Acquisition of an S Corporation by a Member of a Consolidated Group

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106219-98]

RIN 1545-AW32

Acquisition of an S Corporation by a Member of a Consolidated

Group

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 under section

1502. The proposed regulations provide specific rules that apply to the

acquisition of the stock of an S corporation by an affiliated group of

corporations that joins in the filing of a consolidated return. These

rules eliminate the compliance burdens associated with filing a

separate return for the day that an S corporation is acquired by a

consolidated group. Additionally, the proposed regulations clarify that

Sec. 1.1502-76(c) continues to provide rules for the filing of the

separate return for a corporation's items for the period not included

in the consolidated return. This document also provides notice of a

public hearing on these proposed regulations.

DATES: Written comments must be received by March 10, 1999. Outlines of

topics to be discussed at the public hearing scheduled for March 31,

1999, at 10 a.m. must be received by March 17, 1999.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-106219-98), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. Submissions may be hand delivered Monday through

Friday between the hours of 8 a.m. and 5 p.m. to CC:DOM:CORP:R (REG-

106219-98), 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, Jeffrey L.

Vogel, (202) 622-7770; concerning submissions, the hearing, and/or to

be placed on the building access list to attend the hearing, LaNita Van

Dyke, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Income Tax

Regulations (26 CFR part 1) under section 1502 of the Internal Revenue

Code of 1986 (the consolidated return regulations). The amendments

apply to acquisitions by a consolidated group of at least eighty

percent of the stock of an S corporation. When a consolidated group

acquires an S corporation, the interaction of the consolidated return

regulations and the subchapter S rules requires the filing of a

separate return for the day of the acquisition. In most situations,

complying with this requirement results in an unnecessary

administrative burden for taxpayers.

The proposed regulations also clarify the impact of the 1994

revisions to Sec. 1.1502-76(b) (TD 8560, 1994-2 C.B. 200). The 1994

revisions provided taxpayers greater certainty and prevented

inconsistent allocations of items between a separate and a consolidated

return. The proposed regulations clarify that the due date for the

filing of the separate return for the period not included in the

consolidated return continues to be governed by the rules in

Sec. 1.1502-76(c).

Acquisition of an S Corporation

Section 1.1502-76(b)(1)(i) provides that a consolidated return must

include the common parent's items of income, gain, deduction, loss, and

credit for the consolidated return year and each subsidiary's items for

the portion of the year for which the subsidiary is a member. Generally

under Sec. 1.1502-76(b)(1)(ii)(A), a subsidiary becomes a member of the

consolidated group at the end of the day on which its status as a

member changes, and its tax year ends at that time for all Federal

income tax purposes. The subsidiary's items for the period beginning on

the day after it becomes a member of the consolidated group are

generally included in the consolidated return of the group. The

subsidiary's items for the period prior to its becoming a member

generally are included in a separate return.

A small business corporation's selection under section 1362(a) to

be an S corporation terminates under section 1362(d)(2) if it ceases to

be a small business corporation. A small business corporation cannot

have a corporate shareholder. Thus, an S corporation election

terminates when the corporation has another corporation as a

shareholder. The termination is effective on the day the corporation

becomes a shareholder. When the termination of an S corporation

election becomes effective on any day other than the first day of the

taxable year, the taxable year in which the termination occurs is an S

termination year under section 1362(e)(4). The S termination year is

comprised of a short taxable year for which the corporation is an S

corporation (the portion of the S termination year ending on the day

before the terminating event occurs, or S short year) and a short

taxable year for which the corporation is a C corporation (the

remainder of the S termination year, or C short year).

Under section 1362(e)(6)(D), if there is a change in ownership of

50 percent or more of the stock in a corporation during the S

termination year, items of income, gain, loss, deduction, and credit

must be allocated between the S short year and the C short year on the

basis of the corporation's normal method of accounting, as determined

under section 446 (also referred to as a closing of the corporation's

books) as of the close of the S short year, rather than a daily

proration or other method. The S short year and the C short year are

treated as two separate taxable years for most purposes. Separate

returns are required for the S short year and the C short year, and the

due date for the S short year return is the date by which the C short

year return must be filed.

