Pass Through of Items of an S Corporation to its Shareholders

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-209446-82]

RIN 1545-AT52

Pass Through of Items of an S Corporation to its Shareholders

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the

pass through of items of an S corporation to its shareholders, the

adjustments to the basis of stock of the shareholders, and the

treatment of distributions by an S corporation. Changes to the

applicable law were made by the Subchapter S Revision Act of 1982, the

Tax Reform Act of 1984, the Tax Reform Act of 1986, the Technical and

Miscellaneous Revenue Act of 1988, and the Small Business Job

Protection Act of 1996. These proposed regulations provide the public

with guidance needed to comply with the applicable law and will affect

S corporations and their shareholders. This document also contains a

notice of public hearing on these proposed regulations.

DATES: Written comments must be received by November 16, 1998. Outlines

of topics to be discussed at the public hearing scheduled for Tuesday,

December 15, 1998, at 10 a.m. must be received by Tuesday, November 24,

1998.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-209446-82), room

5226, 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-209446-82), 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. The public hearing will be held in room 2615, Internal

Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations under

section 1366, Deane M. Burke or Terri A. Belanger, (202) 622-3070;

concerning the regulations under sections 1367 and 1368, Brenda

Stewart, (202) 622-3120; concerning submissions and the hearing,

Michael Slaughter, (202) 622-7180 (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 of 1995 (44

U.S.C. 3507(d)). Comments on the collection 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, OP:FS:FP, Washington, DC

20224. Comments on the collection of information should be received by

October 19, 1998. Comments are specifically requested concerning:

Whether the proposed collection of information is necessary for the

proper performance of the functions of the Internal Revenue Service,

including whether the information will have practical utility;

The accuracy of the estimated burden associated with the proposed

collection 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 collection 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 cost and costs of operation,

maintenance, and purchase of service to provide information.

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The collection of information in this proposed regulation is in

Sec. 1.1366-1. This information is required in order for a shareholder

in an S corporation to properly compute its tax liability. This

information will be used to determine whether the amount of tax has

been computed correctly. Responses to this collection of information

are mandatory for shareholders in S corporations. The likely

respondents are individuals and businesses or other for-profit

institutions.

The reporting burden contained in Sec. 1.1366-1 is reflected in the

burden of Form 1040, U.S. Individual Income Tax Return, and Form 1120S,

U.S. Income Tax Return for an S Corporation.

Newly designated Sec. 1.1367-1(g) does not impose a new collection

of information. The election in newly designated Sec. 1.1367-1(g),

previously contained in Sec. 1.1367-1(f), was approved by OMB under OMB

Control Number 1545-1139.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number.

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) under sections 1366, 1367, and 1368 of the

Internal Revenue Code of 1986 (Code). Sections 1366, 1367, and 1368

were added by the Subchapter S Revision Act of 1982 (1982 Act) (Public

Law 97-354, 96 Stat. 1669, 1697). Section 1366 was amended by the Tax

Reform Act of 1984 (Public Law 98-369, 98 Stat. 844, 985), the Tax

Reform Act of 1986 (Public Law 99-514, 100 Stat. 2085, 2277, 2343), the

Technical and Miscellaneous Revenue Act of 1988 (Public Law 100-647,

102 Stat. 3406), and the Small Business Job Protection Act of 1996

(1996 Act) (Public Law 104-188, 110 Stat. 1755).

Sections 1367 and 1368 were amended by the Technical Corrections

Act of 1982 (Public Law 97-448, 96 Stat. 2365, 2399-2400), the Tax

Reform Act of 1984 (Public Law 98-369), and the Tax Reform Act of 1986

(Public Law 99-514). Final regulations conforming the regulations to

these amendments were published in the Federal Register on January 3,

1994. The proposed amendments would conform the regulations to

amendments made to sections 1367 and 1368 by the 1996 Act.

Explanation of Provisions

Determination of Shareholder's Tax Liability

Under section 1363, an S corporation generally computes its taxable

income in the same manner as an individual, subject to certain

modifications. Thus, for example, an S corporation is not entitled to a

dividends received deduction under section 243.

Section 1366(a)(1) and the proposed regulations provide rules under

which a shareholder of an S corporation takes into account the

shareholder's pro rata share, as defined under section 1377, of the

corporation's items of income, loss, deduction, or credit. A

shareholder's share of these items is determined for the shareholder's

taxable year in which the taxable year of the S corporation ends. If a

shareholder dies before the end of the corporation's taxable year, the

shareholder's pro rata share of these items is taken into account in

the shareholder's final tax return. If a shareholder is an estate or

trust, and the estate or trust terminates before the end of the

corporation's taxable year, the shareholder's pro rata share of these

items is taken into account in the shareholder's final tax return.

In the case of most items that must be separately stated by an S

corporation, the provisions by which an S corporation accounts to its

shareholders for tax purposes under section 1366 closely parallel the

provisions for a partnership accounting to its partners under section

702. The proposed regulations provide rules outlining this general

pass-through scheme for S corporations to their shareholders.

Under section 1366(a)(1)(A), an S corporation's items of income,

loss, deduction, and credit must be separately stated if their separate

treatment on any shareholder's income tax return could affect the

shareholder's tax liability. These separately stated items include, but

are not limited to, short-term and long-term capital gain or loss,

other items that may be relevant to the shareholder in the computation

of the shareholder's tax liability resulting from the sale or exchange

of capital assets or assets described in section 1231(b), tax-exempt

income, section 170(c) charitable contributions, certain foreign taxes,

items used in determining certain credits, certain itemized deductions,

items of portfolio income or loss and related expenses under section

469, and the corporation's adjustments in computing alternative minimum

tax under sections 56 and 58 and any items of tax preference under

section 57. All items of income, loss, and deduction that are not

separately stated must be combined to compute the nonseparately

computed income or loss of the S corporation under section

1366(a)(1)(B).

Identification of Tax-exempt Income

The proposed regulations define tax-exempt income as income that is

permanently excludable from the gross income of an S corporation and

its shareholders in all circumstances in which the relevant Code

section applies. For example, tax-exempt income includes proceeds of

life insurance contracts that are payable by reason of an individual's

death and that are excludable from gross income under section 101, and

interest on state and local bonds that is excludable from gross income

under section 103.

However, income that is excludible from gross income pursuant to a

provision of the Code that might have the effect of deferring income to

the S corporation or its shareholders is not tax-exempt income. For

example, income from improvements by a lessee on a lessor's property

that is excludible from gross income under section 109 is not tax-

exempt income because, for example, the lessor would recognize the

value of the improvements as income when the property is sold by the

lessor. Similarly, income from the discharge of indebtedness that is

excludible from gross income under section 108 does not constitute tax-

exempt income because the attribute reduction provisions of section

108(b) have the effect of deferring the recognition of such income in

some circumstances while permanently excluding it, in whole or in part,

in other circumstances.

Treasury and the IRS believe that Congress intended that section

108 would allow taxpayers to avoid the immediate adverse tax

consequences that could otherwise result from the inclusion of income

from discharge of indebtedness. The deferral of income excluded under

section 108(a)(1) by reducing the basis of property or other tax

attributes is one method of achieving this purpose. For example, the

legislative history of section 108(a)(1)(D) provides that the exclusion

from gross income for discharge of qualified real property business

indebtedness income simply defers income to the shareholders of an S

corporation and does not result in an adjustment to the basis of the

stock of the corporation. See H.R. Rep. No. 111, 103d Cong., 1st Sess.

625 (1993); H.R. Conf. Rep. No. 213, 103d Cong., 1st Sess. 555 (1993).

Other specific rules apply to the discharge of indebtedness of an S

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corporation. See section 108(d)(7). The legislative history of section

108(d)(7)(A) provides that in order to treat all shareholders in the

same manner, the exclusion of income arising from discharge of

indebtedness and the corresponding reductions in tax attributes

(including losses that are not allowed by reason of any shareholder's

basis limitation) are made at the corporate level. See H.R. Rep. No.

