PRACTISING LAW INSTITUTE
TAX PLANNING FOR DOMESTIC & FOREIGN
PARTNERSHIPS, LLCs, JOINT VENTURES &
OTHER STRATEGIC ALLIANCES 2012
__________________________________________________
THE S CORPORATION RULES AND THE USE OF S
CORPORATIONS AS ACQUISITION VEHICLES
__________________________________________________
December 2012
Mark J. Silverman
Steptoe & Johnson LLP
Washington, D.C.
Aaron P. Nocjar
Steptoe & Johnson LLP
Washington, D.C.
Copyright © 2013, Mark J. Silverman and Aaron P. Nocjar, All Rights Reserved.
Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations,
advice (if any) relating to federal taxes that is contained in this communication (including
attachments) is not intended or written to be used, and cannot be used, for the purpose of (1)
avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or
recommending to another party any plan or arrangement addressed herein.
I.
INTRODUCTION ...............................................................................................................1
II.
BECOMING AN S CORPORATION .................................................................................4
A.
Eligibility .................................................................................................................5
1.
Domestic Corporation ..................................................................................5
2.
Ineligible Corporation ..................................................................................6
3.
a.
In General.........................................................................................6
b.
Prior to the Small Business Act of 1996 ..........................................7
(i)
Affiliated Subsidiaries Not Permitted ..................................7
(ii)
Inactive Subsidiaries Permitted............................................8
(iii)
Transitory Stock Ownership ................................................8
(iv)
Nonaffiliated Subsidiaries Permitted ...................................8
Type of Shareholder .....................................................................................9
a.
In General.........................................................................................9
b.
Trusts as Shareholders ...................................................................10
(i)
In General...........................................................................10
(ii)
Qualified Subchapter S Trust .............................................12
(iii)
Electing Small Business Trust ...........................................13
(a)
In General...............................................................13
(b)
Beneficiaries ..........................................................14
(c)
Potential Current Beneficiaries ..............................15
(d)
Acquisition By Purchase ........................................17
(e)
ESBT Election .......................................................18
(f)
Taxation of ESBTs .................................................18
(g)
Ceasing To Be an ESBT ........................................19
c.
ESOPs ............................................................................................19
d.
Ineligible Shareholder Issues .........................................................21
(i)
Transitory Ownership by Ineligible Shareholders .............21
(ii)
Incorporating a Partnership ................................................21
- ii 4.
Number of Shareholders ............................................................................22
5.
One Class of Stock Requirement ...............................................................25
a.
In General.......................................................................................25
b.
Differences in Voting Rights .........................................................25
c.
Identical Rights with Respect to Distribution and Liquidation
Proceeds .........................................................................................26
d.
e.
(i)
General Rule ......................................................................26
(ii)
Exceptions to General Rule ...............................................27
6.
State Law Requirements for Payment and
Withholding of Income Tax ...................................27
(b)
Buy-Sell and Redemption Agreements ..................28
(c)
Varying Interests ....................................................28
Stock Taken Into Account .............................................................28
(i)
Restricted Stock .................................................................29
(ii)
Deferred Compensation Plans............................................29
(iii)
Straight Debt ......................................................................30
Special Rules for Debt Instruments, Obligations, and Other Similar
Arrangements .................................................................................30
(i)
In General...........................................................................30
(ii)
Debt Arrangements Treated as Equity under General
Principles............................................................................30
(iii)
f.
(a)
(a)
Short-Term Unwritten Advances ...........................30
(b)
Proportionately Held Obligations ..........................31
Call Options, Warrants, or Other Similar Instruments ......31
(a)
Options Issued to Lenders ......................................32
(b)
Options Issued to Employees .................................32
(c)
Call Option Safe Harbor Relief..............................32
(iv)
Convertible Debt ................................................................32
(v)
The Straight Debt Safe Harbor Rules ................................33
Miscellaneous Provisions...............................................................34
(i)
Inadvertent Terminations ...................................................34
(ii)
Effective Dates ...................................................................34
Permitted Taxable Year .............................................................................34
a.
Current Guidance in General .........................................................34
- iii b.
c.
d.
B.
(i)
Pre-1983 .............................................................................34
(ii)
1983-1986 ..........................................................................34
Current Guidance in Detail ............................................................35
(i)
Calendar Year or Business Purpose Year ..........................35
(ii)
Section 444 Fiscal Year .....................................................35
(iii)
Grandfathered Fiscal Year .................................................36
(iv)
Procedural Requirements Relating to Permitted Taxable
Years ..................................................................................37
(a)
Treasury Regulations .............................................37
(b)
Other Guidance ......................................................37
Failure to Adopt, Change To, or Retain Permitted Year ...............38
(i)
Validity of S Election.........................................................38
(ii)
Termination of S Election ..................................................39
The S Election ........................................................................................................40
1.
2.
III.
Prior Guidance ...............................................................................34
Making the Election ...................................................................................40
a.
Timing ............................................................................................40
b.
Consent Required ...........................................................................41
c.
Qualification as a Small Business Corporation .............................42
New Election After Termination ...............................................................43
a.
Five-Year Waiting Period ..............................................................43
b.
Successor Defined ..........................................................................44
c.
New Election after Invalid Election or Retroactive Revocation of
Election ..........................................................................................45
EFFECTS OF AN S ELECTION ......................................................................................45
A.
Pass-Through of S Corporation Items....................................................................45
1.
In General...................................................................................................45
2.
Operation of the Pass-Through Rules ........................................................46
3.
Taxable Year of Inclusion ..........................................................................48
4.
Allocation of Items ....................................................................................48
a.
Per-Share Per-Day Rule .................................................................48
b.
Election To Close the Books..........................................................49
(i)
Termination of Shareholder’s Interest ...............................49
- iv (ii)
5.
B.
Dispositions of Substantial Amounts of Stock ..................50
c.
Allocation in an S Termination Year .............................................51
d.
Special Allocations ........................................................................51
Limitations on Deductibility of Losses ......................................................52
a.
Allocation of Loss Items ................................................................52
b.
Section 1366(d) ..............................................................................52
(i)
In General...........................................................................52
(ii)
Basis Adjustments ..............................................................53
(iii)
Carryover of Disallowed Losses ........................................53
c.
At-Risk Limitation – Section 465 ..................................................55
d.
Passive Loss Limitation – Section 469 ..........................................56
Basis Adjustments ..................................................................................................57
1.
2.
3.
4.
Stock ..........................................................................................................58
a.
Increases .........................................................................................58
b.
Decreases .......................................................................................59
Debt ............................................................................................................60
a.
Decreases .......................................................................................60
b.
Increases (or Restoration) ..............................................................60
Timing of Adjustments ..............................................................................62
a.
Stock ..............................................................................................62
b.
Debt ................................................................................................62
Ordering Rules for Basis Adjustments ......................................................62
a.
Stock ..............................................................................................62
(i)
General Rules .....................................................................63
(a)
Taxable Years Beginning Before January 1, 1997
(i.e., Prior to the Small Business Act of 1996) ......63
(b)
Taxable Years Beginning on or after January 1,
1997, and Before August 18, 1998 ........................63
(c)
Taxable Years Beginning on or after August 18,
1998........................................................................64
(ii)
Elective Ordering Rule ......................................................64
(iii)
Effects of Change to Stock Basis Adjustment Rules .........64
(iv)
Comparison to Partnership Interest Basis Adjustment Rules65
-vb.
C.
Debt ................................................................................................65
Distributions...........................................................................................................65
1.
2.
Corporate-Level Effects .............................................................................65
a.
Appreciated Property .....................................................................65
b.
Depreciated Property .....................................................................66
c.
Other Corporate-Level Effects .......................................................66
Shareholder Effects ....................................................................................67
a.
Most S Corporation Distribution Rules Apply to Section 301(c)
Distributions Only..........................................................................68
b.
S Corporation Having No Earnings and Profits .............................68
c.
S Corporation Having Earnings and Profits...................................69
(i)
First Layer ..........................................................................69
(ii)
Second Layer .....................................................................69
(iii)
Third Layer ........................................................................69
(iv)
S Corporations with Previously Taxed Income .................69
(v)
The Accumulated Adjustments Account ...........................70
(a)
Increases to the AAA .............................................70
(b)
Decreases to the AAA ............................................71
Items Other Than Distributions .................71
ii)
For Distributions ........................................72
iii)
For Distributions in Excess of the AAA ....72
iv)
Distributions of Money and Loss Property 72
(c)
Effect of Debt Basis Adjustments ..........................72
(d)
Ordering Rules for Adjustments to the AAA ........73
(e)
Adjustments to AAA for Redemptions,
Reorganizations, Divisions, and Year Terminations74
(f)
(vi)
i)
i)
Redemptions ..............................................74
ii)
Reorganizations..........................................74
iii)
Corporate Divisions under Section
368(a)(1)(D) ...............................................75
iv)
Year Terminations .....................................75
Which S Corporations Must (Should) Maintain an
AAA? .....................................................................75
Elections Relating to AAA Distribution Rules ..................75
- vi -
(vii)
d.
