otherwise eligible to
make an S election or have a QSSS election made for it; and
(ii) The relevant election is made effective immediately following
the disposition of the stock of the corporation.
(3) Examples. The following examples illustrate the application of
this paragraph (d):
Example 1. Termination upon distribution of QSSS stock to
shareholders of parent. X, an S corporation, owns Y, a QSSS. X
distributes all of its Y stock to X's shareholders. The distribution
terminates the QSSS election because Y no longer satisfies the
requirements of a QSSS. Assuming Y is otherwise eligible to be
treated as an S corporation, Y's shareholders may elect to treat Y
as an S corporation effective on the date of the stock distribution
without requesting the Commissioner's consent.
Example 2. Sale of 100 percent of QSSS stock. X, an S
corporation, owns Y, a QSSS. X sells 100 percent of the stock of Y
to Z, an unrelated S corporation. Z may elect to treat Y as a QSSS
effective on the date of purchase without requesting the
Commissioner's consent.
Sec. 1.1361-6 Effective date.
Except as provided in Sec. 1.1361-4(a)(5)(i), the provisions of
Secs. 1.1361-2 through 1.1361-5 apply to taxable years beginning on or
after the date that final regulations are published in the Federal
Register.
Par. 5. Amend Sec. 1.1362-0 as follows:
1. Add an entry for Sec. 1.1362-2(b)(4).
2. Add entries for Sec. 1.1362-8.
The additions read as follows:
Sec. 1.1362-0 Table of contents.
* * * * *
Section 1.1362-2 Termination of Election
* * * * *
(b) * * *
(4) Termination when stock transferred to another S corporation.
* * * * *
Section 1.1362-8 Dividends Received From Affiliated Subsidiaries
(a) In general.
(b) Determination of active or passive earnings and profits.
(1) In general.
(2) Lower tier subsidiaries.
(3) De minimis exception.
(4) Special rules for earnings and profits accumulated by a C
corporation prior to 80 percent acquisition.
(5) Gross receipts safe harbor.
(c) Allocating distributions to active or passive earnings and
profits.
(1) Distributions from current earnings and profits.
(2) Distributions from accumulated earnings and profits.
(3) Adjustments to active earnings and profits.
(4) Special rules for consolidated groups.
(d) Examples.
(e) Effective date.
Par. 6. Amend Sec. 1.1362-2 as follows:
1. Amend paragraph (b)(1) by adding a sentence to the end of the
paragraph.
2. Add paragraph (b)(4).
3. Amend paragraph (c)(5)(ii)(C) by adding a sentence to the end of
the paragraph.
The additions read as follows:
Sec. 1.1362-2 Termination of election.
* * * * *
(b) * * *
(1) * * * See paragraph (b)(4) of this section for a special rule
applying to the termination of an S election caused by the transfer of
the corporation's stock to another S corporation.
* * * * *
(4) Termination when stock transferred to another S corporation. If
all of the stock of an S corporation (S1) is transferred to another S
corporation (S2) and a QSSS election for S1 is made effective as of the
day of the transfer, S1's S election terminates at the same time as the
deemed liquidation under Sec. 1.1361-4(a)(2). Accordingly, S1 is not
treated as a C corporation for any period solely because of the
transfer of S1 stock to S2, an ineligible S corporation shareholder.
See, however, Sec. 1.338-1(e)(3) if an election under section 338
(without an election under section 338(h)(10)) is made. This paragraph
(b)(4) is effective on the date final regulations are published in the
Federal Register.
(c) * * *
(5) * * *
(ii) * * *
(C) * * * See Sec. 1.1362-8 for special rules regarding the
treatment of dividends received by an S corporation from a C
corporation in which the S corporation holds stock meeting the
requirements of section 1504(a)(2).
* * * * *
Par. 7. Add Sec. 1.1362-8 to read as follows:
Sec. 1.1362-8 Dividends received from affiliated subsidiaries.
(a) In general. For purposes of section 1362(d)(3), if an S
corporation holds stock in a C corporation meeting the
[[Page 19872]]
requirements of section 1504(a)(2), the term ``passive investment
income'' does not include dividends from the C corporation to the
extent those dividends are attributable to the earnings and profits of
the C corporation derived from the active conduct of a trade or
business (``active earnings and profits''). For purposes of applying
section 1362(d)(3), earnings and profits of a C corporation are active
earnings and profits to the extent that the earnings and profits are
derived from activities that would not produce passive investment
income (as defined in section 1362(d)(3)) if the C corporation were an
S corporation.
(b) Determination of active or passive earnings and profits--(1) In
general. An S corporation may use any reasonable method to determine
the amount of dividends that are not treated as passive investment
income under section 1362(d)(3)(E). Paragraph (b)(5) of this section
describes a method of determining the amount of dividends that are not
treated as passive investment income under section 1362(d)(3)(E) that
is deemed to be reasonable under all circumstances.
(2) Lower tier subsidiaries. If a C corporation subsidiary (upper
tier corporation) holds stock in another C corporation (lower tier
subsidiary) meeting the requirements of section 1504(a)(2), the upper
tier corporation's gross receipts attributable to a dividend from the
lower tier subsidiary are considered to be derived from the active
conduct of a trade or business to the extent the lower tier
subsidiary's earnings and profits are attributable to the active
conduct of a trade or business by the subsidiary under paragraph
(b)(1), (b)(3), (b)(4), or (b)(5) of this section. For purposes of this
section, distributions by the lower tier subsidiary will be considered
attributable to active earnings and profits according to the rule in
paragraph (c) of this section. This paragraph (b)(2) does not apply to
any member of a consolidated group (as defined in Sec. 1.1502-1(h)).