432, 98th Cong., 2d Sess., pt. 2, 1640-41 (1984). Furthermore, the

legislative history of section 108 indicates that any cancellation of

indebtedness income remaining after the reduction of the S

corporation's tax attributes does not result in income or have other

tax consequences. See S. Rep. No. 1035, 96th Cong., 2d Sess. 2 (1980).

Thus, the absence of a stock basis increase for income of an S

corporation excluded under section 108(a) is consistent with the

legislative history of section 108 (and its purpose to avoid the

immediate adverse tax consequences that could otherwise result from the

inclusion of income from discharge of indebtedness) and the specific

rules that apply to the discharge of indebtedness income of S

corporations.

Finally, even though a partner is entitled to an increase in the

basis of the partner's interest for income from discharge of

indebtedness of a partnership that is excluded under section 108(a), a

shareholder of an S corporation is not entitled to an increase in stock

basis under similar circumstances. This difference is appropriate

because the principal provisions of section 108 are applied at the

corporate level in the case of an S corporation but at the partner

level in the case of a partnership. See section 108(d)(6). A basis

increase in the partner's interest in the partnership is necessary in

order to apply these provisions at the partner level because, for

example, the income may properly be excluded by some partners and

included by others, and in order to offset the basis reduction that

will occur under section 752(b) as the result of the deemed

distribution arising out of the decrease in the partner's share of

partnership liabilities. These considerations are not present in the

case of an S corporation.

Accordingly, Treasury and the IRS believe that income excluded by

an S corporation pursuant to section 108 is not tax-exempt income for

purposes of section 1366 whether or not the application of section 108

in a particular circumstance results in the permanent exclusion, in

whole or in part, of income. See also Nelson v. Commissioner, 110 T.C.

114 (1998).

Pass Through of Character and Gross Income

Consistent with the adoption of parallel operational rules between

sections 702 and 1366, the items of an S corporation are generally

characterized in the same manner that partnership items are

characterized. The partnership rules provide that the character of a

partnership item reported by a partner is generally determined at the

entity level under a conduit rule. The proposed regulations provide a

similar conduit rule under which the character of a corporate item that

is passed through to and reported by a shareholder is generally

determined at the corporate level. However, exceptions to the general

rule apply for contributions of either noncapital gain property or

capital loss property if an S corporation is formed or availed of by

any shareholder or shareholders for a principal purpose of selling or

exchanging the property to alter the character of the gain or loss. The

character of the gain or loss will be the same as it would have been if

the property were in the hands of the shareholder or shareholders at

the time of the sale or exchange.

Section 1366(c), like section 702(c), provides for the pass through

of gross income to a shareholder for federal income tax purposes. Thus,

where it is necessary to determine the amount or character of the gross

income of a shareholder, the shareholder's gross income includes the

shareholder's pro rata share of the gross income of the S corporation.

This amount is the amount of gross income of the corporation used to

derive the shareholder's pro rata share of S corporation taxable income

or loss. See Rev. Rul. 87-121 (1987-2 C.B. 217).

Limitation on Losses and Deductions

In general, section 1366(d)(1) and the proposed regulations provide

that the amount of losses and deductions taken into account by a

shareholder for any taxable year may not exceed the sum of the

shareholder's adjusted bases in the stock of the S corporation and in

any indebtedness of the S corporation to the shareholder. Moreover, any

loss or deduction for the taxable year not taken into account by a

shareholder by reason of the basis limitation rule is treated under

section 1366(d)(2) and the proposed regulations as incurred by the

corporation with respect to that shareholder in the corporation's first

succeeding taxable year, and subsequent taxable years. For purposes of

the basis limitation rule in section 1366(d), the basis of stock

acquired by gift is the basis of the stock for determining loss under

section 1015. The basis rules under section 1015 operate to minimize

the loss recognized by a donee upon the sale or exchange of the loss

stock acquired by gift. Therefore, the basis limitation rule limits a

donee shareholder's pass-through items of loss or deduction to the

basis used for determining loss upon the sale or exchange of the stock

acquired by gift.

The proposed regulations provide that if a shareholder's aggregate

pro rata share of the items of loss and deduction exceeds the sum of

the shareholder's adjusted bases in stock and debt, the limitation on

losses and deductions must be allocated among the shareholder's pro

rata share of each loss or deduction. This allocation is determined by

taking the proportion that each loss or deduction bears to the total of

all losses and deductions, including those previously disallowed.

Also under the proposed regulations, a shareholder's disallowed

losses and deductions are personal to that shareholder and cannot be

transferred. Moreover, if a shareholder transfers all of the

shareholder's stock in an S corporation, any disallowed loss or

deduction is permanently disallowed.

The proposed regulations provide special rules for a shareholder to

carry over disallowed losses and deductions to any post-termination

transition period. Those special rules generally follow the limitation

rules provided in the proposed regulations for years in which the S

corporation election is in effect, except that the amount of losses and

deductions that may be taken into account is limited to the adjusted

basis of the shareholder's stock (rather than stock and debt) in the

corporation determined at the close of the post-termination transition

period. See section 1366(d)(3)(B).

Finally, the proposed regulations provide rules regarding the

carryover of disallowed losses and deductions in the event of certain

corporate reorganizations. If a corporation acquires, in a transaction

to which section 381(a) applies, the assets of another S corporation

for which disallowed losses and deductions would carry over with

respect to a shareholder under section 1366(d)(2), except for the

reorganization, the losses and deductions will be available to that

shareholder. Where the acquiring corporation is an S corporation, the

losses and deductions will be treated as incurred by the acquiring S

corporation with respect to that shareholder. Where the acquiring

corporation is a C corporation, the proposed regulations provide

special rules for a shareholder

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to carry over disallowed losses and deductions to any post-termination

transition period under section 1377 if the shareholder is a

shareholder of the C corporation after the transaction.

In the case of an S corporation that transfers a part of its assets

constituting an active trade or business to another corporation in a

transaction to which section 368(a)(1)(D) applies, and immediately

thereafter the stock and securities of the controlled corporation are

distributed in a distribution or exchange to which section 355 (or so

much of section 356 as relates to section 355) applies, any disallowed

loss or deduction with respect to a shareholder of the distributing

corporation immediately before the transaction is allocated between the

distributing corporation and the controlled corporation with respect to

the shareholder. This allocation is made in proportion to the fair

market value of the shareholder's stock of the distributing corporation

and the shareholder's stock of the controlled corporation, determined

immediately after the transaction.

Treatment of Family Group

In general, the proposed regulations provide for the reallocation

of items of the corporation among family members under certain

conditions. Section 1366(e) requires a determination of whether an

individual family member who renders services for or provides capital

to the S corporation has received reasonable compensation. The proposed

regulations provide that in determining a reasonable allowance for

services rendered for, or capital furnished to, the S corporation, all

the facts and circumstances are considered, including the amount that

ordinarily would be paid in order to obtain comparable services or

capital from a person who is neither a member of that family nor a

shareholder in the corporation.

For purposes of section 1366(e), similar rules apply to services

rendered, or capital furnished, to an S corporation by a pass-through

entity in which a member of a shareholder's family holds an interest.

The proposed regulations provide that if the pass-through entity does

not receive reasonable compensation for the services rendered or

capital furnished, the Commissioner may prescribe adjustments to the

pass-through entity and the corporation as necessary to reflect the

value of the services rendered or capital furnished.

Special Rules

Section 1366(f) and the proposed regulations provide special rules

limiting the pass through of certain items of an S corporation to its

shareholders. Section 1366(f)(1) and the proposed regulations provide

that the pass-through rules under section 1366(a) are inapplicable with

respect to any credit allowable under section 34 (relating to certain

uses of gasoline and special fuels). In addition, section 1366(f) (2)

and (3) and the proposed regulations provide for a reduction in the

pass through of items for tax imposed on an S corporation under section

1374 or section 1375.