When an S corporation becomes a member of a consolidated group, the

interaction of the consolidated return regulations and the subchapter S

rules results in the corporation having three taxable periods for the

year of the acquisition for which Federal income tax returns are due:

(1) an S short year that ends on the day before the acquisition by the

consolidated group, (2) a C short year consisting solely of the day of

the acquisition, and (3) a short taxable year (included in the

consolidated return) for any items occurring after the day of the

acquisition. Although three separate taxable periods are created when

an S corporation becomes a member of a consolidated group, existing

rules preclude an allocation of items properly attributable to either

the C short year or the consolidated year to the S short

[[Page 69582]]

year, for example, through a daily proration of the items attributable

to the year of the acquisition. Section 1362(e)(6)(D).

The IRS and Treasury have determined that the compliance burdens

associated with filing a separate return for the day that an S

corporation is acquired by a consolidated group are not necessary to

achieve the separate goals of section 1362(e) and the consolidated

return regulations. The proposed regulations will eliminate this

requirement in most situations, while preserving the purpose and effect

of the rules under section 1362(e). These proposed regulations will not

apply, however, if an S corporation becomes a member of a consolidated

group in a qualified stock purchase for which an election under section

338(g) is made. If the common parent of the consolidated group and the

shareholders of the S corporation jointly make a section 338(h)(10)

election, the administrative relief provided by these proposed

regulations is unnecessary because the S corporation election of the

old target corporation does not terminate. See Sec. 1.338(h)(10)-

1(e)(2)(iv).

Under the proposed regulations, an S corporation will become a

member of the consolidated group at the beginning of the day that

includes the acquisition, and its tax year will end for all Federal

income tax purposes at the end of the day preceding the acquisition.

Thus, instead of three short taxable years, the corporation will have

two short taxable years as a result of the acquisition: (1) the period

ending on the day before the S corporation joins the consolidated

group, which will be treated as a taxable year in which the corporation

was an S corporation, and (2) the period during which the corporation

is a member of the consolidated group. The termination of an S

corporation election under section 1362(d)(2) continues to become

effective on the day of the acquisition. However, because the

consolidated return regulations create a separate taxable year for the

corporation, the first day of which is the day on which the S

corporation election terminates, there is no S termination year within

the meaning of section 1362(e)(4). Consequently, section 1362(e)

technically does not apply to the corporation.

Notwithstanding that there is no there is no S termination year,

the proposed regulations provide rules similar to those that would have

applied under section 1362(e). Under the proposed regulations, as under

section 1362(e)(1)(A), the S corporation's short taxable year ends at

the end of the day preceding the date of the acquisition. The Federal

income tax return for the final taxable year of the S corporation will

be due at the earlier of: (1) The date the S corporation return would

have been due if the taxable year of the S corporation did not end or

(2) the date the consolidated group's return for the taxable year that

includes the acquisition is due.

These proposed regulations also preclude the availability of

ratable allocation under Sec. 1.1502-76(b)(2)(ii) and (iii) in order to

achieve the same results that would have obtained if section

1362(e)(6)(D) had applied. Accordingly, if an S corporation joins a

consolidated group and these proposed regulations apply, then items

must be allocated between the two short taxable years that begin and

end with the corporation joining the consolidated group on the basis of

a closing of the books rather than a ratable allocation of the type

that would have been available under section 1362(e)(2) (in the case of

the termination of an S corporation election) or Sec. 1.1502-

76(b)(2)(ii) and (iii) (in the case of a corporation becoming or

ceasing to be a member of a consolidated group).

Due Date for Separate Return

Section 1.1502-76(b) provides guidance regarding the items to be

included in a consolidated return. Items for the portion of a year not

included in the consolidated return must be included in a separate

return.

