AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on
Proposed Regulations under Section 108(b)
Developed by the
S Corporation Taxation Technical Resource Panel
Approved by the
Tax Executive Committee
Submitted to the
Internal Revenue Service
January 13, 2009
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on Proposed Section 108 Regulations
EXECUTIVE SUMMARY
We are writing to offer comments regarding the proposed regulations addressing the
reduction of tax attributes for S corporations under section 108 that were issued on
August 6, 2008 (the Proposed Regulations). 1 The Proposed Regulations provide a
method under which an S corporation reduces its tax attributes under section 108(b) for
taxable years in which the S corporation has discharge of indebtedness income that is
excluded from gross income under section 108(a). While we commend the Service for
clarifying the manner in which an S corporation reduces its tax attributes, we believe the
method as promulgated will in certain circumstances, as discussed below, produce
inequitable results. In addition, we request that any future regulations address some of
the uncertainties discussed below not addressed in the Proposed Regulations. We
appreciate the opportunity to offer our views and welcome the opportunity to discuss this
further or provide any additional comments upon your request.
Statutory Framework
Generally, gross income includes income from the discharge of indebtedness (DOI). 2
However, section 108(a) provides that DOI income is excluded from gross income if,
among other things, the discharge occurs when the taxpayer is insolvent.3 If DOI income
is excluded from a taxpayer's gross income, section 108(b) requires that the amount so
excluded must be applied to reduce tax attributes, such as NOLs, certain carryovers, and
basis in assets. Generally, section 108(b) requires that NOLs be reduced first. Section
108(b)(4)(A) provides that the reduction to tax attributes must be made after the
determination of the income tax imposed for the taxable year of the discharge.
In the case of an S corporation, section 108(d)(7)(A) provides, in part, that the rules under
section 108(a) for the exclusion of DOI income and the reduction of attributes are applied
at the corporate level. Section 108(d)(7)(A) also states that any amount excluded under
section 108(a) is not taken into account under section 1366(a). Section 1366(a) provides
rules regarding the pass-through of items of income, loss, deduction, or credit to the
shareholders of an S corporation based upon each shareholder's proportionate interest in
such corporation. Under section 1366(d)(1), a shareholder is prohibited from taking into
account losses and deductions in excess of the adjusted basis in the shareholder's S
corporation stock and the adjusted basis of any indebtedness of the S corporation to the
shareholder. Any loss or deduction disallowed by section 1366(d)(1) will be treated as
incurred by the corporation in the succeeding taxable year with respect to that
1
Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended,
and to the related regulations promulgated thereunder.
2
Section 61(a)(12).
3
Section 108(a)(1)(B).
2
shareholder.4 Section 108(d)(7)(B) generally provides that any loss or deduction which is
disallowed for the taxable year of the discharge under section 1366(d)(1) (Suspended
Loss) is treated as a NOL for the S corporation.
Overview of the Proposed Regulations
The Proposed Regulations provide detailed rules governing the method in which an S
corporation is required to reduce its tax attributes under section 108(b) for the taxable
years in which the S corporation has DOI income that is excluded from gross income
under section 108(a). Specifically, the Proposed Regulations provide rules addressing the
allocation of excess Deemed NOL (defined below) following section 108(b)'s tax
attribute reductions, the character of the excess Deemed NOL allocated to the
shareholders, and information sharing requirements.
As a preliminary step, under the Proposed Regulations, the S corporation is required to
determine all of its tax attributes for the year of the discharge. In determining such
attributes, the Proposed Regulations make clear that any Suspended Loss, including prior
year losses of S corporation shareholders, disallowed under section 1366(d)(1) is treated
as an NOL tax attribute (Deemed NOL) of the S corporation for the taxable year of the
discharge.5 Once all of the tax attributes for the year of the discharge are determined, the
S corporation is then required to reduce its tax attributes, beginning with its Deemed
NOL, by the amount of DOI income excluded.6 If any Deemed NOL remains following
the section 108(b) attribute reduction, such excess Deemed NOL must be allocated to the
S corporation shareholders as a Suspended Loss for the year of the discharge. 7 Only
individual shareholders that have a Suspended Loss in excess of what would have been
their proportionate share of DOI income (the Separate Excess Loss) under section
1366(a) had it not been excluded under section 108(a) are allocated any excess Deemed
NOL.8 The shareholder's proportionate share of the excess Deemed NOL is equal to its
Separate Excess Loss divided by the sum of all shareholders' Separate Excess Losses.9
Potential for Inequity
The attribute reduction mechanism adopted by the Proposed Regulations generally works
to hold each shareholder accountable for a portion of the total reduction in attributes
equivalent to the shareholder's proportionate ownership interest in the S corporation.