Adjustments to Basis of Stock

Section 1367(a) and Sec. 1.1367-1 prescribe adjustments required by

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

and the manner in which those adjustments are made. Section 1.1367-1

requires a shareholder in an S corporation to adjust the basis of the

shareholder's stock for items of income and loss for any taxable year

before adjusting the basis for distributions.

Section 1309 of the 1996 Act amended section 1368 to require that

in the case of any distribution made during any taxable year, the

adjusted basis of the stock is determined with regard to the

adjustments provided in section 1367(a)(1) for the taxable year. Thus,

the adjustments for distributions made by the S corporation during the

taxable year are taken into account before applying the loss limitation

for the year.

The proposed regulations amend Sec. 1.1367-1 to provide that for

taxable years of the corporation beginning on or after August 18, 1998,

adjustments to the basis of a share of stock are made in the following

order: (1) Increases for income items and the excess of deductions for

depletion over the basis of the property subject to depletion; (2)

decreases for distributions; (3) decreases for noncapital,

nondeductible expenses, and certain oil and gas depletion deductions;

and (4) decreases for items of loss or deduction.

Adjustments Required Before Determining Tax Effect of Distribution

Section 1368 provides rules for determining the source of a

distribution made by an S corporation with respect to its stock and the

tax effect of the distribution on the shareholders. Under Sec. 1.1368-

1, the determination whether a distribution is made out of the

accumulated adjustments account (AAA) or earnings and profits is made

only after the AAA has been adjusted to reflect: (1) Increases for

income items (other than income that is exempt from tax) and the excess

of the deductions for depletion over the basis of the property subject

to depletion; (2) decreases for noncapital, nondeductible expenses

(other than federal taxes attributable to any taxable year in which the

corporation was a C corporation and expenses related to income that is

exempt from tax); (3) decreases for certain oil and gas depletion

deductions; (4) decreases for items of loss or deduction; and (5) the

effect of certain redemptions.

Consistent with the proposed amendments to Sec. 1.1367-1, the

proposed regulations amend Sec. 1.1368-2 to provide that for taxable

years of the corporation beginning on or after August 18, 1998, the

adjustments to the AAA are made in the same order as the adjustments to

the basis of a share of stock under Sec. 1.1367-1 of the proposed

regulations. For purposes of determining the amount of any distribution

made from the AAA, decreases to the AAA to reflect distributions are

made without taking into account any net negative adjustments as

defined in section 1368(e)(1)(C)(ii).

Section 1311(a) of the 1996 Act generally eliminated the S

corporation earnings and profits of a corporation accumulated in those

taxable years beginning before January 1, 1983, for which the

corporation was an electing small business corporation under the

provisions of subchapter S of the Code as then in effect, if the

corporation was also an S corporation for its first taxable year

beginning after December 31, 1996. Several provisions of the existing

final regulations under subchapter S, which were adopted before the

1996 Act amendments, refer separately to S corporation earnings and

profits and C corporation earnings and profits. See, e.g., Sec. 1.1368-

1(f)(2)(iii). Treasury and the IRS specifically request comments on the

extent, if any, to which these regulations should be amended in view of

the general elimination of S corporation earnings and profits. Treasury

and the IRS also request comments on whether section 1311(a) of the

1996 Act applies to qualified casualty insurance electing small

business corporations and qualified oil corporations, within the

meaning of section 6(c) of the 1982 Act.

Proposed Effective Date

The regulations under section 1366 and the amendments to the

regulations under sections 1367 and 1368 are proposed to be effective

for taxable years of the corporation beginning on or after August 18,

1998.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a

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significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It has also been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

does not apply to these regulations. It is hereby certified that the

collection of information in these regulations will not have a

significant economic impact on a substantial number of small entities.

This certification is based upon the fact that these regulations do not

impose a collection of information that is not already required by the

underlying statute or the current regulations and reflected in the

appropriate forms. Therefore, a Regulatory Flexibility Analysis under

the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not required.

Pursuant to section 7805(f) of the Internal Revenue Code, 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 Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments that are submitted

timely (a signed original and eight (8) copies) to the IRS. All

comments will be made available for public inspection and copying.

A public hearing has been scheduled for Tuesday, December 15, 1998,

at 10 a.m. in room 2615, Internal Revenue Building, 1111 Constitution

Avenue NW., Washington, DC. Because of access restrictions, visitors

will not be admitted beyond the Internal Revenue Building lobby more

than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments (a signed original and eight (8) copies) by

November 16, 1998. The outline of topics to be discussed at the hearing

must be received by Tuesday, November 24, 1998.

A period of 10 minutes will be allotted for each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information. The principal authors of these proposed

regulations are Deane M. Burke, Terri A. Belanger, and Brenda Stewart

of the Office of Chief Counsel (Passthroughs and Special Industries),

Internal Revenue Service. However, other personnel from the IRS and

Treasury Department participated in their development.

List of Subjects 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 TAX

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

part:

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

Secs. 1.1366-1 and 1.1366-2 [Removed]

Par. 2. Sections 1.1366-1 and 1.1366-2 are removed.

Par. 3. Sections 1.1366-0 through 1.1366-5 are added to read as

follows:

Sec. 1.1366-0 Table of contents.

The following table of contents is provided to facilitate the use

of Secs. 1.1366-1 through 1.1366-5:

Sec. 1.1366-1 Shareholder's share of items of an S corporation.

(a) Determination of shareholder's tax liability.

(1) In general.

(2) Separately stated items of income, loss, deduction, or

credit.

(3) Nonseparately computed income or loss.

(4) Separate activities requirement.

(5) Aggregation of deductions or exclusions for purposes of

limitations.

(b) Character of items constituting pro rata share.

(1) In general.

(2) Exception for contribution of noncapital gain property.

(3) Exception for contribution of capital loss property.

(c) Gross income of a shareholder.

(1) In general.

(2) Gross income for substantial omission of items.

(d) Shareholders holding stock subject to community property laws.

(e) Net operating loss deduction of shareholder of S corporation.

(f) Cross-reference.

Sec. 1.1366-2 Limitations on deduction of pass-through items of an

S corporation to its shareholders.

(a) In general.

(1) Limitation on losses and deductions.

(2) Carryover of disallowance.

(3) Basis limitation amount.

(i) Stock portion.

(ii) Indebtedness portion.

(4) Limitation on losses and deductions allocated to each item.

(5) Nontransferability of losses and deductions.

(6) Basis of stock acquired by gift.

(b) Special rules for carryover of disallowed losses and deductions

to post-termination transition period described in section 1377(b).

(1) In general.

(2) Limitation on losses and deductions.

(3) Limitation on losses and deductions allocated to each item.

(4) Adjustment to the basis of stock.

(c) Carryover of disallowed losses and deductions in the case of

liquidations, reorganizations, and divisions.

(1) Liquidations and reorganizations.

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

Sec. 1.1366-3 Treatment of family groups.

(a) In general.

(b) Examples.

Sec. 1.1366-4 Special rules limiting the pass through of certain

items of an S corporation to its shareholders.

(a) Pass through inapplicable to section 34 credit.

(b) Reduction in pass through for tax imposed on built-in gains.

(c) Reduction in pass through for tax imposed on excess net passive

income.

Sec. 1.1366-5 Effective date.

Sec. 1.1366-1 Shareholder's share of items of an S corporation.

(a) Determination of shareholder's tax liability--(1) In general.