Section 1.1502-76(b)(1)(ii)(A) provides that a subsidiary becomes

(or ceases to be) a member of the consolidated group at the end of the

day on which its status as a member changes, and its tax year ends at

that time for all Federal income tax purposes. Section 1.1502-

76(b)(2)(i) generally provides that the returns that end and begin with

a subsidiary becoming (or ceasing to be) a member of the consolidated

group are subject to the rules of the Internal Revenue Code applicable

to short periods, as if the subsidiary ceased to exist on becoming a

member (or first existed on becoming a nonmember). Section 1.1502-76(c)

provides rules for the filing of the separate return for the period the

subsidiary was not included in the consolidated group.

The IRS and Treasury are concerned that a broad application of the

provisions of Sec. 1.1502-76(b) could be construed to require an

accelerated filing of the separate return by the fifteenth day of the

third month following the end of the short taxable year that resulted

from the corporation joining or leaving the consolidated group. This

interpretation would, in effect, override the provisions in

Sec. 1.1502-76(c) concerning the due date for the filing of a separate

return.

The IRS and Treasury did not intend to modify the due date for the

separate return for the period not included in the consolidated return

by the changes in Sec. 1.1502-76(b) (as amended by TD 8560). This

proposed regulation clarifies that Sec. 1.1502-76(c) continues to

provide rules for the filing of the separate return.

Proposed Effective Date

The amendments relating to the acquisition of a corporation that,

immediately before becoming a member, had an election under section

1362(a) in effect, are proposed to apply to transactions occurring

after the date final regulations are published in the Federal Register.

The amendments relating to the clarification of the due date for the

separate return for items not included in the return of a consolidated

group are proposed to apply to corporations that became or ceased to be

members of consolidated groups on or after January 1, 1995, the

effective date of the 1994 amendments to Sec. 1.1502-76(b).

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. It is hereby certified that

these regulations will not have a significant economic impact on a

substantial number of small entities. This certification is based upon

the fact that the proposed regulations will provide administrative

relief to small entities by removing the administrative burden of

filing a separate one-day return currently required for certain

acquisitions. 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 RevenueCode, 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 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 March 31, 1999, at 10 a.m.

in room 2615, Internal Revenue Building,

[[Page 69583]]

1111 Constitution Avenue, NW., Washington, DC. Due to building security

procedures, visitors must enter at the 10th Street entrance, located

between Constitution and Pennsylvania Avenues, NW. In addition, all

visitors must present photo identification to enter the building.

Because of access restrictions, visitors will not be admitted beyond

the immediate entrance area more than 15 minutes before the hearing

starts. For information about having your name placed on the building

access list to attend the hearing, see the FOR FURTHER INFORMATION

CONTACT section of this preamble.

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

March 10, 1999. The outline of topics to be discussed and the time to

be devoted to each topic must be received by March 17, 1999.

A period of 10 minutes will be allotted to 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 author of these regulations is

Jeffrey L. Vogel of the Office of the Assistant Chief Counsel

(Corporate), IRS. 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 * * *

Section 1.1502-76 also issued under 26 U.S.C. 1502. * * *

Par. 2. Section 1.1362-3 is amended by adding a sentence to the end

of paragraph (a) to read as follows:

Sec. 1.1362-3 Treatment of S termination year.

(a) In general. * * * See, however, Sec. 1.1502-76(b)(1)(ii)(A)(2)

for special rules for an S election that terminates under section

1362(d) immediately before the S corporation becomes a member of a

consolidated group (within the meaning of Sec. 1.1502-1(h)).

* * * * *

Par. 3. Section 1.1502-76 is amended as follows:

1. The text of paragraph (b)(1)(ii)(A) is redesignated as paragraph

(b)(1)(ii)(A)(1).

2. A paragraph heading for newly designated

paragraph(b)(1)(ii)(A)(1) is added.

3. The first sentence of newly designated paragraph(b)(1)(ii)(A)(1)

is revised.

4. Paragraph (b)(1)(ii)(A)(2) is added.

5. Paragraph (b)(2)(v) is redesignated as paragraph(b)(2)(vi).

6. New paragraph (b)(2)(v) is added.

7. Paragraph (b)(5) is redesignated as paragraph (b)(6).

8. Paragraph (b)(4) is redesignated as paragraph (b)(5).

9. New paragraph (b)(4) is added.

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

a. The first sentence of paragraph (b)(5), Example 6(b) is revised.

b. The second sentence of paragraph (b)(5), Example 6(c) is

revised.

c. Example 7 is added to paragraph (b)(5).