D.
Election to Distribute Earnings and Profits First ...75
(b)
Election to Make a Deemed Dividend ...................76
(c)
Election to Forego PTI ...........................................76
Planning Issue for S Corporation Having Earnings and
Profits and Insufficient AAA .............................................76
Special Elections ............................................................................76
(i)
Termination of Shareholder’s Interest ...............................76
(ii)
Dispositions of Substantial Amounts of Stock ..................77
Structuring Financing.............................................................................................77
1.
2.
E.
(a)
Maximizing Basis ......................................................................................77
a.
Contributions from Shareholders ...................................................77
b.
Loans from Shareholders ...............................................................78
(i)
Taxation of Shareholder S Corporation Debt ....................78
(ii)
Contribution of Shareholder S Corporation Debt ..............80
c.
Back-to-Back Loans.......................................................................81
d.
Shareholder Guarantees .................................................................82
e.
Sales Financing ..............................................................................83
Creating Priority for Investors ...................................................................83
Special Effects of an S Election .............................................................................84
1.
Cancellation of Indebtedness Income and Sections 108 and 1366 ............84
2.
Passive Activity Losses Under Section 469...............................................87
3.
Determination of Alternative Minimum Taxable Income .........................88
4.
Charitable Contributions of Appreciated Property ....................................89
F.
Coordination with Subchapter C of the Code ........................................................91
G.
Treatment of S Corporations as Shareholders of C Corporations..........................91
H.
1.
General Tax Treatment of S Corporations as Shareholders.......................91
2.
S Corporations as Owners of 80 Percent-Owned Subsidiaries ..................93
Qualified Subchapter S Subsidiaries ......................................................................93
1.
Introduction ................................................................................................94
2.
Electing QSub Status .................................................................................94
a.
IRS Notice 97-4 – Pre-October 10, 2000 Elections .......................94
b.
Final QSub Regulations and Form 8869 ........................................95
c.
Extensions to Elect QSub Status ....................................................96
- vii d.
IV.
Subsequent QSub Election Apparently Not Prohibited .................96
3.
The Effect of a QSub Election ...................................................................96
4.
Termination of a QSub Election ..............................................................100
5.
QSubs and Tax-Free Reorganizations .....................................................103
ADDITIONAL EFFECTS OF CONVERTING TO AN S CORPORATION ................105
A.
Corporate Level Tax on Built-In Gains – Section 1374 ......................................105
1.
Purpose.....................................................................................................105
2.
General Rule ............................................................................................105
3.
Computation of Tax .................................................................................106
4.
Recognized Built-In Gain ........................................................................107
5.
Recognized Built-In Loss ........................................................................108
6.
Limitation – Net Unrealized Built-In Gain ..............................................109
7.
a.
In General.....................................................................................109
b.
Subsequent Adjustments to NUBIG ............................................110
Scope of Provision ...................................................................................114
a.
S Corporations Covered ...............................................................114
b.
Assets Covered.............................................................................114
8.
NOL Carryovers , Capital Loss Carryovers, and other Loss and Deduction
Carryovers ................................................................................................117
9.
Installment Sales ......................................................................................118
10.
Partnership Interests .................................................................................119
a.
Overview ......................................................................................119
b.
Look-Through Rules: (Treas. Reg. § 1.1374-4(i)(1)) .................120
c.
Disposition of a Partnership Interest: (Treas. Reg. § 1.13744(i)(3)) ..........................................................................................121
d.
Special Rules ................................................................................122
(i)
Section 704(c) Gain or Loss ............................................122
(ii)
Disposition of Distributed Property (Treas. Reg. § 1.13744(i)(7)) ..............................................................................122
11.
Effective Date of Section 1374 ................................................................123
12.
Regulations Cover Additional Issues .......................................................124
13.
Recordkeeping Issues...............................................................................125
14.
Additional Planning Issues ......................................................................125
- viii 15.
B.
V.
Old Capital Gains Tax .............................................................................126
Corporate Level Tax on Passive Investment Income - Section 1375 ..................127
1.
In General.................................................................................................127
2.
Definitions................................................................................................128
3.
Rules Relating to C Corporation Subsidiaries .........................................128
4.
Special Rules Relating to QSubs .............................................................129
5.
Waiver of Section 1375 Tax ....................................................................129
6.
Planning To Avoid Section 1375 Tax ......................................................129
C.
LIFO Recapture ...................................................................................................129
D.
Investment Credit Recapture................................................................................133
E.
Estimated Taxes ...................................................................................................133
CEASING TO BE AN S CORPORATION ....................................................................133
A.
Terminating the S Election ..................................................................................133
1.
Revocation ...............................................................................................133
2.
Generating Passive Investment Income ...................................................134
a.
b.
3.
Gross Receipts .............................................................................134
(i)
Sale or Exchange of Capital Assets .................................135
(ii)
Exclusions and Deferrals .................................................136
Passive Investment Income ..........................................................136
(i)
Royalties ..........................................................................136
(ii)
Rents ................................................................................137
(iii)
Dividends .........................................................................137
(a)
In General.............................................................137
(b)
Dividends from Affiliated Subsidiaries ...............137
(iv)
Interest..............................................................................139
(v)
Annuities ..........................................................................139
(vi)
Sale of “Stock or Securities”............................................139
(vii)
Special Rules for Dealers and Patrons .............................139
c.
Accumulated Earnings and Profits...............................................140
d.
Effective Date of Termination for Passive Income......................141
e.
Planning To Avoid Termination for Passive Income ..................141
By Ceasing To Be a Small Business Corporation ...................................141
- ix B.
What Is Not a Termination ..................................................................................142
C.
Inadvertent Terminations .....................................................................................143
D.
Treatment of S Termination Years ......................................................................144
E.
VI.
VII.
Definition .................................................................................................144
2.
Effect ........................................................................................................144
Post-Termination Distributions............................................................................145
SUMMARY OF OTHER RELEVANT PROVISIONS ..................................................146
A.
Investment Interest Deduction Limitation – Section 163(d)................................147
B.
Acquisitions to Avoid Tax – Section 269 ............................................................147
C.
Limitation on the Use of the Cash Method of Accounting – Section 448 ...........148
D.
Reduction of Paperwork Burden on Certain S Corporations ...............................148
COMPARISON OF S CORPORATIONS WITH OTHER ENTITIES AS
ACQUISITION VEHICLES ...........................................................................................148
A.
Factors That Encourage the Use of S Corporations .............................................148
1.
Repeal of the “General Utilities” Doctrine ..............................................148
2.
Noncorporate Rate Compared to the Corporate Rate ..............................149
a.
Ordinary Income Rates ................................................................149
b.
Capital Gains Rates ......................................................................149
c.
Reduction of the Double Tax on C Corporation Earnings ...........149
3.
Former C Corporations Taxed on Built-In Gain ......................................150
4.
The Alternative Minimum Tax ................................................................150
B.
Types of Pass-Through Entities ...........................................................................151
C.
Advantages of S Corporations .............................................................................152
D.
VIII.
1.
1.
Compared with C Corporations ...............................................................152
2.
Compared with Partnerships ....................................................................153
Disadvantages of S Corporations .........................................................................154
ACQUIRING AND CONVERTING C CORPORATIONS TO S CORPORATION
STATUS ..........................................................................................................................155
A.
B.
Making a C Corporation Eligible .........................................................................155
1.
Purchase of Stock .....................................................................................155
2.
Recapitalization........................................................................................155
3.
Divisive D Reorganization .......................................................................156
Changing Taxable Years To Obtain Maximum Benefit ......................................157
-x-
C.
IX.
1.
New Corporations ....................................................................................157
2.
Existing Corporations ..............................................................................157
3.
Acquisition of Existing C Corporation ....................................................157
Effect of Conversion on the Corporation .............................................................158
S CORPORATION AS AN ACQUISITION VEHICLE ................................................158
A.
B.
Special Concerns with S Corporations ................................................................158
1.
Newly-Formed S Corporation..................................................................158
2.
Avoiding Termination ..............................................................................160
3.
Other Considerations ...............................................................................160
Particular Transaction Structures Involving S Corporations ...............................161
1.
Asset Acquisitions by S Corporations .....................................................161
a.
Taxable Asset Acquisitions..........................................................161
b.
Tax-Free Asset Acquisitions ........................................................161
(i)
2.