An S corporation must report, and a shareholder is required to take

into account in the shareholder's return, the shareholder's pro rata

share, whether or not distributed, of the S corporation's items of

income, loss, deduction, or credit described in paragraphs (a)(2), (3),

and (4) of this section. A shareholder's pro rata share is determined

in accordance with the provisions of section 1377(a) and the

regulations thereunder. The shareholder takes these items into account

in determining the shareholder's taxable income and tax liability for

the shareholder's taxable year with or within which the taxable year of

the corporation ends. If the shareholder dies (or if the shareholder is

an estate or trust and the estate or trust terminates) before the end

of the taxable year of the corporation, the shareholder's pro rata

share of these items is taken into account on the shareholder's final

return. For the limitation on allowance of a shareholder's pro rata

share of S corporation losses or deductions, see section 1366(d) and

Sec. 1.1366-2.

(2) Separately stated items of income, loss, deduction, or credit.

Each shareholder must take into account separately the shareholder's

pro rata share of any item of income (including tax-exempt income),

loss, deduction, or credit of the S corporation that if separately

taken into account by any

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shareholder could affect the shareholder's tax liability for that

taxable year differently than if the shareholder did not take the item

into account separately. The separately stated items of the S

corporation include, but are not limited to, the following items--

(i) The corporation's combined net amount of gains and losses from

sales or exchanges of capital assets grouped by applicable holding

periods, by applicable rate of tax under section 1(h), and by any other

classification that may be relevant in determining the shareholder's

tax liability;

(ii) The corporation's combined net amount of gains and losses from

sales or exchanges of property described in section 1231 (relating to

property used in the trade or business and involuntary conversions),

grouped by applicable holding periods, by applicable rate of tax under

section 1(h), and by any other classification that may be relevant in

determining the shareholder's tax liability;

(iii) Charitable contributions, grouped by the percentage

limitations of section 170(b), paid by the corporation within the

taxable year of the corporation;

(iv) The taxes described in section 901 that have been paid (or

accrued) by the corporation to foreign countries or to possessions of

the United States;

(v) Each of the corporation's separate items involved in the

determination of credits against tax allowable under part IV of

subchapter A (section 21 and following) of the Internal Revenue Code,

except for any credit allowed under section 34 (relating to certain

uses of gasoline and special fuels);

(vi) Each of the corporation's separate items of gains and losses

from wagering transactions (section 165(d)); soil and water

conservation expenditures (section 175); deduction under an election to

expense certain depreciable business expenses (section 179); medical,

dental, etc., expenses (section 213); the additional itemized

deductions for individuals provided in part VII of subchapter B

(section 212 and following) of the Internal Revenue Code; and any other

itemized deductions for which the limitations on itemized deductions

under sections 67 or 68 applies;

(vii) Any of the corporation's items of portfolio income or loss,

and expenses related thereto, as defined under section 469;

(viii) The corporation's tax-exempt income. For purposes of

subchapter S, tax-exempt income is income that is permanently

excludible from gross income in all circumstances in which the

applicable provision of the Internal Revenue Code applies. For example,

income that is excludible from gross income under section 101 (certain

death benefits) or section 103 (interest on state and local bonds) is

tax-exempt income, while income that is excludible from gross income

under section 108 (income from discharge of indebtedness) or section

109 (improvements by lessee on lessor's property) is not tax-exempt

income;

(ix) The corporation's adjustments described in sections 56 and 58,

and items of tax preference described in section 57; and

(x) Any item identified in guidance (including forms and

instructions) issued by the Commissioner as an item required to be

separately stated under this paragraph (a)(2).

(3) Nonseparately computed income or loss. Each shareholder must

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

nonseparately computed income or loss of the S corporation. For this

purpose, nonseparately computed income or loss means the corporation's

gross income less the deductions allowed to the corporation under

chapter 1 of the Internal Revenue Code, determined by excluding any

item requiring separate computation under paragraph (a)(2) of this

section.

(4) Separate activities requirement. An S corporation must report,

and each shareholder must take into account in the shareholder's

return, the shareholder's pro rata share of an S corporation's items of

income, loss, deduction, or credit described in paragraphs (a)(2) and

(3) of this section for each of the corporation's activities as defined

in section 469 and the regulations thereunder.

(5) Aggregation of deductions or exclusions for purposes of

limitations--(i) In general. A shareholder aggregates the shareholder's

separate deductions or exclusions with the shareholder's pro rata share

of the S corporation's separately stated deductions or exclusions in

determining the amount of any deduction or exclusion allowable to the

shareholder under subtitle A of the Internal Revenue Code as to which a

limitation is imposed.

(ii) Example. The provisions of paragraph (a)(5)(i) of this section

are illustrated by the following example:

Example. In 1999, Corporation M, an S corporation, purchases and

places in service section 179 property costing $10,000. Corporation

M elects to expense the entire cost of the property. Shareholder A

owns 50 percent of the stock of Corporation M. Shareholder A's pro

rata share of this item after Corporation M applies the section

179(b) limitations is $5,000. Because the aggregate amount of

Shareholder A's pro rata share and separately acquired section 179

expense may not exceed $19,000 (the aggregate maximum cost that may

be taken into account under section 179(a) for the applicable

taxable year), Shareholder A may elect to expense up to $14,000 of

separately acquired section 179 property that is purchased and

placed in service in 1999, subject to the limitations of section

179(b).

(b) Character of items constituting pro rata share--(1) In general.

Except as provided in paragraph (b)(2) or (3) of this section, the

character of any item of income, loss, deduction, or credit described

in section 1366(a)(1)(A) or (B) and paragraph (a) of this section is

determined for the S corporation and retains that character in the

hands of the shareholder. For example, if an S corporation has capital

gain on the sale or exchange of a capital asset, a shareholder's pro

rata share of that gain will also be characterized as a capital gain

regardless of whether the shareholder is otherwise a dealer in that

type of property. Similarly, if an S corporation engages in an activity

that is not for profit (section 183), a shareholder's pro rata share of

the S corporation's deductions will be characterized as not for profit.

Also, if an S corporation makes a charitable contribution to an

organization qualifying under section 170(b)(1)(A), a shareholder's pro

rata share of the S corporation's charitable contribution will be

characterized as made to an organization qualifying under section

170(b)(1)(A).

(2) Exception for contribution of noncapital gain property. If an S

corporation is formed or availed of by any shareholder or group of

shareholders for a principal purpose of selling or exchanging

contributed property that in the hands of the shareholder or

shareholders would not have produced capital gain if sold or exchanged

by the shareholder or shareholders, then the gain on the sale or

exchange of the property recognized by the corporation is not treated

as a capital gain.

(3) Exception for contribution of capital loss property. If an S

corporation is formed or availed of by any shareholder or group of

shareholders for a principal purpose of selling or exchanging

contributed property that in the hands of the shareholder or

shareholders would have produced capital loss if sold or exchanged by

the shareholder or shareholders, then the loss on the sale or exchange

of the property recognized by the corporation is treated as a capital

loss to the extent that, immediately before the contribution, the

adjusted basis of the property in the hands of the shareholder

[[Page 44187]]

or shareholders exceeded the fair market value of the property.

(c) Gross income of a shareholder--(1) In general. Where it is

necessary to determine the amount or character of the gross income of a

shareholder, the shareholder's gross income includes the shareholder's

pro rata share of the gross income of the S corporation. The

shareholder's pro rata share of the gross income of the S corporation

is the amount of gross income of the corporation used in deriving the

shareholder's pro rata share of S corporation taxable income or loss

(including items described in section 1366(a)(1) (A) or (B) and

paragraph (a) of this section). For example, a shareholder is required

to include the shareholder's pro rata share of S corporation gross

income in computing the shareholder's gross income for the purposes of

determining the necessity of filing a return (section 6012(a)) and the

shareholder's gross income derived from farming (sections 175 and

6654(i)).

(2) Gross income for substantial omission of items--(i) In general.

For purposes of determining the applicability of the 6-year period of

limitation on assessment and collection provided in section 6501(e)

(relating to omission of more than 25 percent of gross income), a

shareholder's gross income includes the shareholder's pro rata share of

S corporation gross income (as described in section 6501(e)(1)(A)(i)).

