Passthrough of Items of an S Corporation to its Shareholders

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8852]

RIN 1545-AT52

Passthrough of Items of an S Corporation to its Shareholders

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the

passthrough 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 regulations provide the public with

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

corporations and their shareholders.

DATES: Effective Date: These regulations are effective August 18, 1998.

Applicability Dates: For dates of applicability, see Sec. 1.1366-5,

Sec. 1.1367-3, and Sec. 1.1368-4, plus Transition Rule and Effective

Date under SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations under

section 1366, Martin Schaffer, Deane M. Burke, or David Shulman (202)

622-3070; concerning the regulations under sections 1367 and 1368,

Brenda Stewart, (202) 622-3120.

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations

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

in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507)

under control number 1545-1613. Responses to this collection of

information are mandatory.

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.

The burden for this requirement 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''.

Suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP,

Washington, DC 20224, and 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.

Books or records relating to this 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 amends 26 CFR part 1 to provide additional rules

under sections 1366, 1367, and 1368 relating to the passthrough 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.

On August 18, 1998, the IRS published in the Federal Register (63

FR 44181), a notice of proposed rulemaking (REG-209446-82) regarding

sections 1366, 1367, and 1368. Comments responding to the proposed

regulations were received. The public hearing was canceled because

there were no requests to speak. After considering the comments

received, the proposed regulations are adopted as amended by this

Treasury decision.

Explanation of Revisions and Summary of Comments

1. Aggregation of Deductions From an S Corporation With Deductions From

Other Sources

The proposed regulations provide that a shareholder of an S

corporation must aggregate its separate deductions and exclusions with

the shareholder's pro rata share of the S corporation's separately

stated deductions or exclusions in determining the allowable amount of

any deduction or exclusion that is subject to a limitation in the Code.

The proposed regulations provide an example of this rule for

property expensed under section 179. A commentator suggested that the

example implies that a shareholder must expense its pro rata share of

section 179 expense from the S corporation before it can expense any

separately acquired property.

The example is intended to illustrate that a shareholder may

expense only up to the amount allowable under section 179 in any given

year regardless of whether the property is owned individually or

through an S corporation. The example is not intended to imply that a

shareholder must elect to expense property held in an S corporation

before it can expense any separately acquired property. However, once

an S corporation elects to expense property under section 179, a

shareholder will generally elect to expense personal property only to

the extent the shareholder's pro rata share of the corporation's

section 179 expense does not exceed the shareholder's individual

limitation under section 179(b). Accordingly, no modifications have

been made to the example in the final regulations.

The commentator also requested that the final regulations provide

additional examples that illustrate the aggregation of the

shareholder's pro rata share of deductions and exclusions from an S

corporation with deductions and exclusions from other sources and the

operation of any limitations on those aggregated deductions and

exclusions. Specifically, the commentator requested that the final

regulations include an example in which the shareholder's aggregate

section 179 expenses from several passthrough sources exceeds the

maximum section 179 expense allowable. The allocation of the section

179 expense among the various sources is more appropriately addressed

in the regulations under section 179 and is beyond the scope of these

regulations. Accordingly, the final regulations do not adopt this

comment.

2. Recharacterization of Gains and Losses at the Shareholder Level

Generally, the items of an S corporation that are passed through,

and reported by, a shareholder are characterized at the corporate level

in the same manner that partnership items are characterized at the

partnership level.

However, the proposed regulations also contain exceptions to this

general rule 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 that in the hands of the shareholder or

shareholders would have produced a different character of 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.

Commentators suggested that, in the absence of a statutory

provision like section 724 in the partnership context,

[[Page 71642]]

the IRS lacked the authority to recharacterize gain or loss at the

shareholder level. Thus, the commentators asserted that the final

regulations should not adopt the recharacterization rules.

Alternatively, the commentators suggested limiting the

recharacterization rule to sales or exchanges occurring within a

specified time period.