Effect on Election ............................................................162
(a)
Merger ..................................................................162
(b)
Consolidation .......................................................163
(c)
C Reorganization .................................................163
(d)
Acquisitive D Reorganization ..............................163
(ii)
Allocation of Income or Loss in the Acquisition Year ....164
(iii)
Carryover of Corporate Attributes ...................................164
(iv)
Pre-Reorganization Distributions.....................................165
(v)
Distributions Pursuant to the Merger ...............................165
(vi)
Post-Reorganization Distributions ...................................165
(vii)
LIFO Recapture ...............................................................166
Stock Acquisitions by S Corporations .....................................................166
a.
b.
Taxable Stock Acquisitions .........................................................167
(i)
Effect on Election Prior to the Small Business Act of 1996167
(ii)
Effect on Election Pursuant to the Small Business Act of
1996..................................................................................168
(iii)
Allocation of Income or Loss in the Acquisition Year ....169
Tax-Free Stock Acquisitions........................................................169
(i)
Availability of Tax-Free Treatment .................................169
(ii)
Effect on Election ............................................................170
- xi -
c.
(iii)
Pre-Reorganization Distributions.....................................170
(iv)
Distributions Contemporaneously with the Reorganization170
(v)
Post-Reorganization Distributions ...................................170
Alternatives to S Corporation Acquiring Stock of Target ...........171
(i)
(ii)
X.
Brother “S” – Sister “C” Merger .....................................171
(a)
Subchapter C Issues .............................................171
(b)
Subchapter S Issues..............................................172
Brother “S” – Sister “S” Structure ...................................172
S CORPORATION AS A TARGET ...............................................................................172
A.
Asset Dispositions................................................................................................172
1.
Taxable Asset Dispositions – Direct Sale of Assets ................................172
2.
Taxable Asset Dispositions – Taxable Merger ........................................173
3.
4.
B.
a.
Installment Sale Issues .................................................................173
b.
Effect on Election ........................................................................175
c.
Allocation of Income (Loss) in Year of Disposition ...................175
Deemed Asset Dispositions – Section 338(h)(10) ...................................175
a.
The Election .................................................................................175
b.
Consequences of the Election ......................................................176
c.
Effective Dates .............................................................................178
d.
Deemed Ownership of Stock Held by a QSST ............................178
Tax-Free Asset Dispositions ....................................................................178
a.
Availability of Reorganization Provisions ...................................178
b.
Effect on Election ........................................................................179
c.
Allocation of Income (Loss) in Year of Disposition ...................179
d.
Carryovers ....................................................................................179
e.
Suspended Losses ........................................................................180
f.
Pre-Reorganization Distributions.................................................180
g.
Distributions Pursuant to the Reorganization ..............................180
h.
Post-Reorganization Distributions ...............................................181
Stock Dispositions ...............................................................................................181
1.
Sales of Stock ...........................................................................................181
a.
Effect on Election ........................................................................181
- xii -
2.
C.
b.
Allocation of Income (Loss) Items in the Year ...........................182
c.
Amount and Character of Gain or Loss on the Sale ....................182
d.
Pre-Sale Distributions ..................................................................182
e.
Post-Sale Distributions.................................................................182
f.
Section 338(g) Election................................................................183
g.
Section 1411 Net Investment Income Tax ...................................183
Redemptions ............................................................................................184
a.
Effect on Election ........................................................................184
b.
Allocation of Income or Loss in the Year ....................................184
c.
Distributions.................................................................................184
(i)
Section 302(a) Redemptions ............................................184
(ii)
Section 302(d) Redemptions ............................................185
Complete Liquidation ..........................................................................................186
1.
General Tax Consequences ......................................................................186
2.
Effect on Election ....................................................................................187
3.
Allocation of Income and Loss in Year of Liquidation ...........................187
THE S CORPORATION RULES AND THE USE OF S CORPORATIONS AS
ACQUISITION VEHICLES
I.
INTRODUCTION
Congress introduced the S corporation1 when it added subchapter S to the Internal
Revenue Code in the Technical Amendments Act of 1958, P.L. 85-866. Congress intended to
aid closely held business owners by combining the non-tax advantages of limited liability with
the tax advantages of the pass through of entity-level income. In order to avoid several technical
traps created by the Technical Amendments Act of 1958, Congress revamped subchapter S of the
Code in 1982 by enacting the Subchapter S Revision Act of 1982, P.L. 97-354 (the “Revision
Act of 1982”). Congress made another wholesale change to subchapter S of the Code by
enacting the Small Business Job Protection Act of 1996, P.L. 104-188 (the “Small Business Act
of 1996”), largely in an effort to increase the number of small businesses eligible to be treated as
S corporations. Congress also made changes to subchapter S of the Code in the American Jobs
Creation Act of 2004, P.L. 108-357 (the “2004 JOBS Act”) and the Gulf Opportunity Zone Act
of 2005, P.L. 109-135 (the “GO-Zone Act”), both of which simplify the eligibility requirements
for becoming an S corporation and address other miscellaneous technical issues. Subsequent
Congresses have tinkered with the rules as well.
The use of the S corporation by closely held business owners has been growing since the
Tax Reform Act of 1986, P.L. 99-514 (the “TRA of 1986”).2 In the TRA of 1986, Congress (i)
The term “S corporation” as used herein means any qualifying corporation for which an
S election is in effect. Section 1361(a)(1). Unless otherwise indicated or clear from context,
references to “Section” are to the Internal Revenue Code of 1986, as amended from time to time
(the “Code”). “Section” also refers to portions of this Outline, and “section” refers to provisions
of Public Laws and legislation. References to “subchapter S of the Code” are to subchapter S,
chapter 1, subtitle A of the Code. References to “subchapter C of the Code” are to subchapter C,
chapter 1, subtitle A of the Code. References to “subchapter K of the Code” are to subchapter K,
chapter 1, subtitle A of the Code.
1
“The [Internal Revenue Service’s Statistics of Income Bulletin] also reported on trends
among corporations for tax years 1992 through 2000, including the continued growth of returns
for S corporations. While the number of taxable corporation returns filed has decreased annually
by an average of about 1.2 percent, tax returns filed by S corporations...have increased on an
annual basis by about 9.5 percent.” Tax Statistics, AGI Triples Among Top 400 Taxpayers,
Number of S Corporations Rise, IRS Says, 124 Daily Tax Report G-7 (June 27, 2003). “[T]he
use of the [S corporation] has soared and is projected to keep growing. For 1995, there
were...2,161,000 [S corporations]...; for 2001 the respective numbers had risen to...3,023,000;”
for 2002 the respective numbers had risen to 3,200,000, while by 2009 the totals are expected to
be 4,136,000. Burgess Raby & William Raby, New Tax Laws and Choice of the Small Business
Entity, 2003 Tax Notes 113-6 (June 11, 2003); CCH Standard Federal Tax Reports, CCH, Vol.
92, Issue No. 30, Report No. 30 (July 14, 2005); see also Staff of J. Comm. on Taxation, 108th
Cong., Background and Proposals Relating to S Corporations (Comm. Print 2003). As of 2003,
(Continued …)
2
-2completely repealed the General Utilities doctrine,3 (ii) enacted the corporate alternative
minimum tax, and (iii) reduced the top individual income tax rate to a level below the top
corporate tax rate. In the years since the TRA of 1986, the limited liability company (“LLC”) is
beginning to become the entity of choice for many newly organized, closely held businesses,
because it too generally combines the non-tax advantage of limited liability and the tax
advantage of the pass-through treatment of entity-level tax items (i.e., no entity-level tax).4
Despite the growing popularity of the LLC, the S corporation remains attractive because the tax
rules applicable to S corporations are considered to be simpler than the tax rules applicable to
partnerships (under which most multi-member domestic LLCs operate).5 Also, an S corporation
remains the only entity that offers pass-through treatment to existing closely held businesses
taxed as C corporations6 without the immediate imposition of two levels of tax upon conversion
from C corporation status. Furthermore, an S corporation is the only entity that offers passthrough treatment to businesses that must operate in corporate form, such as certain financial
“[M]ore than half of all corporations now file as S corporations.” IR-2004-9 (Jan. 14, 2004)
(discussing highlights of the Fall 2003 Statistics of Income Bulletin).
3
The General Utilities doctrine generally permitted a corporation to avoid recognition of
gain or loss on a distribution with respect to stock of appreciated or depreciated property. As a
result of the complete repeal of the doctrine, corporations generally must recognize gain on a
distribution of appreciated property unless the distribution qualifies as a nontaxable distribution
under Section 337(a). See Sections 311(b), 336(a), 337(a). Furthermore, corporations now
generally must recognize loss on the distribution of certain depreciated property if the
distribution is in complete liquidation of the corporation and it is made to a shareholder who is
not an 80-percent distributee. See Sections 311(a), 336(d).