In this respect, the amount of S corporation gross income used in

deriving the shareholder's pro rata share of any item of S corporation

income, loss, deduction, or credit (as included or disclosed in the

shareholder's return) is considered as an amount of gross income stated

in the shareholder's return for purposes of section 6501(e).

(ii) Example. The following example illustrates the provisions of

paragraph (c)(2)(i) of this section:

Example. Shareholder A, an individual, owns 25 percent of the

stock of Corporation N, an S corporation that has $10,000 gross

income and $2,000 taxable income. A reports only $300 as A's pro

rata share of N's taxable income. A should have reported $500 as A's

pro rata share of taxable income, derived from $2,500 of N's gross

income. Because A's return included only $300 without a disclosure

meeting the requirements of section 6501(e)(1)(A)(ii) describing the

difference of $200, A is regarded as having reported on the return

only $1,500 ($300/$500 of $2,500) as gross income from N.

(d) Shareholders holding stock subject to community property laws.

If a shareholder holds S corporation stock that is community property,

then the shareholder's pro rata share of any item or items listed in

paragraphs (a)(2), (3), and (4) of this section with respect to that

stock is reported by the husband and wife in accordance with community

property rules.

(e) Net operating loss deduction of shareholder of S corporation.

For purposes of determining a net operating loss deduction under

section 172, a shareholder of an S corporation must take into account

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

or credit of the corporation. See section 1366(b) and paragraph (b) of

this section for rules on determining the character of the items. In

determining under section 172(d)(4) the nonbusiness deductions

allowable to a shareholder of an S corporation (arising from both

corporation sources and any other sources), the shareholder separately

takes into account the shareholder's pro rata share of the deductions

of the corporation that are not attributable to a trade or business and

combines this amount with the shareholder's nonbusiness deductions from

any other sources. The shareholder also separately takes into account

the shareholder's pro rata share of the gross income of the corporation

not derived from a trade or business and combines this amount with the

shareholder's nonbusiness income from all other sources. See section

172 and the regulations thereunder.

(f) Cross-reference. For rules relating to the consistent tax

treatment of subchapter S items, see section 6037(c).

Sec. 1.1366-2 Limitations on deduction of pass-through items of an S

corporation to its shareholders.

(a) In general--(1) Limitation on losses and deductions. The

aggregate amount of losses and deductions taken into account by a

shareholder under Sec. 1.1366-1(a)(2), (3), and (4) for any taxable

year of an S corporation cannot exceed the sum of--

(i) The adjusted basis of the shareholder's stock in the

corporation (as determined under paragraph (a)(3)(i) of this section);

and

(ii) The adjusted basis of any indebtedness of the corporation to

the shareholder (as determined under paragraph (a)(3)(ii) of this

section).

(2) Carryover of disallowance. A shareholder's aggregate amount of

losses and deductions for a taxable year in excess of the sum of the

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

any indebtedness of the S corporation to the shareholder is not allowed

for the taxable year. However, any disallowed loss or deduction is

treated as incurred by the corporation in the corporation's first

succeeding taxable year, and subsequent taxable years, with respect to

the shareholder to the extent that the shareholder's adjusted basis of

stock or indebtedness exceeds zero. For rules on determining the

adjusted bases of stock of an S corporation and indebtedness of the

corporation to the shareholder, see paragraphs (a)(3) (i) and (ii) of

this section.

(3) Basis limitation amount--(i) Stock portion. A shareholder

generally determines the adjusted basis of stock for purposes of

paragraphs (a)(1)(i) and (2) of this section (limiting losses and

deductions) by taking into account only increases in basis under

section 1367(a)(1) for the taxable year and decreases in basis under

section 1367(a)(2)(A), (D) and (E) (relating to distributions,

noncapital, nondeductible expenses, and certain oil and gas depletion

deductions) for the taxable year. In so determining this loss

limitation amount, the shareholder disregards decreases in basis under

section 1367(a)(2)(B) and (C) (for losses and deductions, including

losses and deductions previously disallowed) for the taxable year.

However, if the shareholder has in effect for the taxable year an

election under Sec. 1.1367-1(f) (proposed to be redesignated as

Sec. 1.1367-1(g)) to decrease basis by items of loss and deduction

prior to decreasing basis by noncapital, nondeductible expenses and

certain oil and gas depletion deductions, the shareholder also

disregards decreases in basis under section 1367(a)(2)(D) and (E). This

basis limitation amount for stock is determined at the time prescribed

under Sec. 1.1367-1(d)(1) for adjustments to the basis of stock.

(ii) Indebtedness portion. A shareholder determines the

shareholder's adjusted basis in indebtedness of the corporation for

purposes of paragraphs (a)(1)(ii) and (2) of this section (limiting

losses and deductions) without regard to any adjustment under section

1367(b)(2)(A) for the taxable year. This basis limitation amount for

indebtedness is determined at the time prescribed under Sec. 1.1367-

2(d)(1) for adjustments to the basis of indebtedness.

(4) Limitation on losses and deductions allocated to each item. If

a shareholder's pro rata share of the aggregate amount of losses and

deductions specified in Sec. 1.1366-1(a)(2), (3), and (4) exceeds the

sum of the adjusted basis of the shareholder's stock in the corporation

(determined in accordance with paragraph (a)(3)(i) of this section) and

the adjusted basis of any indebtedness of the corporation to the

shareholder (determined in

[[Page 44188]]

accordance with paragraph (a)(3)(ii) of this section), then the

limitation on losses and deductions under section 1366(d)(1) must be

allocated among the shareholder's pro rata share of each loss or

deduction. The amount of the limitation allocated to any loss or

deduction is an amount that bears the same ratio to the amount of the

limitation as the loss or deduction bears to the total of the losses

and deductions. For this purpose, the total of losses and deductions

for the taxable year is the sum of the shareholder's pro rata share of

losses and deductions for the taxable year, and the losses and

deductions disallowed and carried forward from prior years pursuant to

section 1366(d)(2).

(5) Nontransferability of losses and deductions. Any loss or

deduction disallowed under paragraph (a)(1) of this section is personal

to the shareholder and cannot in any manner be transferred to another

person. If a shareholder transfers some but not all of the

shareholder's stock in the corporation, the amount of any disallowed

loss or deduction under this section is not reduced and the transferee

does not acquire any portion of the disallowed loss or deduction. If a

shareholder transfers all of the shareholder's stock in the

corporation, any disallowed loss or deduction is permanently

disallowed.

(6) Basis of stock acquired by gift. For purposes of section

1366(d)(1)(A) and paragraphs (a)(1)(i) and (2) of this section, the

basis of stock in a corporation acquired by gift is the basis of the

stock that is used for purposes of determining loss.

(b) Special rules for carryover of disallowed losses and deductions

to post-termination transition period described in section 1377(b)--(1)

In general. If, for the last taxable year of a corporation for which it

was an S corporation, a loss or deduction was disallowed to a

shareholder by reason of the limitation in paragraph (a) of this

section, the loss or deduction is treated under section 1366(d)(3) as

incurred by that shareholder on the last day of any post-termination

transition period (within the meaning of section 1377(b)).

(2) Limitation on losses and deductions. The aggregate amount of

losses and deductions taken into account by a shareholder under

paragraph (b)(1) of this section cannot exceed the adjusted basis of

the shareholder's stock in the corporation determined at the close of

the last day of the post-termination transition period. For this

purpose, the adjusted basis of a shareholder's stock in the corporation

is determined at the close of the last day of the post-termination

transition period without regard to any reduction required under

paragraph (b)(4) of this section. If a shareholder disposes of a share

of stock prior to the close of the last day of the post-termination

transition period, the adjusted basis of that share is its basis as of

the close of the day of disposition. Any losses and deductions in

excess of a shareholder's adjusted stock basis are permanently

disallowed. For purposes of section 1366(d)(3)(B) and this paragraph

(b)(2), the basis of stock in a corporation acquired by gift is the

basis of the stock that is used for purposes of determining loss.