(3) De minimis exception. If less than 10 percent of a C
corporation's earnings and profits for a taxable year are derived from
activities that would produce passive investment income if the C
corporation were an S corporation, all earnings and profits produced by
the corporation during that taxable year are considered active earnings
and profits.
(4) Special rules for earnings and profits accumulated by a C
corporation prior to 80 percent acquisition. A C corporation may treat
all earnings and profits accumulated by the corporation in all taxable
years ending before the S corporation held stock meeting the
requirements of section 1504(a)(2) as active earnings and profits in
the same proportion as the C corporation's active earnings and profits
for the three taxable years ending prior to the time when the S
corporation acquired 80 percent of the C corporation bears to the C
corporation's total earnings and profits for those three taxable years.
(5) Gross receipts safe harbor. A corporation may treat its
earnings and profits for a year as active earnings and profits in the
same proportion as the corporation's gross receipts (as defined in
Sec. 1.1362-2(c)(4)) derived from activities that would not produce
passive investment income (if the C corporation were an S corporation),
including those that do not produce passive investment income under
paragraphs (b)(2) through (b)(4) of this section, bear to the
corporation's total gross receipts for the year in which the earnings
and profits are produced.
(c) Allocating distributions to active or passive earnings and
profits--(1) Distributions from current earnings and profits. Dividends
distributed by a C corporation from current earnings and profits are
attributable to active earnings and profits in the same proportion as
current active earnings and profits bear to total current earnings and
profits of the C corporation.
(2) Distributions from accumulated earnings and profits. Dividends
distributed by a C corporation out of accumulated earnings and profits
for a taxable year are attributable to active earnings and profits in
the same proportion as accumulated active earnings and profits for that
taxable year bear to total accumulated earnings and profits for that
taxable year immediately prior to the distribution.
(3) Adjustments to active earnings and profits. For purposes of
applying paragraph (c)(1) or (c)(2) of this section to a distribution,
the active earnings and profits of a corporation shall be reduced by
the amount of any prior distribution properly treated as attributable
to active earnings and profits from the same taxable year.
(4) Special rules for consolidated groups. For purposes of applying
section 1362(d)(3) and this section to dividends received by an S
corporation from the common parent of a consolidated group (as defined
in Sec. 1.1502-1(h)), the following rules apply--
(i) The current earnings and profits, accumulated earnings and
profits, and active earnings and profits of the common parent shall be
determined under the principles of Sec. 1.1502-33 (relating to earnings
and profits of any member of a consolidated group owning stock of
another member); and
(ii) The gross receipts of the common parent shall be the sum of
the gross receipts of each member of the consolidated group (including
the common parent), adjusted to eliminate gross receipts from
intercompany transactions (as defined in Sec. 1.1502-13(b)(1)(i)).
(d) Examples. The following examples illustrate the principles of
this section:
Example 1. (i) X, an S corporation, owns 85 percent of the one
class of stock of Y. On December 31, 1998, Y declares a dividend of
$100 ($85 to X), which is equal to Y's current earnings and profits.
In 1998, Y has total gross receipts of $1,000, $200 of which would
be passive investment income if Y were an S corporation.
(ii) One-fifth ($200/$1,000) of Y's gross receipts for 1998 is
attributable to activities that would produce passive investment
income. Accordingly, one-fifth of the $100 of earnings and profits
is passive, and $17 (\1/5\ of $85) of the dividend from Y to X is
passive investment income.
Example 2. (i) The facts are the same as in Example 1, except
that Y owns 90 percent of the stock of Z. Y and Z do not join in the
filing of a consolidated return. In 1998, Z has gross receipts of
$15,000, $12,000 of which are derived from activities that would
produce passive investment income. On December 31, 1998, Z declares
a dividend of $1,000 ($900 to Y) from current earnings and profits.
(ii) Four-fifths ($12,000/15,000) of the dividend from Z to Y
are attributable to passive earnings and profits. Accordingly, $720
(\4/5\ of $900) of the dividend from Z to Y is considered gross
receipts from an activity that would produce passive investment
income. The $900 dividend to Y gives Y a total of $1,900 ($1,000 +
$900) in gross receipts, $920 ($200 + $720) of which is attributable
to passive investment income-producing activities. Under these
facts, $41 ($920/1,900 of $85) of Y's distribution to X is passive
investment income to X.
(e) Effective date. This section applies to dividends received in
taxable years beginning on or after the date that final regulations are
published in the Federal Register.
Sec. 1.1368-0 [Amended]
Par. 8. Amend Sec. 1.1368-0 in the entry for Sec. 1.1368-2(d)(2) by
revising ``Reorganizations'' to read ``Liquidations and
reorganizations''.
Sec. 1.1368-2 [Amended]
Par. 9. Amend Sec. 1.1368-2 in paragraph (d)(2) by revising
``Reorganizations'' to read ``Liquidations and reorganizations'' in the
heading and by revising ``section 381(a)(2)'' to read ``section
381(a)'' in the first sentence.
Par. 10. Amend Sec. 1.1374-8 by adding two sentences to the end of
paragraph (b) to read as follows:
[[Page 19873]]
Sec. 1.1374-8 Section 1374(d)(8) transactions.
* * * * *
(b) Separate determination of tax. * * * If a C corporation elects
to be treated as an S corporation, and also makes a QSSS election under
section 1361(b)(3) (effective on the same date as the S election) with
respect to a subsidiary, the assets held by the QSSS at the time of the
QSSS election will be treated as assets held by the parent when it
became an S corporation. The preceding sentence applies to QSSS
elections made after the date final regulations are published in the
Federal Register.
* * * * *
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
[FR Doc. 98-10373 Filed 4-21-98; 8:45 am]
BILLING CODE 4830-01-U
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