4
Absent certain elections, a domestic LLC owned by a single member is disregarded as
an entity separate from its owner for federal tax purposes, and a domestic LLC owned by more
than one member is treated as a partnership for federal tax purposes. See Treas. Reg. §
301.7701-3. Different classification rules apply to foreign LLCs. See id.
5
For example, the following partnership rules are not present in subchapter S of the
Code: (i) the allocation rules of Section 704(b) and (c); (ii) the distribution rules of Sections 731
through 737; (iii) the “hot assets” character rules of Section 751; and (iv) the special rules
regarding basis adjustments under Sections 734(b), 743(b), and 754. See Staff of J. Comm. on
Taxation, 108th Cong., Background and Proposals Relating to S Corporations (Comm. Print
2003). “Interestingly...between 1996 and 2000, growth in the number of S corporations has
exceeded growth in the number of limited liability companies taxed as partnerships. We believe
this is due in no small measure to the complexity of the partnership system compared with S
corporations.” Hearing on H.R. 714, H.R. 1498, and H.R. 1896 Before the Subcomm. on Select
Revenue Measures of the House Comm. on Ways and Means, 108th Cong. (June 19, 2003)
(statement of Gregory F. Jenner, Deputy Asst. Secr. for Tax Policy, Dept. of Treasury).
The term “C corporation” means a corporation that is not an S corporation. Section
1361(a)(2).
6
-3institutions.7 Finally, although an LLC taxed as a partnership and an S corporation both
generally pass their entity-level tax items to their owners without an entity-level tax, only S
corporations may use the Code provisions applicable to tax-free corporate reorganizations. Thus,
the rules regarding S corporations continue to be important.
The Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-27 (the
“Jobs and Growth Act of 2003”), reduced the individual shareholder-level tax applicable to
dividends and the individual shareholder-level tax applicable to net capital gains to 15 percent
generally for taxable years beginning after December 31, 2002 and not beginning after December
31, 2008. These reduced rates were extended to taxable years beginning before 2011 by the Tax
Increase Prevention and Reconciliation Act of 2005, P.L. 109-222. The American Taxpayer
Relief Act of 2012 made these capital gains and dividend rates permanent, effective for tax years
beginning after Dec. 31, 2012, and added a 20 percent rate for high income taxpayers. The 20
percent rate applies only to amounts above those taxed at the lower rates. The American
Taxpayer Relief Act of 2012 also added a 3.8 percent net investment income tax, which applies
in addition to capital gain taxes.
The reduction of such taxes reduces one of the largest disadvantages of conducting
business as a C corporation – and, correspondingly, one of the largest attractions of pass-through
treatment provided by S corporations and entities taxed as partnerships. The Jobs and Growth
Act of 2003 also reduced the top individual income tax rate applicable to ordinary income to 35
percent,8 which aligned the top individual income tax rate with the top corporate tax rate. This
reduction in the top individual income tax rate applicable to ordinary income increased the
incentive to conduct business through a pass-through entity, such as an S corporation or an entity
taxed as a partnership, rather than through a C corporation. The American Taxpayer Relief Act
of 2012 raised the marginal rate to 39.6 percent for income above $400,000 for singles and
$450,000 for marrieds-filing-jointly and surviving spouses, effective for tax years beginning
after December 31, 2012. This rate is higher than the top corporate tax rate. These changes may
alter the equation that closely held business owners use in determining which type of entity will
best serve their needs.
7
See Hearing on H.R. 714, H.R. 1498, and H.R. 1896 Before the Subcomm. on Select
Revenue Measures of the House Comm. on Ways and Means, 108th Cong. (June 19, 2003)
(statement of Donald C. Alexander on behalf of U.S. Chamber of Commerce and statement of
C.R. Cloutier, Chairman of Independent Community Bankers of America). A study published in
the Daily Tax Report on January 2, 2003 indicates that closely held financial institutions (e.g.,
small banks and thrifts) are converting to S corporation status at an increasing rate. See Number
of S Corporation Banks, Thrifts Rising, Grant Thornton Says, Daily Tax Report, Jan. 2, 2003, at
G-1.
8
This reduction in individual income tax rates is effective for taxable years beginning
after December 31, 2002 and not beginning after December 31, 2010. See section 107 of the
Jobs and Growth Act of 2003.
-4This Outline will explore and analyze various transactions involving S corporations and
special issues that arise in connection with those transactions. To do so, the Outline first will
review the law relating to S corporations, past and present.9 This review will include a
discussion of the following S corporation issues:
II.

The requirements for a corporation to be treated as an S corporation.

Situations in which an S corporation may be required to pay corporatelevel taxes.

The method by which S corporation tax items are taken into account by
the corporation and its shareholders.

The effect of such tax items on basis in stock and debt held by
shareholders.

The use of such basis to absorb S corporation losses.

The taxation of S corporation distributions at the corporate and
shareholder levels.

The treatment of wholly owned subsidiaries of S corporations.

The events that cause a corporation to cease being an S corporation.

The consequences of a corporation ceasing to be an S corporation.

The advantages and disadvantages of S corporation status in relation to
partnership or C corporation status.
BECOMING AN S CORPORATION
The benefits of subchapter S of the Code are available only if an S election is in effect.
In planning transactions involving S corporations, pressure is accordingly placed upon making or
confirming and preserving a valid S election. In this regard, compliance with the eligibility
requirements and the mechanics of filing an S election are essential. This Section reviews the
eligibility requirements and filing mechanics for S corporations.
9
This Outline will discuss prior law with respect to S corporations because, among other
reasons, the validity of an S election made under old law remains important. For example, the
potential consequences of an invalid S election filed years ago under old law may result in the
imposition of corporate-level taxes. The possible imposition of such taxes presumably would be
relevant to persons considering an acquisition of the purported S corporation. In addition, a
discussion of prior law promotes an understanding of current law.
-5A.
Eligibility
An S election may only be made by a “small business corporation,” which is an entity
meeting certain requirements described below. Section 1361(b)(1). In general, a small business
corporation must (i) be a domestic corporation, (ii) not be an ineligible corporation, (iii) have
only certain types of shareholders, (iv) have no more than 100 shareholders, and (v) have
outstanding only one class of stock. Each of these five requirements raises numerous issues,
which are discussed below. In addition, this Section addresses (i) whether the use of a particular
taxable year by a small business corporation is a condition for S corporation eligibility and (ii)
other issues related to an S corporation’s taxable year.
1.
Domestic Corporation
The entity must be classified as a corporation for federal tax purposes.10 Treas. Reg. §§
1.1361-1(c), 301.7701-2; see PLR 200548012 (ruling that a corporation remained a small
business corporation under Section 1361(b) despite technically violating its articles of
incorporation, because the corporation timely corrected the violation and always remained
organized under its applicable state corporate statute); see also PLR 200835002; PLR
200539005; PLR 200535017; PLR 200315020 (ruling that a corporation remained a small
business corporation under Section 1361(b) despite a state-law administrative dissolution and
subsequent reincorporation because the corporation continued to qualify as a corporation for
federal tax purposes under Treas. Reg. § 301.7701-2 throughout the entire period). Thus, the
Internal Revenue Service (the “Service”) has ruled that a state law limited liability partnership
that checks the box to be treated as an association taxable as a corporation for federal tax
purposes under Treas. Reg. § 301.7701-3 may make an S election. See PLR 200326023; PLR
200215006; cf. PLR 200201005 (ruling that a general partnership classified as an association
taxable as a corporation for federal tax purposes may make an S election). An LLC that validly
elects under Treas. Reg. § 301.7701-3 to be treated as an association taxable as a corporation
10
An eligible entity that makes a timely and valid S election also is treated as having
made an election to be classified as an association taxable as a corporation as of the effective
date of the S election. Treas. Reg. § 301.7701-3(c)(1)(v)(C). This rule applies to S elections
filed on or after July 20, 2004. Treas. Reg. § 301.7701-3(h)(3). Entities that filed S elections
before July 20, 2004, may also rely on this rule. Id. The purpose of this rule is to eliminate the
rather common situation in the past where an entity (not automatically treated as a corporation
for federal tax purposes) hoping to be treated as an S corporation made a timely S election but
inadvertently failed to elect to be treated as an association taxable as a corporation. Prior to the
new rule, this failure technically rendered the entity ineligible to make an S election. In such
cases, taxpayers were faced with the need to obtain relief through the private letter ruling
process, when possible. See, e.g., PLR 200516008. If an eligible entity fails to make a timely S
election as well as failing to make an election to be classified as an association taxable as a
corporation as of the intended effective date of the S election, the entity may request joint relief
for such late elections under either Rev. Proc. 2007-62, 2007-41 I.R.B. 786, or Rev. Proc. 200448, 2004-2 C.B. 172.