Unlike the partnership rules, the recharacterization rules in the

proposed regulations are limited to transactions in which an S

corporation is used for a principal purpose of changing the character

of the gain or loss of contributed property. These rules are reasonable

approaches to remedying any improper attempts to utilize section

1366(b) to avoid tax. The length of time between the contribution of

the property to the S corporation and the S corporation's sale or

exchange of the property will be a factor considered in evaluating

whether the S corporation was availed of for a principal purpose of

changing the character of the gain or loss. However, the final

regulations do not adopt any particular time period. Thus, the final

regulations retain the recharacterization rules as proposed.

3. Gross Income Reporting Requirement

Section 1366(c), like section 702(c) in the partnership context,

provides for the passthrough 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

proposed regulations provide that a 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.

A commentator suggested that the rule in the proposed regulations

attempts to narrow the disclosure exception under section 6501(e) by

applying a pro rata concept with respect to a shareholder's gross

income. The commentator recommended that the final regulations not

adopt the gross income reporting rules or, alternatively, provide a de

minimis exception to the rule for certain shareholders who own minority

interests in an S corporation.

The rule in the proposed regulations parallels the rules for

determining the amount of gross income reported by a partner in a

partnership. See section 702(c); Sec. 1.702-1(c)(2). Accordingly, the

final regulations do not adopt this suggestion.

4. Carryover of Disallowed Losses Under Section 1366(d)

Section 1366(d) provides that a shareholder's disallowed losses and

deductions for any taxable year shall be treated as incurred by the

corporation in the succeeding taxable year with respect to that

shareholder. The proposed regulations provide that a shareholder's

losses and deductions disallowed under section 1366(d) are personal to

the shareholder and cannot in any manner be transferred to another

person. A commentator requested that the final regulations provide an

exception to this rule for transferees that have an identity of

investment interest or common basis with the transferor, such as when

stock is transferred incident to divorce under section 1041.

Under section 1366(d), the carryover of disallowed losses and

deductions is with respect to the shareholder whose investment limited

the items of loss or deduction. Thus, the carryover is not available to

a transferee who acquires the stock whether by sale, death, gift, or

otherwise. Accordingly, the final regulations retain the rule that

disallowed losses and deductions are nontransferable.

The proposed regulations also provide that if a shareholder

transfers all of the shareholder's stock in the corporation, any

disallowed loss or deduction is permanently disallowed. A commentator

suggested that the final regulations permit a former shareholder of an

S corporation who subsequently reacquires stock in the S corporation to

utilize the losses and deductions previously disallowed to the

shareholder.

Losses and deductions that are disallowed in any taxable year carry

over under section 1366(d) to the succeeding taxable year of the

corporation with respect to a particular shareholder. If a shareholder

completely terminates its interest in the corporation, the shareholder

will not be a shareholder in the succeeding taxable year of the

corporation and the disallowed losses would not carry over. There is no

statutory authority for the carryover of disallowed items if a

shareholder is not a shareholder in the year succeeding the

disallowance. The disallowed items of loss and deduction are amounts

that exceed the shareholder's economic investment in the corporation.

Once the shareholder terminates its interest in the corporation, it is

not necessary to preserve the shareholder's position in the

corporation. Thus, the final regulations do not adopt this

commentator's suggestion.

5. Basis in S Corporation Stock Received as a Gift

Section 1366(d)(1) limits the amount of corporate losses and

deductions that can pass through to, and be deducted by, a shareholder

to the shareholder's adjusted basis in the corporation's stock and debt

of the corporation to the shareholder.

The proposed regulations provide that, for purposes of section

1366(d)(1), a shareholder's basis in stock acquired by gift is the

basis of the stock used for purposes of determining loss under section

1015. Thus, if the fair market value of the stock exceeds the donor's

adjusted basis on the date of the gift, for purposes of section

1366(d)(1), the adjusted basis of the stock in the hands of the donee

is its adjusted basis in the hands of the donor. However, if the

donor's adjusted basis in the stock exceeds the stock's fair market

value on the date of the gift, for purposes of section 1366(d)(1), the

adjusted basis of the stock in the hands of the donee is the stock's

fair market value on the date of the gift.

One commentator argued that the basis for determining loss under

section 1015 is applicable only on the disposition of the gifted asset.

The basis for determining loss in section 1015 generally does not

affect the basis for depreciation or the deductibility of net expenses

arising out of the use or operation of the gifted asset.