(3) Limitation on losses and deductions allocated to each item. If

the aggregate amount of losses and deductions treated as incurred by

the shareholder under paragraph (b)(1) of this section exceeds the

adjusted basis of the shareholder's stock determined under paragraph

(b)(2) of this section, the limitation on losses and deductions under

section 1366(d)(3)(B) must be allocated among each loss or deduction.

The amount of the limitation allocated to each loss or deduction is an

amount that bears the same ratio to the amount of the limitation as the

amount of each loss or deduction bears to the total of all the losses

and deductions.

(4) Adjustment to the basis of stock. The shareholder's basis in

the stock of the corporation is reduced by the amount allowed as a

deduction by reason of this paragraph (b). For rules regarding

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

see Sec. 1.1367-1.

(c) Carryover of disallowed losses and deductions in the case of

liquidations, reorganizations, and divisions--(1) Liquidations and

reorganizations. If a corporation acquires the assets of an S

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

or deduction disallowed under paragraph (a) of this section with

respect to a shareholder of the distributor or transferor S corporation

is available to that shareholder as a shareholder of the acquiring

corporation. Thus, where the acquiring corporation is an S corporation,

a loss or deduction of a shareholder of the distributor or transferor S

corporation disallowed prior to or during the taxable year of the

transaction is treated as incurred by the acquiring S corporation with

respect to that shareholder if the shareholder is a shareholder of the

acquiring S corporation after the transaction. Where the acquiring

corporation is a C corporation, a post-termination transition period

arises the day after the last day that an S corporation was in

existence and the rules provided in paragraph (b) of this section apply

with respect to any shareholder of the acquired S corporation that is

also a shareholder of the acquiring C corporation after the

transaction. See the special rules under section 1377 for the

availability of the post-termination transition period if the acquiring

corporation is a C corporation.

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

an S corporation transfers a portion of its assets constituting an

active trade or business to another corporation in a transaction to

which section 368(a)(1)(D) applies, and immediately thereafter the

stock and securities of the controlled corporation are distributed in a

distribution or exchange to which section 355 (or so much of section

356 as relates to section 355) applies, any loss or deduction

disallowed under paragraph (a) of this section with respect to a

shareholder of the distributing S corporation immediately before the

transaction is allocated between the distributing corporation and the

controlled corporation with respect to the shareholder. The amount of

disallowed loss or deduction allocated to the distributing (or

controlled) corporation with respect to the shareholder is an amount

that bears the same ratio to each item of disallowed loss or deduction

as the value of the shareholder's stock in the distributing (or

controlled) corporation bears to the total value of the shareholder's

stock in the distributing and controlled corporations, in each case as

determined immediately after the distribution.

Sec. 1.1366-3 Treatment of family groups.

(a) In general. Under section 1366(e), if an individual, who is a

member of the family of one or more shareholders of an S corporation,

renders services for, or furnishes capital to, the corporation without

receiving reasonable compensation, the Commissioner shall prescribe

adjustments to those items taken into account by the individual and the

shareholders as may be necessary to reflect the value of the services

rendered or capital furnished. For these purposes, in determining the

reasonable value for services rendered, or capital furnished, to the

corporation, consideration will be given to all the facts and

circumstances, including the amount that ordinarily would be paid in

order to obtain comparable services or capital from a person (other

than a member of the family) who is not a shareholder in the

corporation. In addition, for purposes of section 1366(e), if a member

of the family of one

[[Page 44189]]

or more shareholders of the S corporation holds an interest in a pass-

through entity (e.g., a partnership, S corporation, trust, or estate),

that performs services for, or furnishes capital to, the S corporation

without receiving reasonable compensation, the Commissioner shall

prescribe adjustments to the pass-through entity and the corporation as

may be necessary to reflect the value of the services rendered or

capital furnished. For purposes of section 1366(e), the term family of

any shareholder includes only the shareholder's spouse, ancestors,

lineal descendants, and any trust for the primary benefit of any of

these persons.

(b) Examples. The provisions of this section may be illustrated by

the following examples:

Example 1. The stock of an S corporation is owned 50 percent by

F and 50 percent by T, the minor son of F. For the taxable year, the

corporation has items of taxable income equal to $70,000.

Compensation of $10,000 is paid by the corporation to F for services

rendered during the taxable year, and no compensation is paid to T,

who rendered no services. Based on all the relevant facts and

circumstances, reasonable compensation for the services rendered by

F would be $30,000. In the discretion of the Internal Revenue

Service, up to an additional $20,000 of the $70,000 of the

corporation's taxable income, for tax purposes, may be allocated to

F as compensation for services rendered. If the Service allocates

$20,000 of the corporation's taxable income to F as compensation for

services, taxable income of the corporation would be reduced by

$20,000 to $50,000, of which F and T each would be allocated

$25,000. F would have $30,000 of total compensation paid by the

corporation for services rendered.

Example 2. The stock of an S corporation is owned by A and B.

For the taxable year, the corporation has paid compensation to a

partnership that rendered services to the corporation during the

taxable year. The spouse of A is a partner in that partnership.

Consequently, if based on all the relevant facts and circumstances

the partnership did not receive reasonable compensation for the

services rendered to the corporation, the Internal Revenue Service,

in its discretion, may make adjustments to those items taken into

account by the partnership and the corporation as may be necessary

to reflect the value of the services rendered.

Sec. 1.1366-4 Special rules limiting the pass through of certain items

of an S corporation to its shareholders.

(a) Pass through inapplicable to section 34 credit. Section 1.1366-

1(a) does not apply to any credit allowable under section 34 (relating

to certain uses of gasoline and special fuels).

(b) Reduction in pass through for tax imposed on built-in gains.

For purposes of Sec. 1.1366-1(a), if for any taxable year of the S

corporation a tax is imposed on the corporation under section 1374, the

amount of the tax imposed is treated as a loss sustained by the S

corporation during the taxable year. The character of the deemed loss

is determined by allocating the loss proportionately among the

recognized built-in gain items giving rise to the tax and attributing

the character of each recognized built-in gain item to the allocable

portion of the loss.

(c) Reduction in pass through for tax imposed on excess net passive

income. For purposes of Sec. 1.1366-1(a), if for any taxable year of

the S corporation a tax is imposed on the corporation under section

1375, each item of passive investment income shall be reduced by an

amount that bears the same ratio to the amount of the tax as the amount

of the item bears to the total passive investment income for that

taxable year.

Sec. 1.1366-5 Effective date.

Sections 1.1366-1 through 1.1366-4 apply to taxable years of an S

corporation beginning on or after August 18, 1998.

Par. 4. Section 1.1367-0 is amended in the table as follows:

1. The entries for Sec. 1.1367-1 (e) through (g) are revised.

2. The entries for Sec. 1.1367-1 (h) through (j) are added.

The additions and revisions read as follows:

Sec. 1.1367-0 Table of contents.

* * * * *

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

corporation.

* * * * *

(e) Ordering rules for taxable years beginning before January 1,

1997.

(f) Ordering rules for taxable years beginning on or after August

18, 1998.

(g) Elective ordering rule.

(h) Examples.

(i) [Reserved]

(j) Adjustments for items of income in respect of a decedent.

* * * * *

Par. 5. Section 1.1367-1 is amended as follows:

1. The heading and introductory text of paragraph (e) are revised.

2. Paragraphs (f) and (g) are redesignated as paragraphs (g) and

(h), respectively.

3. New paragraph (f) is added.

4. The first and second sentences of newly designated paragraph (g)

are revised.

5. Newly designated paragraph (h) is amended as follows:

a. The heading for Example 1 is revised.

b. Example 2 and Example 3 are redesignated as Example 3 and

Example 4, respectively.

c. New Example 2 is added.

d. The heading of newly designated Example 4 is revised.

e. Example 5 is added.