-6also may make an S election. See PLR 200315010. It also appears that a state law limited
partnership that validly elects under Treas. Reg. § 301.7701-3 to be treated as an association
taxable as a corporation may make an S election. See PLR 200330004.11
An entity classified as a corporation for federal tax purposes also must be treated as a
“domestic” corporation for federal tax purposes in order to make an S election. Section
1361(b)(1). The regulations define a “domestic corporation” by reference to Treas. Reg. §
301.7701-5 as a corporation created or organized in the United States or under the laws of the
United States or of any state or territory. Treas. Reg. § 1.1361-1(c); see PLR 201126023 (ruling
that a foreign corporation that became a domestic corporation via a state law corporate
domestication that also constituted a reorganization under Section 368(a)(1)(F) was eligible to
make an S election).
2.
Ineligible Corporation
A corporation that is an “ineligible corporation” is not a “small business corporation” and
thus cannot be an S corporation. Section 1361(b)(1). The term “ineligible corporation” is
defined in Section 1361(b)(2) and Treas. Reg. § 1.1361-1(d).
a.
In General
Section 1361(b)(2) defines an “ineligible corporation” as any corporation that is:
(i) a financial institution using the reserve method of accounting for bad debts described in
Section 585;12 (ii) an insurance company subject to taxation under subchapter L; (iii) a Section
936 corporation; or (iv) a DISC or former DISC. See also Treas. Reg. § 1.1361-1(d). Prior to
the enactment of the Small Business Act of 1996, the list of ineligible corporations also included
a member of an affiliated group (determined under Section 1504 without regard to Section
11
Note, however, that the Service will not rule on whether such a state law limited
partnership has more than one class of stock for purposes of Section 1361(b)(1)(D), which
provides that an S corporation may have only one class of stock. See Rev. Proc. 2004-3, 2004-1
I.R.B. 114; infra Section II.A.5. (discussing the one class of stock requirement).
12
Section 1361(g) permits a bank that changes from the reserve method of accounting for
bad debts for its first taxable year it is an S corporation to elect to take into account all resulting
adjustments under Section 481 in the last taxable year it was a C corporation. See also Rev.
Proc. 2008-18, 2008-10 I.R.B. 573 (providing additional guidance regarding such election). If
no such election were made in that situation, such Section 481 adjustments would be taken into
account by the shareholders of the S corporation (through their pro rata shares of S corporation
income or loss) and by the S corporation itself for, barring other reasons, the built-in gains tax of
Section 1374. Section 1361(g) applies to taxable years beginning after December 31, 2006. See
Section 233 of the U.S. Troop Readiness, Veterans’ Care, Katrina Recovery, and Iraq
Accountability Appropriations Act, 2007, P.L. 180-28 (the “Iraq Act of 2007”).
-71504(b))13 and banks (as defined in Section 581) not using a reserve method of accounting for
bad debts.14 As a result, a corporation could not be an S corporation if it owned 100 percent of
the stock of a C corporation.15 The Small Business Act of 1996 removed such corporations from
the list of “ineligible corporations.” Thus, the Small Business Act of 1996 allowed corporations
that were affiliated under Section 1504 (without regard to Section 1504(b)) to be small business
corporations and to elect S status if they satisfied the remaining S corporation requirements.
Accordingly, an S corporation now may own up to 100 percent of the stock of a C
corporation. The S corporation may not, however, be included in a consolidated federal income
tax return because it is not an “includible corporation” for purposes of Section 1504(a), and thus
it cannot be a member of an affiliated group. See Section 1504(b)(8). For example, if an S
corporation holds 100 percent of the stock of a C corporation that, in turn, holds 100 percent of
the stock of another C corporation, the two C corporations may elect to file a consolidated return,
but the S corporation may not join in the election. See Section 1504(b)(8); H.R. Conf. Rep. No.
737, 104th Cong., 2d Sess. 244 (1996).
b.
Prior to the Small Business Act of 1996
(i)
Affiliated Subsidiaries Not Permitted
Prior to the Small Business Act of 1996, acquisitions and dispositions of S corporations
and their assets required special planning to ensure that the S corporation did not become a
member of an affiliated group (determined under Section 1504 without regard to Section
1504(b)). As a practical matter, because Section 1361(b)(1) prevents a small business
corporation from having corporate shareholders, the restriction on affiliation generally came into
play when an S corporation was acquiring another corporation.
13
Under Section 1504, a corporation generally is a member of an affiliated group if it
owns stock in another “includible corporation” possessing at least 80 percent of the voting power
and at least 80 percent of the value of such corporation’s outstanding stock. Section 1504(a)(2).
14
Section 1315 of the Small Business Act of 1996 (amending Section 1361(b)(2) of the
Code) permitted banks (as defined in Section 581 of the Code) that are not using a reserve
method of accounting for bad debts to elect S status.
15
Section 1504(b) excludes certain corporations (e.g., foreign corporations) from the
general definition of “includible corporation,” and thus from the affiliated group. Section
1504(b) did not include S corporations prior to the Small Business Act of 1996. Thus, prior to
the Small Business Act of 1996, if an S corporation acquired the parent of a consolidated group,
the S corporation would become the new parent of the affiliated group but at the price of losing
its S status.
-8(ii)
Inactive Subsidiaries Permitted
However, prior to the Small Business Act of 1996, an exception existed for stock in
certain inactive subsidiaries. Under Former Section 1361(c)(6) (repealed by section 1308(d)(1)
of the Small Business Act of 1996), a corporation was not treated as a member of an affiliated
group by reason of its stock ownership in a subsidiary if the subsidiary had not begun business at
any time on or before the close of the taxable year and the subsidiary did not have gross income
for such period. The determination of when a corporation begins business was based on all the
facts and circumstances of the particular case. Treas. Reg. § 1.1361-1(d)(3)(ii). Mere
organizational activities – such as obtaining a corporate charter or incorporating to reserve a
corporate name – were not sufficient. Id. However, a corporation was considered to have begun
business if its activities had advanced to the extent necessary to establish the nature of its
business operations, such as acquiring operating assets necessary for the intended operation. Id.
The election terminated on the first day that the subsidiary either begins business or realizes
gross income under its method of accounting. Treas. Reg. § 1.1361-1(d)(3)(iii).
(iii)
Transitory Stock Ownership
For purposes of determining whether a corporation remained a small business
corporation, transitory ownership of stock in a subsidiary (i.e., stock meeting the Section 1504(a)
tests) could be disregarded. In Rev. Rul. 72-320, 1972-1 C.B. 270, the Service ruled that
momentary ownership of all of the stock in another corporation acquired in connection with a
divisive reorganization under Section 368(a)(1)(D) did not terminate the S election of the
transferor corporation. The ruling specifically notes that the S corporation never contemplated
more than "momentary" control of the newly formed spun-off corporation. In Rev. Rul. 73-496,
1973-2 C.B. 313, the Service disregarded a 30-day period during which an S corporation
controlled a subsidiary prior to the liquidation of the subsidiary under former Section 334(b)(2).
These rulings provided needed flexibility in planning the acquisition or division of a business by
an S corporation.
In Haley Bros. Construction Corp. v. Commissioner, 87 T.C. 498 (1986), the Tax Court
strongly stated in dictum that the Service's 30-day rule was inconsistent with the statute. The
Court expressly reserved its opinion on whether "momentary" ownership would terminate an S
election. Despite Haley Bros. Construction Corp., the Service, relying on both Rev. Rul. 72-320
and Rev. Rul. 73-496, continued to issue rulings that ignored transitory stock ownership. See,
e.g., TAM 9245004; PLR 9414016; PLR 9321006; PLR 9320009; PLR 9319041; PLR 9319018;
PLR 9319016; PLR 9319002; PLR 9318024; PLR 9312025; PLR 9312019; PLR 9311022; PLR
9306017; PLR 9303021.
(iv)
Nonaffiliated Subsidiaries Permitted
Note that, prior to the Small Business Act of 1996, a small business corporation could
own stock in another corporation so long as such ownership did not meet the 80 percent
vote/value test of Section 1504(a). This could be accomplished, for example, if the S corporation
owned only 79 percent of the voting power of a target corporation. For example, an S
corporation could own all of the common stock of a subsidiary corporation as long as another
-9person owned voting preferred stock in the subsidiary that entitled such person to a 21 percent
vote on all matters. See PLR 8441009.
Moreover, although Former Section 1361(b)(2)(A) (repealed by section 1308 of the
Small Business Act of 1996) precluded a corporation that was a member of an affiliated group
(determined under Section 1504 without regard to Section 1504(b)) from being an S corporation,
an S corporation could be a member of a controlled group (i.e., brother-sister corporations were
not prevented from making S elections). For example, one of two corporations that are wholly
owned by an individual could elect S status even though the corporations constituted a controlled
group under Section 1563(a)(2).