The proposed regulations, however, apply the loss basis rule in

section 1015 not for purposes of determining the depreciable basis of a

gifted asset, but rather for purposes of determining the amount of

passthrough losses and deductions (including depreciation deductions

and operating losses) that are allowable to a shareholder under section

1366. The donee of loss stock cannot dispose of the stock and recognize

the loss inherent in the stock on the date of gift. If the donee could

use the donor's basis to take depreciation deductions and operating

losses of the S corporation, the donee in effect would realize the

benefit of the loss inherent in the stock.

Another commentator agreed that the basis for determining loss in

section 1015 ought to be the basis of gifted stock for purposes of

section 1366. Thus, the final regulations continue to provide that for

purposes of section 1366, the basis of stock acquired by gift is the

basis for determining loss under section 1015.

6. Allocation of Disallowed Losses in Certain Corporate Separations

The proposed regulations provide rules for the carryover of

disallowed

[[Page 71643]]

losses and deductions in the case of certain corporate reorganizations.

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. The proposed regulations provide that 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.

A commentator suggested that the term value as used in the proposed

regulations is ambiguous and that the final regulations should

specifically state ``fair market value.'' The commentator also

recommended that because the computation of fair market value

introduces a host of valuation issues into the transaction, the final

regulations should permit an allocation of disallowed losses and

deductions based on the relative adjusted bases of the assets of the

distributing and controlled corporations. Finally, the commentator

requested that the final regulations allow S corporations to allocate

disallowed losses and deductions to the controlled or distributing

corporation based upon the source of those losses and deductions. The

final regulations permit shareholders to allocate disallowed losses and

deductions according to any reasonable method, including a method based

on the relative fair market value of the shareholder's stock in the

distributing and controlled corporations immediately after the

distribution, a method based on the relative adjusted bases of the

assets in the distributing and controlled corporations immediately

after the distribution, or, in the case of losses and deductions

clearly attributable to either the distributing or controlled

corporation, a method that allocates such losses and deductions

accordingly.

7. Allocation of Tax on Passive Investment Income Under Section

1366(f)(3)

Section 1366(f)(3) provides that if any tax is imposed under

section 1375 for a taxable year, each item of passive investment income

is reduced by an amount which bears the same ratio to the amount of the

tax as the amount of the item bears to the total passive investment

income for the taxable year.

A commentator requested guidance in the final regulations on

whether the allocation of any tax imposed under section 1375 is made

based on the total gross or total net passive investment income. Under

section 1375, the amount of excess passive investment income is

allocated to the items of passive investment income based on the net

passive investment income of the corporation. The allocation of the tax

imposed on the excess passive investment income should be similarly

allocated. Accordingly, the final regulations clarify that the

allocation of any tax under section 1375 is based on the total net

passive investment income for the taxable year.

8. Accrual of Charitable Contribution Deductions Under Section

170(a)(2)

The proposed regulations under section 1366 provide that each

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

any charitable contributions paid by the corporation during the

corporation's taxable year. A commentator requested that the final

regulations clarify that separately stated items include charitable

contributions paid or deemed to be paid. The commentator suggested that

an accrual basis S corporation may elect under section 170(a)(2) to

treat charitable contributions as paid in the year prior to the year in

which the charitable contribution is actually paid.

Under section 1363(b), S corporations generally compute their

taxable income in the same manner as in the case of an individual.

However, S corporations are not permitted to take charitable

contribution deductions by virtue of the cross reference in section

1363(b)(2) to section 703(a)(2). Instead, the deductions for charitable

contributions pass through to the shareholders of the S corporation.

Individuals cannot make the election under section 170(a)(2). Treasury

and the Service believe that an S corporation also cannot make the

election under section 170(a)(2). Accordingly, the final regulations do

not adopt this suggestion.

9. Treatment of Section 108 Income

The regulations enumerate items of income (including tax-exempt

income), loss, deduction, or credit of an S corporation that must be

taken into account separately by each shareholder pursuant to section

1366(a)(1)(A). ``Tax-exempt income'' does not include income from

discharge of indebtedness excluded from income under section 108

because such income is not permanently excludible from income in all

circumstances in which section 108 applies. One commentator objected to

this treatment of section 108 income, arguing that such income is tax-

exempt and that application of section 108 at the S corporation level

pursuant to section 108(d)(7)(A) does not preclude the pass-through of

section 108 income. Another commentator, however, agreed with the

approach taken by the regulations.