6. Paragraph (i) is added and reserved and paragraph (j) is added.

The additions and revisions read as follows:

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

corporation.

* * * * *

(e) Ordering rules for taxable years beginning before January 1,

1997. For any taxable year of a corporation beginning before January 1,

1997, except as provided in paragraph (g) of this section, the

adjustments required by section 1367(a) are made in the following

order--

* * * * *

(f) Ordering rules for taxable years beginning on or after August

18, 1998. For any taxable year of a corporation beginning on or after

August 18, 1998, except as provided in paragraph (g) of this section,

the adjustments required by section 1367(a) are made in the following

order--

(1) Any increase in basis attributable to the income items

described in section 1367(a)(1) (A) and (B), and the excess of the

deductions for depletion described in section 1367(a)(1)(C);

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

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

(3) Any decrease in basis attributable to noncapital, nondeductible

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

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

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

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

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

basis under paragraph (e)(3) or (f)(4) of this section, whichever

applies, prior to decreasing basis under paragraph (e)(2) or (f)(3) of

this section, whichever applies. If a shareholder makes this election,

any amount described in paragraph (e)(2) or (f)(3) of this section,

whichever applies, that is in excess of the shareholder's basis in

stock and indebtedness is treated, solely for purposes of this section,

as an amount described in paragraph (e)(2) or (f)(3) of this section,

whichever applies, in the succeeding taxable year. * * *

(h) * * *

Example 1. Adjustments to basis of stock for taxable years

beginning before January 1, 1997. * * *

Example 2. Adjustments to basis of stock for taxable years

beginning on or after August 18, 1998. (i) On December 31, 2001, A

owns a block of 50 shares of stock with an adjusted

[[Page 44190]]

basis per share of $6 in Corporation S. On December 31, 2001, A

purchases for $400 an additional block of 50 shares of stock with an

adjusted basis of $8 per share. Thus, A holds 100 shares of stock

for each day of the 2002 taxable year. For S's 2002 taxable year,

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

1367(a)(1)(A) (relating to increases in basis of stock) is $300, A's

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

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

to items of loss and deduction) is $300, and A's pro rata share of

the amount of the items described in section 1367(a)(2)(D) (relating

to decreases in basis of stock attributable to noncapital,

nondeductible expenses) is $200. S makes a distribution to A in the

amount of $100 during 2002.

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

section, A first increases the basis of each share of stock by $3

($300/100 shares) and then decreases the basis of each share by $1

($100/100 shares) for the distribution. A next decreases the basis

of each share by $2 ($200/100 shares) for the noncapital,

nondeductible expenses and then decreases the basis of each share by

$3 ($300/100 shares) for the items of loss. Thus, on January 1,

2003, A has a basis of $3 per share in the original block of 50

shares ($6 + $3 -$1 -$2 -$3) and a basis of $5 per share in the

second block of 100 shares ($8 + $3 -$1 -$2 -$3).

* * * * *

Example 4. Effects of section 1377(a)(2) election and

distribution on basis of stock for taxable years beginning before

January 1, 1997. * * *

Example 5. Effects of section 1377(a)(2) election and

distribution on basis of stock for taxable years beginning on or

after August 18, 1998. (i) The facts are the same as in Example 4,

except that all of the events occur in 2001 rather than in 1994 and

except as follows: On June 30, 2001, B sells 25 shares of her stock

for $5,000 to D and 25 shares back to Corporation S for $5,000.

Under section 1377(a)(2)(B) and Sec. 1.1377-1(b)(2), B and C are

affected shareholders because B has transferred shares to

Corporation S. Pursuant to section 1377(a)(2)(A) and Sec. 1.1377-

1(b)(1), B and C, the affected shareholders, and Corporation S agree

to treat the taxable year 2001 as if it consisted of two separate

taxable years for all affected shareholders for the purposes set

forth in Sec. 1.1377-1(b)(3)(i).

(ii) On June 30, 2001, B and C, pursuant to the ordering rules

of paragraph (f)(1) of this section, increase the basis of each

share by $60 ($6,000/100 shares) for the nonseparately computed

income. Then B and C reduce the basis of each share by $120

($12,000/100 shares) for the distribution. Finally, B and C decrease

the basis of each share by $40 ($4,000/100 shares) for the

separately stated deduction item.

(iii) The basis of the stock of B is reduced from $120 to $20

per share ($120 + $60 - $120 - $40). Prior to accounting for the

separately stated deduction item, the basis of the stock of C is

reduced from $80 to $20 ($80 + $60 - $120). Finally, because the

period from January 1 through June 30, 2001 is treated under

Sec. 1.1377-1(b)(3)(i) as a separate taxable year for purposes of

making adjustments to the basis of stock, under section 1366(d) and

Sec. 1.1366-2(a)(2), C may deduct only $20 per share of the

remaining $40 of the separately stated deduction item, and the basis

of the stock of C is reduced from $20 per share to $0 per share.

Under section 1366 and Sec. 1.1366-2(a)(2), C's remaining separately

stated deduction item of $20 per share is treated as having been

incurred in the first succeeding taxable year of Corporation S,

which, for this purpose, begins on July 1, 2001.

(i) [Reserved]

(j) Adjustments for items of income in respect of a decedent. The

basis determined under section 1014 of any stock in an S corporation is

reduced by the portion of the value of the stock that is attributable

to items constituting income in respect of a decedent. For the

determination of items realized by an S corporation constituting income

in respect of a decedent, see sections 1367(b)(4)(A) and 691 and

applicable regulations thereunder. For the determination of the

allowance of a deduction for the amount of estate tax attributable to

income in respect of a decedent, see section 691(c) and applicable

regulations thereunder.

Par. 6. The first sentence of Sec. 1.1367-3 is removed and two

sentences are added in its place to read as follows:

Sec. 1.1367-3 Effective date and transition rule.

Except for Sec. 1.1367-1(f), Example 2 and Example 5 of

Sec. 1.1367-1(h), and Sec. 1.1367-1(j), Secs. 1.1367-1 and 1.1367-2

apply to taxable years of the corporation beginning on or after January

1, 1994. Section 1.1367-1(f), Example 2 and Example 5 of Sec. 1.1367-

1(h), and Sec. 1.1367-1(j) apply only to taxable years of the

corporation beginning on or after August 18, 1998. * * *

Par. 7. Section 1.1368-0 is amended in the table as follows:

1. The entry for Sec. 1.1368-1(e) is revised and entries for

Sec. 1.1368-1 (e)(1) and (e)(2) are added.

2. The entries for Sec. 1.1368-2 (a)(4) and (d) are revised.

3. An entry for Sec. 1.1368-2(a)(5) is added.

The additions and revisions read as follows:

Sec. 1.1368-0 Table of contents.

* * * * *

Sec. 1.1368-1 Distributions by S corporations.

* * * * *

(e) Certain adjustments taken into account.

(1) Taxable years beginning before January 1, 1997.

(2) Taxable years beginning on or after August 18, 1998.

* * * * *

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

(a) Accumulated adjustments account.

* * * * *

(4) Ordering rules for the AAA for taxable years beginning

before January 1, 1997.

(5) Ordering rules for the AAA for taxable years beginning on or

after August 18, 1998.

* * * * *

(d) Adjustment in the case of redemptions, liquidations,

reorganizations, and divisions.

* * * * *

Par. 8. Section 1.1368-1 is amended by revising paragraphs (d)(1)

and (e) to read as follows:

Sec. 1.1368-1 Distributions by S corporations.

* * * * *

(d) S corporation with earnings and profits--(1) General treatment

of distribution. Except as provided in paragraph (d)(2) of this

section, a distribution made with respect to its stock by an S

corporation that has accumulated earnings and profits as of the end of

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

is treated in the manner provided in section 1368(c). See section 316

and Sec. 1.316-2 for provisions relating to the allocation of earnings

and profits among distributions.