3.
Type of Shareholder
a.
In General
Under Section 1361(b)(1)(B), the stock of a small business corporation can be held only
by certain types of shareholders:

an individual16 (other than a nonresident alien individual17) (Section
1361(b)(1)(B), (C));

an estate of an individual,18 including an estate of an individual in
bankruptcy (Sections 1361(b)(1)(B), 1361(c)(3); CCA 200217003),
although the Service may take the position that an estate is in reality a
testamentary trust if the administration of the estate is unduly extended
(see Old Virginia Brick Co. v. Comm’r, 367 F.2d 276 (4th Cir. 1966));

certain tax-exempt organizations (Section 1361(b)(1)(B), (c)(6)), although
such tax-exempt organizations (other than employee stock ownership
plans (“ESOPs”)) must take into account all tax items attributable to their
16
An LLC wholly owned by a single individual member may hold stock of a small
business corporation if the LLC is disregarded as an entity separate from its individual owner for
federal tax purposes (i.e., the LLC does not elect to be treated as an association taxable as a
corporation under Treas. Reg. § 301.7701-3). See PLR 200927014.
17
However, a nonresident alien individual may join with other permissible S corporation
shareholders to conduct business in a form analogous to an S corporation through the use of a
partnership. See Treas. Reg. § 1.701-2(d) ex. 2.
18
A trust to which an election under Section 645 (relating to certain grantor trusts) is in
effect is treated for purposes of subtitle A of the Code as part of the grantor’s estate. Section
645(a). Thus, such a trust can be a permissible shareholder. See, e.g., Treas. Reg. § 1.13611(k)(1) ex. 3(ii).
- 10 investment in an S corporation in computing their unrelated business
taxable income (Section 512(e)); and

certain trusts (as discussed below).
Note that a federally recognized Indian tribal government is not a permissible shareholder. See
Rev. Rul. 2004-50, 2004-22 I.R.B. 1.
Also note that, for purposes of subchapter S of the Code, stock that is issued in
connection with the performance of services and that is substantially nonvested is not treated as
outstanding stock; correspondingly, the holder of that stock is not treated as a shareholder solely
by reason of holding such stock unless the holder makes a Section 83(b) election. Treas. Reg. §
1.1361-1(b)(3).
Further, certain stock in an S corporation bank held by a director of that bank (“restricted
bank director stock”) generally is not taken into account as outstanding stock for purposes of
subchapter S of the Code. Section 1361(f). If a director receives a distribution (not in part or
full payment in exchange for stock) from an S corporation with respect to restricted bank director
stock, the amount of such distribution will be includible in the gross income of the director and
deductible by the S corporation. Section 1368(f). These provisions apply to taxable years
beginning after December 31, 2006. See Section 8232 of the Iraq Act of 2007.
b.
Trusts as Shareholders
The Small Business Act of 1996 significantly expanded the eligibility of trusts to be
shareholders of an S corporation. The Service has issued final regulations to conform to this
expansion of the trust eligibility rules.
(i)
In General
Grantor Trusts: A trust all of which is treated as owned by a single individual who is a
citizen or resident of the United States (i.e., a grantor trust) is a permissible shareholder. Section
1361(c)(2)(A)(i), (B)(i); Treas. Reg. § 1.1361-1(h)(1)(i); see, e.g., PLR 201039010; PLR
200652006; PLR 200235009; PLR 200235008; PLR 200235007; see also PLR 200942020 (subtrusts created by grantor trust are permissible shareholders of an S corporation provided the
individual grantor is treated as the owner of the sub-trusts). A grantor trust which continues in
existence after the death of the deemed owner is permissible for a period of two years after the
death of the deemed owner. Section 1361(c)(2)(A)(ii); Treas. Reg. § 1.1361-1(h)(1)(ii).19
19
Prior to the Small Business Act of 1996, a grantor trust which continued in existence
after the death of the deemed owner was a permissible shareholder, but only for a period of 60
days (two years if the entire corpus was included in the deemed owner’s gross estate). Former
Section 1361(c)(2)(A)(ii); Former Treas. Reg. § 1.1361-1(h)(1)(ii).
- 11 Testamentary Trusts: A trust to which stock is transferred pursuant to the terms of a
will is a permissible shareholder, but only for a period of two years from the date of transfer.
Section 1361(c)(2)(A)(iii); Treas. Reg. § 1.1361-1(h)(1)(iv)(A).20 Similarly, a trust to which
stock is transferred pursuant to the terms of an electing trust (as defined in Treas. Reg. § 1.6451(b)(2)) during the election period (as defined in Treas. Reg. § 1.645-1(b)(6)), or deemed to be
distributed at the close of the election period pursuant to Treas. Reg. § 1.645-1(h)(1), is a
permissible shareholder, but only for a period of two years from the day the stock is transferred
or deemed distributed to the trust. Treas. Reg. § 1.1361-1(h)(1)(iv)(B).21
Voting Trusts: A trust created primarily to exercise the voting power of the stock
transferred to it (i.e., a voting trust) is a permissible shareholder. Section 1361(c)(2)(A)(iv);
Treas. Reg. § 1.1361-1(h)(3)(v); PLR 201226019; PLR 9410010.
IRAs: By contrast, a trust that qualifies as an individual retirement account generally is
not a permissible shareholder. Rev. Rul. 92-73, 1992-2 C.B. 224. Similarly, the Tax Court has
held that a Roth individual retirement account is not an eligible S corporation shareholder. See
Taproot Administrative Services, Inc. v. Comm’r, 133 T.C. 202 (2009), aff’d, 679 F.3d 1109
(9th Cir. 2012).22
Foreign Trusts: Finally, any of the preceding permissible trusts is deemed not to be a
permissible shareholder if it qualifies as a foreign trust. Section 1361(c)(2)(A).
20
Prior to the Small Business Act of 1996, a trust to which stock was transferred pursuant
to the terms of a will was a permissible shareholder, but only for a period of 60 days from the
date of transfer. Former Section 1361(c)(2)(A)(iii); Former Treas. Reg. § 1.1361-1(h)(1)(iv).
The preamble to the final regulations states: “[T]he purpose of section 645 is to create
parity between electing trusts and wills. In furtherance of this purpose, the commentator
reasoned that if an electing trust transfers or is deemed to distribute S corporation stock to a new
trust, the new trust should be a permitted shareholder for the 2-year period beginning on the day
the stock is transferred or deemed distributed to the new trust. The final regulations adopt the
commentator’s suggestion to clarify that a testamentary trust also includes a trust that receives S
corporation stock from an electing trust.” T.D. 9078 (July 16, 2003).
21
22
The 2004 JOBS Act added Section 1361(c)(2)(A)(vi) to allow a bank to make an S
election where the bank’s stock is held in a trust that qualifies as an individual retirement account
(including a Roth individual retirement account). See section 233(a), P.L. 108-357. Note that
this provision only applies to bank stock held in an individual retirement account on October 22,
2004, the date of the enactment of the 2004 JOBS Act. Thus, this provision has limited
application. For example, this provision does not permit a bank to be an S corporation where (i)
any portion of its stock is held in a trust that qualifies as an individual retirement account and (ii)
such stock was transferred to the trust after October 22, 2004. The GO-Zone Act slightly
broadened this rule to apply to depository holding companies as well as banks. See Section
413(a)(1), P.L. 109-135.
- 12 (ii)
Qualified Subchapter S Trust
In General: A qualified subchapter S trust (“QSST”) is a permissible type of
shareholder if the beneficiary makes an election under Section 1361(d)(2) to treat the trust as a
grantor trust and to treat the beneficiary of the trust as the owner of the S corporation stock held
in trust. Section 1361(d)(1); Treas. Reg. § 1.1361-1(h)(1)(iii). A QSST is a trust with terms that
require that (i) during the life of the current income beneficiary, there shall be only one income
beneficiary of the trust, (ii) any corpus distributed during the life of the current income
beneficiary may be distributed only to such beneficiary, (iii) the income interest of the current
income beneficiary in the trust shall terminate on the earlier of such beneficiary’s death or the
termination of the trust, and (iv) upon the termination of the trust during the life of the current
income beneficiary, the trust shall distribute all of its assets to such beneficiary. Section
1361(d)(3)(A). A QSST must also distribute currently all of its income (as defined in Treas.