Treasury and the Service continue to believe that 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 the specific rules that apply to the discharge of indebtedness

income of S corporations. Accordingly, the treatment of section 108

income is unchanged in the final regulations.

10. Adjustment to Basis of Stock

Section 1367(a) and Sec. 1.1367-1 of the proposed regulations

prescribe the order of 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.

A commentator suggested that the final regulations should provide

that life insurance premiums on policies owned by the S corporation do

not affect either a shareholder's basis in stock/debt or the

corporation's accumulated adjustments account (AAA). The commentator

further suggested that Sec. 1.1367-1(c)(2) (relating to noncapital,

nondeductible expenses) be amended to make special provision for

accounts receivable when debt is restored.

Because these comments relate to provisions in Sec. 1.1367-1 that

were not affected by the amendments contained in the proposed

regulations, the comments are not reflected in the final regulations.

11. Adjustments Required Before Determining Tax Effect of Distribution

Section 1.1368-2 of the proposed regulations 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 to the

shareholders for

[[Page 71644]]

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

One commentator interpreted Sec. 1.1368-2(a)(5) of the proposed

regulations, which prescribes the order in which adjustments are made

to the AAA for purposes of determining the source of a distribution, as

providing that the AAA is adjusted in the same order as the adjustments

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

regulations. The commentator stated that although the Small Business

Job Protection Act of 1996 (1996 Act) changed the order of the

adjustments to the basis of a share of stock, the 1996 Act did not

change the order of the adjustments to the AAA except in situations

involving a net negative adjustment (where the reductions in the

account for the taxable year exceed the increases for the taxable

year). When a net negative adjustment occurs, the AAA is adjusted to

take into account distributions before the AAA is adjusted to take into

account any net negative adjustment.

Consistent with the comment received, the final regulations make

clear that except in situations involving a net negative adjustment,

the order of adjustments to the AAA is not changed. Examples are added

to the final regulations to illustrate the effect of the 1996 Act on

the AAA ordering rules.

12. Transition Rule and Effective Date Sections 1367 and 1368

Sections 1.1367-3 and 1.1368-4 of the proposed regulations provide

that the amendments to the final regulations under section 1367 and

1368 apply only to taxable years of the corporation beginning on or

after August 18, 1998.

Commentators suggested that because the amendments to sections 1367

and 1368 under the 1996 Act are effective for taxable years beginning

after December 31, 1996, the final regulations should be effective, at

least on an elective basis, for the period beginning from the effective

date of the 1996 Act and ending on the effective date of the final

regulations.

Sections 1.1367-3 and 1.1368-4 of the final regulations reflect

this comment and provide that for taxable years beginning on or after

January 1, 1997, and before August 18, 1998, the adjustments to the

basis of a shareholder's stock and the treatment of distributions by an

S corporation, respectively, must be determined in a reasonable manner,

taking into account the statute and the legislative history. Return

positions consistent with the final regulations will be considered

reasonable.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in Executive Order 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, the notice of proposed rulemaking preceding these

regulations was submitted to the Chief Counsel for Advocacy of the

Small Business Administration for comment on its impact on small

business.

Drafting Information. The principal authors of these final

regulations are Terri A. Belanger, Deane M. Burke, 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

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

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

PART 1--INCOME TAXES

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

part as follows:

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

Par. 2. Sections 1.1366-0 and 1.1366-1 are added, Sec. 1.1366-2 is

revised, and Secs. 1.1366-3 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 passthrough 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.

[[Page 71645]]

Sec. 1.1366-3 Treatment of family groups.

(a) In general.

(b) Examples.

Sec. 1.1366-4 Special rules limiting the passthrough of certain

items of an S corporation to its shareholders.

(a) Passthrough inapplicable to section 34 credit.