* * * * *

(e) Certain adjustments taken into account--(1) Taxable years

beginning before January 1, 1997. For any taxable year of the

corporation beginning before January 1, 1997, paragraphs (c) and (d) of

this section are applied only after taking into account--

(i) The adjustments to the basis of the shares of a shareholder's

stock described in section 1367 (without regard to section

1367(a)(2)(A) (relating to decreases attributable to distributions not

includable in income)) for the S corporation's taxable year; and

(ii) The adjustments to the AAA required by section 1368(e)(1)(A)

(but without regard to the adjustments for distributions under

Sec. 1.1368-2(a)(3)(iii)) for the S corporation's taxable year.

(2) Taxable years beginning on or after August 18, 1998. For any

taxable year of the corporation beginning on or after August 18, 1998,

paragraphs (c) and (d) of this section are applied only after taking

into account--

(i) The adjustments to the basis of the shares of a shareholder's

stock described in section 1367(a)(1) (relating to increases in basis

of stock) for the S corporation's taxable year; and

(ii) The adjustments to the AAA required by section 1368(e)(1)(A)

(but without regard to the adjustments for distributions under

Sec. 1.1368-2(a)(3)(iii)) for the S corporation's taxable year. Any

[[Page 44191]]

net negative adjustment (as defined in section 1368(e)(1)(C)(ii)) for

the taxable year shall not be taken into account.

* * * * *

Par. 9. Section 1.1368-2 is amended as follows:

1. Paragraphs (a)(1) and (a)(3)(ii) and the heading and

introductory text of paragraph (a)(4) are revised.

2. Paragraph (a)(5) is added.

3. The heading for paragraph (d) is revised.

The additions and revisions read as follows:

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

(a) Accumulated adjustments account--(1) In general. The

accumulated adjustments account is an account of the S corporation and

is not apportioned among shareholders. The AAA is relevant for all

taxable years beginning on or after January 1, 1983, for which the

corporation is an S corporation. On the first day of the first year for

which the corporation is an S corporation, the balance of the AAA is

zero. The AAA is increased in the manner provided in paragraph (a)(2)

of this section and is decreased in the manner provided in paragraph

(a)(3) of this section. For the adjustments to the AAA in the case of

redemptions, liquidations, reorganizations, and corporate separations,

see paragraph (d) of this section.

* * * * *

(3) Decreases to the AAA * * *

(ii) Extent of allowable reduction. The AAA may be decreased under

paragraph (a)(3)(i) of this section below zero. The AAA is decreased by

noncapital, nondeductible expenses under paragraph (a)(3)(i)(C) of this

section even though a portion of the noncapital, nondeductible expenses

is not taken into account by a shareholder under Sec. 1.1367-1(g)

(relating to the elective ordering rule). The AAA is also decreased by

the entire amount of any loss or deduction even though a portion of the

loss or deduction is not taken into account by a shareholder under

section 1366(d)(1) or is otherwise not currently deductible under the

Internal Revenue Code. However, in any subsequent taxable year in which

the loss, deduction, or noncapital, nondeductible expense is treated as

incurred by the corporation with respect to the shareholder under

section 1366(d)(2) or Sec. 1.1367-1(g) (or in which the loss or

deduction is otherwise allowed to the shareholder), no further

adjustment is made to the AAA.

* * * * *

(4) Ordering rules for the AAA for taxable years beginning before

January 1, 1997. For any taxable year beginning before January 1, 1997,

the adjustments to the AAA are made in the following order--

* * * * *

(5) Ordering rules for the AAA for taxable years beginning on or

after August 18, 1998. For any taxable year of the corporation

beginning on or after August 18, 1998, the adjustments to the AAA are

made in the following order--

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

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

taxable year;

(ii) The AAA is decreased (but not below zero) by any portion of an

ordinary distribution to which section 1368(b) or (c)(1) applies

(without taking into account any net negative adjustment (as defined in

section 1368(e)(1)(C)(ii)) before it is decreased under paragraph

(a)(3)(i) of this section;

(iii) The AAA is decreased under paragraph (a)(3)(i)(C) and (D) of

this section before it is decreased under paragraph (a)(3)(i)(A) and

(B) of this section;

(iv) The AAA is decreased under paragraph (a)(3)(i)(A) and (B) of

this section; and

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

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

* * * * *

(d) Adjustment in the case of redemptions, liquidations,

reorganizations, and divisions * * *

* * * * *

Par. 10. Section 1.1368-3 is amended as follows:

1. The heading for Example 1 is revised.

2. Example 2 through Example 6 are redesignated as Example 3

through Example 7, respectively.

3. New Example 2 is added.

The revision and addition read as follows:

Sec. 1.1368-3 Examples.

* * * * *

Example 1. Distributions by S corporations without C corporation

earnings and profits for taxable years beginning before January 1,

1997. * * *

Example 2. Distributions by S corporations without earnings and

profits for taxable years beginning on or after August 18, 1998. (i)

Corporation S, an S corporation, has no earnings and profits as of

January 1, 2001, the first day of its 2001 taxable year. S's sole

shareholder, A, holds 10 shares of S stock with a basis of $1 per

share as of that date. On March 1, 2001, S makes a distribution of

$38 to A. For S's 2001 taxable year, A's pro rata share of the

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

increases in basis of stock) is $50. A's pro rata share of the

amount of the items described in sections 1367(a)(2)(B) through (D)

(relating to decreases in basis of stock for items other than

distributions) is $26, $20 of which is attributable to items

described in section 1367(a)(2)(B) and (C) and $6 of which is

attributable to items described in section 1367(a)(2)(D) (relating

to decreases in basis attributable to noncapital, nondeductible

expenses).

(ii) Under section 1368(d)(1) and Sec. 1.1368-1(e)(1) and (2),

the adjustments to the basis of A's stock in S described in sections

1367(a)(1) are made before the distribution rules of section 1368

are applied. Thus, A's basis per share in the stock is $6.00 ($1 +

[$50/10]) before taking into account the distribution. Under section

1367(a)(2)(A), the basis of A's stock is decreased by distributions

to A that are not includible in A's income. Under Sec. 1.1367-

1(c)(3), the amount of the distribution that is attributable to each

share of A's stock is $3.80 ($38 distribution/10 shares). Thus, A's

basis per share in the stock is $2.20 ($6.00--$3.80), after taking

into account the distribution. Under section 1367(a)(2)(D), the

basis of each share of A's stock in S after taking into account the

distribution, $2.20, is decreased by $.60 ($6 noncapital,

nondeductible expenses/10). Thus, A's basis per share after taking

into account the nondeductible, noncapital expenses is $1.60. Under

section 1367(a)(2)(B) and (C), A's basis per share is further

decreased by $2 ($20 items described in section 1367(a)(2)(B) and

(C)/10 shares). However, basis may not be reduced below zero.

Therefore, the basis of each share of A's stock is reduced to zero.

As of January 1, 2002, A has a basis of $0 in his shares of S stock.

Pursuant to section 1366(d)(2), the $.40 of loss in excess of A's

basis in each of his shares of S stock is treated as incurred by the

corporation in the succeeding taxable year with respect to A.

* * * * *

Par. 11. The first sentence of Sec. 1.1368-4 is removed and two

sentences are added in its place to read as follows:

Sec. 1.1368-4 Effective date and transition rule.

Except for Secs. 1.1368-1(e)(2), 1.1368-2(a)(5), and Example 2 of

Sec. 1.1368-3, Secs. 1.1368-1, 1.1368-2, and 1.1368-3 apply to taxable

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

Sections 1.1368-1(e)(2), 1.1368-2(a)(5) and Example 2 of Sec. 1.1368-3

apply only to taxable years of the corporation beginning on or after

August 18, 1998. * * *

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

[FR Doc. 98-21639 Filed 8-17-98; 8:45 am]

BILLING CODE 4830-01-U