Reg. § 1.643(b)-1) to one individual who is a citizen or resident of the United States. Section
1361(d)(3)(B); Treas. Reg. § 1.1361-1(j)(1)(i); see PLR 201122003 (ruling that each income
beneficiaries’ share of a trust constituted a separate independent share of the trust under Section
663(c) and, provided that the income was distributed currently, each separate share qualified as a
QSST under Section 1361(d)(3)); PLR 201119005 (ruling that division of QSST into two
separate shares resulted in separate trusts for Section 1361(d) purposes, and that, provided all net
income for each share was distributed currently to the applicable income beneficiary and each
was administrated as a QSST, each share of the trust qualified as a QSST under Section
1361(d)(3) during the life of the income beneficiary for that share); PLR 200402009 (ruling that,
because the distribution of cash from an S corporation to two QSSTs should be allocated to
principal under state law, the receipt of such cash is not receipt of income by the trusts for
purposes of the income distribution requirement of Section 1361(d)(3)(B); as a result, a
distribution of such cash to the QSST beneficiaries is not required); PLR 200234062 (ruling that,
because the distribution of LLC interests from an S corporation to a QSST is allocable to the
principal of the QSST under state law, the receipt of such interests is not receipt of income by the
trust for purposes of the income distribution requirement of Section 1361(d)(3)(B); as a result, a
distribution of the LLC interests to the QSST beneficiary is not required); see also PLR
200451021 (ruling that, because proceeds from a partial redemption of S corporation stock do
not constitute fiduciary accounting income under state law, allocation of such proceeds to the
principal of a QSST and the retention of such proceeds by the QSST will not cause the QSST to
violate the income distribution requirement of Section 1361(d)(3)(B)).
A trust can be treated as a QSST notwithstanding that the beneficiary may be treated as
the owner of the trust. PLR 9420030. A provision in a trust agreement that authorizes the
trustee to accumulate trust income in the event that the trust does not hold any shares of an S
corporation does not preclude the trust’s qualification as a QSST. Rev. Rul. 92-20, 1992-1 C.B.
301. Similarly, a provision in a trust agreement that requires the trustee to distribute the income
for the period after the last distribution date and before the date of the beneficiary’s death to
either the estate or to the successor beneficiary does not preclude the trust’s qualification as a
QSST. Rev. Rul. 92-64, 1992-2 C.B. 214. However, a trust that qualifies as a charitable
remainder trust under Section 664 cannot qualify as a QSST. Rev. Rul. 92-48, 1992-1 C.B. 301.
- 13 The 2004 JOBS Act amended Section 1361(d)(1) to clarify that, for purposes of the atrisk and passive activity rules,23 the disposition of S corporation stock by a QSST is treated as a
disposition of such stock by the beneficiary of the QSST.24 See section 236, P.L. 108-357. This
amendment clarifies that a beneficiary of a QSST may deduct losses suspended under the at-risk
and passive activity rules with respect to S corporation stock held by the QSST when the QSST
disposes of such stock.
Election Procedures: A QSST election must be made separately with respect to each
corporation whose stock is held by the trust. Treas. Reg. § 1.1361-1(j)(6). The current income
beneficiary of the trust must make the election by signing and filing a statement with the service
center with which the corporation files its income tax return. Id. A QSST election generally
must be made within 2 months and 16 days after the transfer of S corporation stock to the trust.
Id. If a C corporation has made an S election and, before the election is effective, stock of that
corporation is transferred to a trust, the QSST election must be made within 2 months and 16
days after the transfer of such stock to the trust. Id. If the trust holds C corporation stock and
then such corporation makes an S election, the 2-month-and-16-day period starts on either the
effective date of the S election (in case of a retroactive S election effective date) or the date the S
election is made (in case of a prospective S election effective date). Id. A QSST election may
be effective no earlier than 15 days and 2 months before the date on which the election is filed.
Id.
(iii)
Electing Small Business Trust
(a)
In General
For tax years beginning after December 31, 1996, an electing small business trust
(“ESBT”) is a permissible type of shareholder. Section 1361(c)(2)(v), (e). An ESBT is used to
facilitate family financial planning by allowing an individual to establish a trust to hold S
corporation stock and to “spray” current or accumulated income among the beneficiaries of the
trust.
23
For a general description of the at-risk rules and passive activity rules, see infra Section
III.A.5. See also Prop. Treas. Reg. § 1.465-66 (providing that losses previously suspended by
the at-risk rules will be taken into account upon a disposition of the relevant at-risk activity);
Allen v. Comm’r, 55 T.C.M. (CCH) 641 (1988) (“See Proposed Income Tax Regs. Sec. 1.46512(a)…and 1.465-66(a)…. We are cognizant of the fact that proposed regulations merely state
respondent’s position on a relevant issue and has no effect of law. However, we agree with
respondent’s position as set forth in the proposed regulations cited herein.”); Section 469(g)
(providing that losses previously suspended by the passive activity rules will be taken into
account upon a disposition of the relevant passive activity).
24
This amendment applies to transfers made after December 31, 2004. See section
236(b), P.L. 108-357.
- 14 An ESBT is a trust that has the following characteristics: (i) all “beneficiaries” of the
trust are individuals, estates, or charitable organizations described in Section 170(c)(1)-(5) that
are eligible to be S corporation shareholders;25 (ii) charitable organizations described in Section
170(c)(1) hold only contingent interests and are not “potential current beneficiaries” of the
trust;26 (iii) no interest in the trust is acquired by purchase (i.e., acquired with a cost basis
determined under Section 1012); (iv) the trust is neither a QSST, a tax-exempt trust, a charitable
remainder annuity trust, nor a charitable remainder unitrust;27 and (v) the trustee of the trust
elects to apply Section 1361(e) to the trust. See Section 1361(e). Final regulations provide that
grantor trusts also may elect to be treated as an ESBT because grantor trusts are common family
estate planning tools. See Treas. Reg. § 1.1361-1(m)(1)(iv), -1(m)(8) exs. 3 & 4. But see PLR
200235009 (ruling that a trust that elected to be treated as an ESBT was a permitted shareholder
because it met the definition of a grantor trust rather than the definition of an ESBT); PLR
200235008 (same); PLR 200235007 (same).
(b)
Beneficiaries
Regulations provide additional guidance as to who is treated as a beneficiary of an ESBT.
See Treas. Reg. § 1.1361-1(m)(1)(ii). Generally, any person who has a present, remainder, or
reversionary interest in the ESBT is treated as a beneficiary of the trust. Treas. Reg. § 1.13611(m)(1)(ii)(A).
The term “beneficiary” does not include a distributee trust (other than a trust described in
Section 170(c)(2)-(3)), but does include persons who have a beneficial interest in such a
distributee trust. Treas. Reg. § 1.1361-1(m)(1)(ii)(B). A distributee trust is a trust that receives
or may receive a distribution from an ESBT, whether the rights to receive the distribution are
fixed or contingent, or immediate or deferred. Id. For example, suppose an intended ESBT
provides for discretionary distributions of income or principal to A for life, and upon A’s death
the division of the remainder into separate trusts for the benefit of A’s children. Pursuant to the
regulations, the beneficiaries of the intended ESBT are A and A’s children, and not the separate
25
For tax years beginning on or before December 31, 1997, charitable organizations
described in Section 170(c)(2)-(5) could be beneficiaries of an ESBT, but only if such
organizations held contingent interests and were not potential current beneficiaries. See Former
Section 1361(e)(1)(A)(i).
26
Prior to the enactment of the Consolidated Appropriations Act, 2001, P.L. 106-554,
organizations described in Section 170(c)(1) (such as a state) were not permitted beneficiaries of
an ESBT. The amendment that allows such organizations to be permitted beneficiaries has
retroactive effect (i.e., such amendment is effective for tax years beginning after December 31,
1996).
The Taxpayer Relief Act of 1997, P.L. 105-34,(the “TRA of 1997”) clarified that a
charitable remainder annuity trust and a charitable remainder unitrust (as defined in Section
664(d)) cannot be an ESBT (effective for taxable years beginning after December 31, 1996).
Section 1361(e)(1)(B).
27
- 15 trusts for the benefit of A’s children. Because all the beneficiaries are individuals, the intended
ESBT qualifies as an ESBT. See PLR 200522005; PLR 199930035.
The term “beneficiary” does not include a person in whose favor a power of appointment
may be exercised. Treas. Reg. § 1.1361-1(m)(1)(ii)(C). Such a person becomes a beneficiary
only when the power is exercised in such person’s favor. Id. Finally, a nonresident alien may be
an ESBT beneficiary. Treas. Reg. § 1.1361-1(m)(1)(ii)(D). However, as mentioned below, a
nonresident alien may not be a potential current beneficiary of an ESBT (i.e., a nonresident alien
presumably could hold a contingent interest in an ESBT). Id.