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

(c) Reduction in passthrough 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 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 in the regulations 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, a calendar year 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

[[Page 71646]]

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 (as defined in 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 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 A's pro rata share,

$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 passthrough 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

[[Page 71647]]

the S corporation to the shareholder is not allowed for the taxable

year. However, any disallowed loss or deduction retains its character

and is treated as incurred by the corporation in the corporation's

first succeeding taxable year, and subsequent taxable years, with

respect to the shareholder. 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(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 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 under section

1015(a).

(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 under

section 1015(a).

(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

[[Page 71648]]

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. Such allocation

shall be made according to any reasonable method, including a method

based on the relative fair market value of the shareholder's stock in

the distributing and controlled corporations immediately after the

distribution, a method based on the relative adjusted basis of the

assets in the distributing and controlled corporations immediately

after the distribution, or, in the case of losses and deductions

clearly attributable to either the distributing or controlled

corporation, any method that allocates such losses and deductions

accordingly.

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 or more shareholders of the S corporation holds an

interest in a passthrough 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 passthrough 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 Internal Revenue

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 passthrough of certain items

of an S corporation to its shareholders.

(a) Passthrough 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 passthrough 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 net

recognized built-in gains giving rise to the tax and attributing the

character of each net recognized built-in gain to the allocable portion

of the loss.

(c) Reduction in passthrough 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 net 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. 3. 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. 4. Section 1.1367-1 is amended as follows:

1. The paragraph 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.

[[Page 71649]]

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 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. 5. Sec. 1.1367-3 is revised to read as follows:

Sec. 1.1367-3 Effective date and transition rule.

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

2 and Example 5, and (j) apply only to taxable years of the corporation

beginning on or after August 18, 1998. For taxable years beginning

before January 1, 1994, and taxable years beginning on or after January

1, 1997, and before August 18, 1998, the basis of a shareholder's stock

must be determined in a reasonable manner, taking into account the

statute and legislative history. Except for Sec. 1.1367-1(f), (h)

Example 2 and Example 5, and (j), return positions consistent with

Secs. 1.1367-1 and 1.1367-2 are reasonable for taxable years beginning

before January 1, 1994. Return positions consistent with Sec. 1.1367-

1(f), (h) Example 2 and Example 5, and (j) are reasonable for taxable

years beginning on or after January 1, 1997, and before August 18,

1998.

Par. 6. 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 (2) are added.

[[Page 71650]]

2. The entry for Sec. 1.1368-2(a)(4) is revised.

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

4. The entry for Sec. 1.1368-2(d) is revised.

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) * * *

(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. 7. 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

includible 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 net

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

taxable year shall not be taken into account.

* * * * *

Par. 8. Section 1.1368-2 is amended as follows:

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

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

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

3. The paragraph 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) * * *

(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 S 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)(i) of this section for

the taxable year;

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

(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)(iii) of this section;

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

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

(iv) The AAA is decreased by any net negative adjustment (as

defined in section 1368(e)(1)(C)(ii)); 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. 9. Section 1368-3 is amended as follows:

1. The heading for Example 1 is revised.

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

through Example 9, respectively.

3. Example 2 is redesignated as Example 3.

[[Page 71651]]

4. The heading for newly redesignated Example 3 is revised.

5. New Example 2, Example 4, and Example 5 are added.

The revisions and additions 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. The balance in Corporation S's AAA is $100. 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.

Example 3. Distributions by S corporations with C corporation

earnings and profits for taxable years beginning before January 1,

1997. * * *

Example 4. Distributions by S corporations with earnings and

profits and no net negative adjustment for taxable years beginning

on or after August 18, 1998. (i) Corporation S, an S corporation,

has accumulated earnings and profits of $1,000 and a balance in the

AAA of $2,000 on January 1, 2001. S's sole shareholder B holds 100

shares of stock with a basis of $20 per share as of January 1, 2001.

On April 1, 2001, S makes a distribution of $1,500 to B. B's pro

rata share of the income earned by S during 2001 is $2,000 and B's

pro rata share of S's losses is $1,500. For the taxable year ending

December 31, 2001, S does not have a net negative adjustment as

defined in section 1368(e)(1)(C). S does not make the election under

section 1368(e)(3) and Sec. 1.1368-1(f)(2) to distribute its

earnings and profits before its AAA.