However, there are circumstances under which such mechanism will lead to inequitable
results whereby one or more shareholders of the S corporation will shoulder a portion of
4
Section 1366(d)(2)(A).
Proposed reg. section 1.108-7(d)(1).
6
Section 108(b)(2)(A).
7
Proposed reg. section 1.108-7(d)(2)(i).
8
Proposed reg. section 1.108-7(d)(2(ii)(B) and (C).
9
Proposed reg. section 1.108-7(d)(2)(ii)(B). See prop. reg. section 1.108-7(e), Example 5 (illustrating how
the Proposed Regulations can operate to reduce tax attributes in a manner consistent with each
shareholder's proportionate ownership interest).
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the total reduction in tax attributes disproportionate to such shareholder's or shareholders'
proportionate interest in the S corporation.
The following is an example illustrating the inequitable results that may arise by
employing the tax attribute reduction mechanism as set forth in the Proposed Regulations.
Assume that during the entire calendar year 2008, A, B, and C each own equal shares of
the stock in X, a calendar year S corporation. As of December 31, 2008, A, B, and C
each have a zero stock basis and X does not have any indebtedness to A, B, or C. For the
2008 taxable year, X excludes from gross income $30,000 of DOI income under section
108(a)(1)(A). The DOI income (had it not been excluded) would have been allocated
$10,000 to A, $10,000 to B, and $10,000 to C under section 1366(a). B has $20,000 of
Suspended Loss from prior years and C has $30,000 of Suspended Loss from prior years.
The $50,000 of Suspended Loss is treated as a Deemed NOL.10
Under section 108(b)(2)(A), X's $30,000 of excluded DOI income reduces the $50,000
Deemed NOL to $20,000. Therefore, X has a $20,000 excess Deemed NOL to allocate
to its shareholders. Because A has no Separate Excess Loss, none of the $20,000 excess
Deemed NOL is allocated to A. Each of B and C has a Separate Excess Loss amount of
$10,000 and $20,000, respectively. Thus, the sum of all shareholders' Separate Excess
Loss amounts is $30,000. Pursuant to the Proposed Regulations, X will allocate
$6,666.66 of the $20,000 excess Deemed NOL to B ($20,000 x $10,000/$30,000) and
$13,333.33 of the $20,000 excess Deemed NOL to C ($20,000 x $20,000/$30,000).
Shareholders B and C treat their allocated share of the excess Deemed NOL as a
Suspended Loss. Accordingly, at the beginning of 2009, A has no loss carryovers, B has
$6,666.66 of loss carryover under section 1366(d), and C has $13,333.33 of loss
carryover under section 1366(d).
In the instant case, because A has no Suspended Loss, B and C have to carry the burden
of the entire attribute reduction which is inconsistent with the well accepted principle that
S corporation shareholders should take into account their pro rata share of the
corporation's items of income, loss, deduction, or credit. Simply put, to the extent
shareholders of an S corporation do not all have suspended losses at least equal to the
amount of DOI income that would have been allocated to them under section 1366(a) had
the income not been excluded from income, those shareholders with suspended losses in
excess of their proportionate share of the DOI income will bear a disproportionate burden
of attribute reduction. It is very common that S corporation shareholders will not have
suspended losses in proportion to their ownership. Some shareholders may have utilized
basis in indebtedness to absorb losses, some may have purchased shares more recently
and thus had higher outside stock basis, some may have received stock from a decedent.
The inequity can also arise when the Suspended Loss of all shareholders is less than the
DOI income. For example, assume that during the entire calendar year 2007, A and B
10
Section 108(d)(7)(B).
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each own 50 percent of the stock in X, a calendar year S corporation. As of December 31,
2007, A and B each have a zero stock basis and X does not have any indebtedness to A or
B. X also owns land with a basis of $80,000 and a fair market value of $200,000. For
the 2007 taxable year, X excludes from gross income $30,000 of DOI income under
section 108(a)(1)(A). The DOI income (had it not been excluded) would have been
allocated $15,000 to A and $15,000 to B under section 1366(a). A has $10,000 of
Suspended Loss from prior years and B has no Suspended Loss from prior years. The
$10,000 of Suspended Loss is treated as a Deemed NOL.11 On October 1, 2009, X sells
the land for $200,000 to an unrelated party.