11. Newly designated paragraph (b)(6)(i) is revised.

The revisions and additions read as follows:

Sec. 1.1502-76 Taxable year of members of group.

* * * * *

(b) * * * (1) * * *

(ii) * * * (A) * * * (1) In general. If a corporation (S), other

than one described in paragraph (b)(1)(ii)(A)(2), becomes or ceases to

be a member during a consolidated return year, it becomes or ceases to

be a member at the end of the day on which its status as a member

changes, and its tax year ends for all Federal income tax purposes at

the end of that day. * * *

(2) Special rule for former S corporations. If S becomes a member

in a transaction other than in a qualified stock purchase for which an

election under section 338(g) is made, and immediately before becoming

a member an election under section 1362(a) was in effect, then S will

become a member at the beginning of the day the termination of its S

corporation election is effective. S's tax year ends for all Federal

income tax purposes at the end of the preceding day. This paragraph

(b)(1)(ii)(A)(2) applies to transactions occurring after the date that

final regulations are published in the Federal Register.

* * * * *

(2) * * *

(v) Acquisition of S corporation. If a corporation is acquired in a

transaction to which paragraph (b)(1)(ii)(A)(2) of this section

applies, then paragraphs (b)(2)(ii) and (iii) of this section do not

apply and items of income, gain, loss, deduction, and credit are

assigned to each short taxable year on the basis of the corporation's

normal method of accounting as determined under section 446. This

paragraph (b)(2)(v) applies to transactions occurring after the date

that final regulations are published in the Federal Register.

* * * * *

(4) Determination of due date for separate return. Paragraph (c) of

this section contains rules for the filing of the separate return

referred to in this paragraph (b). In applying paragraph (c) of this

section, the due date for the filing of S's separate return shall also

be determined without regard to the ending of the tax year under

paragraph (b)(1)(ii) of this section or the deemed cessation of its

existence under paragraph (b)(2)(i) of this section.

* * * * *

(5) * * *

Example 6. Allocation of partnership items. * * *

(b) Analysis. Under paragraph (b)(2)(vi)(A) of this section, T

is treated, solely for purposes of determining T's tax year in which

the partnership's items are included, as selling or exchanging its

entire interest in the partnership as of P's sale of T stock. * * *

(c) Controlled partnership. * * * Under paragraph(b)(2)(vi)(B)

of this section, T's distributive share of the partnership items is

treated as T's items for purposes of paragraph (b)(2) of this

section. * * *

Example 7. Acquisition of S corporation. (a) Facts. Z is a small

business corporation for which an election under section 1362(a) was

in effect at all times since Year 1. At all times, Z had only 100

shares of stock outstanding, all of which were owned by individual

A. On July 1 of Year 3, P acquired all of the Z stock. P does not

make an election under section 338(g) with respect to its purchase

of the Z stock.

(b) Analysis. As a result of P's acquisition of the Z stock, Z's

election under section 1362(a) terminates. See sections

1361(b)(1)(B) and 1362(d)(2). Z is required to join in the filing of

the P consolidated return. See Sec. 1.1502-75. Z's tax year ends for

all Federal income tax purposes on June 30 of Year 3. If no

extension of time is sought, Z must file a separate return for the

period from January 1 through June 30 of Year 3 on or before March

15 of Year 4. See paragraph (b)(4) of this section. Z will become a

member of the P consolidated group as of July 1 of Year 3. See

paragraph (b)(1)(ii)(A)(2) of this section. P group's Year 3

consolidated return will include Z's items from July 1 to December

31 of Year 3.

(6) Effective date--(i) General rule. Except as provided in

paragraphs

[[Page 69584]]

(b)(1)(ii)(A)(2) and (b)(2)(v) of this section, this paragraph (b)

applies to corporations becoming or ceasing to be members of

consolidated groups on or after January 1, 1995.

* * * * *

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 98-32932 Filed 12-16-98; 8:45 am]

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