(ii) The AAA is increased from $2,000 to $4,000 for the $2,000

of income earned during the 2001 taxable year. The AAA is decreased

from $4,000 to $2,500 for the $1,500 of losses. The AAA is decreased

from $2,500 to $1,000 for the portion of the distribution ($1,500)

to B that does not exceed the AAA.

(iii) As of December 31, 2001, B's basis in his stock is $10

($20 + $20 ($2,000 income/100 shares)--$15 ($1,500 distribution/100

shares)--$15 ($1,500 loss/100 shares).

Example 5. Distributions by S corporations with earnings and

profits and net negative adjustment for taxable years beginning on

or after August 18, 1998. (i) Corporation S, an S corporation, has

accumulated earnings and profits of $1,000 and a balance in the AAA

of $2,000 on January 1, 2001. S's sole shareholder B holds 100

shares of stock with a basis of $20 per share as of January 1, 2001.

On April 1, 2001, S makes a distribution of $2,000 to B. B's pro

rata share of the income earned by S during 2001 is $2,000 and B's

pro rata share of S's losses is $3,500. For the taxable year ending

December 31, 2001, S has a net negative adjustment as defined in

section 1368(e)(1)(C). S does not make the election under section

1368(e)(3) and Sec. 1.1368-1(f)(2) to distribute its earnings and

profits before its AAA.

(ii) The AAA is increased from $2,000 to $4,000 for the $2,000

of income earned during the 2001 taxable year. Because under section

1368(e)(1)(C)(ii) and Sec. 1.1368-2(a)(ii), the net negative

adjustment is not taken into account, the AAA is decreased from

$4,000 to $2,000 for the portion of the losses ($2,000) that does

not exceed the income earned during the 2001 taxable year. The AAA

is reduced from $2,000 to zero for the portion of the distribution

to B ($2,000) that does not exceed the AAA. The AAA is decreased

from zero to a negative $1,500 for the portion of the $3,500 of loss

that exceeds the $2,000 of income earned during the 2001 taxable

year.

(iii) Under Sec. 1.1367-1(c)(1), the basis of a shareholder's

share in an S corporation stock may not be reduced below zero.

Accordingly, as of December 31, 2001, B's basis per share in his

stock is zero ($20 + $20 income--$20 distribution--$35 loss).

Pursuant to section 1366(d)(2), the $15 of loss in excess of B'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 B.

* * * * *

Par. 10. Sec. 1.1368-4 is revised 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 1.1368-3

Example 2, Example 4, and Example 5, 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. Section 1.1368-1(e)(2), Sec. 1.1368-2(a)(5), and

Sec. 1.1368-3 Example 2, Example 4, and Example 5 apply only to taxable

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

taxable years beginning before January 1, 1994, and taxable years

beginning on or after January 1, 1997, and before August 18, 1998, the

treatment of distributions by an S corporation to its shareholders must

be determined in a reasonable manner, taking into account the statute

and legislative history. Except with regard to the deemed dividend rule

under Sec. 1.1368-1(f)(3), Sec. 1.1368-1(e)(2), Sec. 1.1368-2(a)(5),

and Sec. 1.1368-3 Example 2, Example 4, and Example 5, return positions

consistent with Secs. 1.1368-1, 1.1368-2, and 1.1368-3 are reasonable

for taxable years beginning before January 1, 1994. Return positions

consistent with Secs. 1.1368-1(e)(2), 1.1368-2(a)(5), and 1.1368-3

Example 2, Example 4, and Example 5 are reasonable for taxable years

beginning on or after January 1, 1997, and before August 18, 1998.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 11. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Par. 12. In Sec. 602.101, paragraph (b) is amended by adding an

entry for 1.1366-1 to the table to read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(b) * * *

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

Current OMB

CFR part or section where identified and described control No.

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

* * * * *

1.1366-1................................................... 1545-1613

* * * * *

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

[[Page 71652]]

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

Approved: December 13, 1999.

Jonathan Talisman,

Acting Assistant Secretary of the Treasury.

[FR Doc. 99-32697 Filed 12-21-99; 8:45 am]

BILLING CODE 4830-01-U