Under section 108(b)(2)(A), X's $30,000 of excluded DOI income reduces the $10,000
Deemed NOL to $0. Under section 108(b)(2)(E), the remaining $20,000 of excluded
DOI income reduces the $80,000 basis in the land to $60,000. Following the attribute
reduction, X has no excess Deemed NOL to allocate to its shareholders. As a
consequence of the reduction in basis, each of A and B recognizes an additional $10,000
of gain on the sale of land.
Similar to the prior example, the application of the Proposed Regulations to the instant
case produces a consequence that is inconsistent with the general principle, as set forth
above, of S corporations. Here, A, who had the Suspended Loss, surrenders his loss and
recognizes an additional $10,000 of gain while B, who had no Suspended Loss, suffers
only to the extent of the $10,000 of additional gain.
Consequently, we believe that in light of the examples above, it is vital from a policy
perspective that the tax attribute reduction rules in the Proposed Regulations be modified
in a manner such that all shareholders share tax attribute reductions in proportion to their
ownership interests in the S corporation. We realize the Service may be constrained by
the statute; however, we do not believe it is appropriate to issue regulations that produce
inequitable results and are contrary to the overall premise that all items of income, gain,
loss, deduction or credit be allocated equally to each share.
Request for Clarification
When final regulations are issued addressing attribute reduction, we would also
appreciate clarification regarding the following matters:
Reduction of Subchapter C Attributes
Generally, section 1371(b)(1) provides that no carryforward and carryback items arising
in a taxable year for which a corporation is a C corporation may be carried to a taxable
year for which the corporation is an S corporation. However, certain exceptions exist
under which certain tax attributes of a C corporation are carried over to an S year. For
example, under section 1374(b), NOLs, capital losses, business credits, and minimum tax
11
Section 108(d)(7)(B).
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credits of a C corporation may be carried over to an S year to offset the amount of the S
corporation's recognized built-in gain.
On the other hand, section 108(d)(7) states that the provisions of sections 108(a), (b), (c)
and (g) are to be applied at the corporate level in the case of an S corporation. That
section appears to be a more specific rule with respect to the application of section 108
than the general rule of section 1371. Accordingly, it appears that C corporation
attributes carrying forward into an S corporation year would be available for attribute
reduction. These C corporation attributes are clearly existent during the S year: if S
status were to terminate, the resulting C corporation should be able to avail itself of any
attributes for which the carryforward period has not yet expired. The final regulations
should clarify that for purposes of section 108, any C corporation attributes such as NOL,
credit or capital loss carryforwards can be reduced under section 108(b).
Ordering Rule
To the extent C corporation NOLs carrying forward into an S corporation year are
eligible for reduction under section 108(b), the regulations should clarify which losses are
reduced first -- (1) losses suspended under section 1366(d) or (2) C corporation NOL
carryforwards from pre S election years. Section 108(b)(2)(A) and section 1366(d)(2)(A)
appear to require that losses suspended under section 1366(d) would be reduced first.
Sections 108(b)(2)(A) and 108(b)(4)(B) require that net operating losses for the taxable
year of discharge be reduced first and then any net operating loss carryforwards be
reduced next (in the order generated). Section 1366(d)(2)(A) states that any loss or
deduction which is disallowed under section 1366(d)(1) shall be treated as incurred by
the corporation in the succeeding taxable year with respect to that shareholder.
Accordingly, it appears that losses suspended under 1366(d) for any year (no matter how
long ago the corporation actually took the deduction that has been suspended) would be
considered an NOL for the taxable year of discharge and thus be reduced prior to any C
corporation NOLs for which the carryforward period had not yet expired.
Application to Losses Suspended Under Section 465 or Section 469
Regulations should also clarify that section 108(b) and section 108(d)(7) apply
exclusively to losses suspended pursuant to section 1366(d)(1) and do not apply to losses
suspended under sections 465 or 469.
Eliminate Dependence on Shareholder Reporting
The Proposed Regulations create a rule that causes one shareholder's tax position to be
affected by the tax position of another shareholder. Since shareholders are required to
report to the S corporation the amount of their suspended losses in order to apply the
Proposed Regulations, an error in calculating stock basis in the year of DOI discovered in
a later year will require that the S corporation and all shareholders amend their returns. It
would be preferable for the Service to craft a rule that minimizes dependence on
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information furnished by individual shareholders. Crafting the regulation in this way
would (1) mitigate the occurrence of miscalculations with respect to tax attribute
reductions and the allocation of excess Deemed NOLs resulting from inaccurate
information provided by the shareholders; (2) lessen the information reporting burden for
both the shareholders and the S corporation; and (3) reduce the amount of paperwork
received by the Service.
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