Prior to issuance of the regulations mentioned above, the Service issued IRS Notice 9749, 1997-2 C.B. 304, to provide guidance as to the definition of an ESBT beneficiary. The
regulations apply (and supersede IRS Notice 97-49) for taxable years of ESBTs beginning on
and after May 14, 2002. Treas. Reg. § 1.1361-1(m)(9).
(c)
Potential Current Beneficiaries
In General: A potential current beneficiary of an ESBT generally means, with respect to
any period, any person who during such period is entitled to, or at the discretion of any person
may receive, a distribution from the principal or income of the ESBT (determined without regard
to an unexercised power of appointment).28 Section 1361(e)(2). All potential current
beneficiaries of an ESBT generally are treated as shareholders of the S corporation (e.g., for
purposes of the permitted shareholder rules discussed above and for purposes of the 100shareholder limit, which is addressed in detail below in Section II.A.4. of this Outline). Section
1361(c)(2)(B)(v); Treas. Reg. § 1.1361-1(m)(4)(i). However, if an ESBT has no potential
current beneficiary, then the ESBT is treated as the sole shareholder. Section 1361(c)(2)(B)(v).
Furthermore, as mentioned above, in order for a trust to qualify as an ESBT, charitable
organizations described in Section 170(c)(1) must not be potential current beneficiaries of the
trust.
Additional Guidance: Regulations provide additional guidance as to who may be a
potential current beneficiary of an ESBT. See Treas. Reg. § 1.1361-1(m)(4). A person is
counted as a shareholder only once even though that person may be treated as a shareholder of
the S corporation by direct ownership and through one or more eligible trusts in Section
1361(c)(2)(A) (e.g., an ESBT). Treas. Reg. § 1.1361-1(m)(4)(vii). A person who is entitled to
receive a distribution only after a specified time or upon the occurrence of a specified event
(such as the death of the holder of a power of appointment) is not a potential current beneficiary
until such time or the occurrence of such event. Treas. Reg. § 1.1361-1(m)(4)(v). The right of a
beneficiary to assign the beneficiary’s interest to a third party does not result in the third party
being a potential current beneficiary until that interest is actually assigned. Treas. Reg. § 1.13611(m)(4)(viii).
28
The 2004 JOBS Act clarified that potential current beneficiaries do not include those
who may be named by virtue of a power of appointment. Section 234(a), P.L. 108-357. For a
more detailed discussion, see infra.
- 16 -
A husband directly owning stock and a wife indirectly owning stock as a potential current
beneficiary of an ESBT are treated as one shareholder. Treas. Reg. § 1.1361-1(m)(4)(vii). If all
or a portion of an ESBT is treated as owned by a person under the grantor trust rules, such owner
is a potential current beneficiary of such ESBT. Treas. Reg. § 1.1361-1(m)(4)(ii).
Special Rules for Objects of Powers of Appointment: The 2004 JOBS Act amended
Section 1361(e)(2) so that a power of appointment would not be taken into account in
determining the potential current beneficiaries of an ESBT to the extent such power remains
unexercised. Section 234(a), P.L. 108-357. This amendment applies for taxable years beginning
after December 31, 2004. Section 234(b), P.L. 108-357.
For taxable years beginning on or before December 31, 2004, regulations under section
1361(e) provide that a person to whom a distribution is or may be made during a period pursuant
to a power of appointment is a potential current beneficiary. Treas. Reg. § 1.1361-1(m)(4)(vi).
Thus, for taxable years beginning on or before December 31, 2004, if any person has a lifetime
power of appointment over an ESBT that, for example, would permit distributions from the trust
to be made to more than 75 persons, the corporation’s S election generally will terminate because
the number of potential current beneficiaries will exceed 75. See Treas. Reg. § 1.13611(m)(4)(vi)(A). The potential beneficiaries of the power may avoid “potential current
beneficiary” status if the holder of the power permanently (rather than temporarily) releases the
power in a manner that is valid under applicable local law. Treas. Reg. § 1.1361-1(m)(4)(vi)(B);
see, e.g., PLR 200401011.
On August 14, 2008, the Treasury Department and the Service finalized regulations that
address what constitutes a “power of appointment” in the ESBT context. See T.D. 9422. The
regulations generally adopt for ESBT purposes the transfer tax definition of a “power of
appointment” in Sections 2041 and 2514 and Treas. Reg. §§ 20.2041-1(b) and 25.2514-1(b). See
Treas. Reg. § 1.1361-1(m)(4)(vi).29 The regulations also provide that a “power of appointment”
will include a power, regardless of by whom held, to add a beneficiary or class of beneficiaries to
the class of potential current beneficiaries but generally will not include a power held by a
fiduciary who is not also a beneficiary of the trust to spray or sprinkle trust distributions among
beneficiaries. Id. The regulations also provide special ESBT rules for a power that will not
constitute a power of appointment for transfer tax purposes to make distributions to certain
charitable organizations. Id. These regulations are effective on August 14, 2008. Treas. Reg. §
1.1361-1(m)(9).
Special Rules for Distributee Trusts: Special rules for distributee trusts (i.e., trusts that
may receive distributions from an ESBT) exist under the regulations as well. They provide that a
distributee trust does not include a trust that has no assets and no items of income, loss,
29
Note that the regulations provide that it is immaterial for ESBT purposes whether a
power of appointment meets the narrower definition of a “general power of appointment” for
transfer tax purposes under Treas. Reg. §§ 20.2041-1(c) and 25.2514-1(c). Treas. Reg. § 1.13611(m)(4)(vi).
- 17 deduction, or credit (e.g., a trust which is to be funded by another trust at some future time).
Treas. Reg. § 1.1361-1(m)(4)(iv). The regulations also provide that, if the distributee trust is (or
would be) a trust eligible to be an S corporation shareholder (e.g., an ESBT or a QSST), the
persons who would be the distributee trust’s potential current beneficiaries if it were an ESBT
are treated as the potential current beneficiaries of the actual ESBT. Treas. Reg. § 1.13611(m)(4)(iv)(C), (D). However, if the distributee trust is described in Section 1361(c)(2)(A)(ii) or
(iii), the estate described in Section 1361(c)(2)(B)(ii) or (iii) is treated as the potential current
beneficiary of the ESBT for the two-year period during which such trust would be permitted as a
shareholder. Treas. Reg. § 1.1366-1(m)(4)(iv)(C). If the distributee trust is not (or would not
be) eligible to be an S corporation shareholder, then the distributee trust is the potential current
beneficiary, which terminates the corporation’s S election. Treas. Reg. § 1.1361-1(m)(4)(iv)(B).
Inadvertent Termination Relief: The Code provides some relief for inadvertent
failures to meet the S corporation eligibility requirements as a result of an ESBT having a
particular potential current beneficiary. If an ESBT disposes of all of the stock that it holds in an
S corporation, the term “potential current beneficiary” does not include any person who
otherwise first became a potential current beneficiary during the 1-year period ending on the date
of such disposition.30 Section 1361(e)(2). Thus, if on a certain date a 101st person otherwise
becomes a potential current beneficiary, the trust has one year to dispose of the S corporation
stock before the corporation’s S election terminates for failing to meet the 100-shareholder limit.
Note: A potential current beneficiary of a trust is not necessarily a beneficiary of the
same trust for purposes of that trust meeting the definition of an ESBT. For example, for taxable
years beginning on or before December 31, 2004, a person in whose favor property may be
appointed currently, but to whom no such appointment has been made, is a potential current
beneficiary (relevant for the permissible shareholder rules and 75-shareholder limit) but not a
beneficiary (relevant for the eligibility requirements of an ESBT). See Preamble to Treas. Reg. §
1.1361-1(m), T.D. 8994 (May 13, 2002).
Prior Guidance: Prior to issuance of the regulations mentioned above, the Service
issued IRS Notice 97-49, 1997-2 C.B. 304, to provide guidance as to the definition of a potential
current beneficiary. The regulations apply (and supersede IRS Notice 97-49) for taxable years of
ESBTs beginning on and after May 14, 2002. Treas. Reg. § 1.1361-1(m)(9).
(d)
Acquisition By Purchase
Regulations clarify that an interest in a trust will be treated as acquired by purchase if any
portion of a beneficiary’s basis in the interest is determined under Section 1012. Thus, an
acquisition of an interest in a trust treated as part-sale and part-gift will terminate the trust’s
status as an ESBT. Treas. Reg. § 1.1361-1(m)(1)(iii). For example, a gift of a beneficial interest
30
Section 234(a) of the 2004 JOBS Act extended this period from 60 days to one year.
The 1-year period is effective for taxable years beginning after December 31, 2004. See section
234(b), P.L. 108-357.
- 18 in a trust, in which the donee must pay the gift tax, constitutes an acquisition by purchase. See
id.
(e)
ESBT Election
The trustee of a trust must elect to treat such trust as an ESBT. Section 1361(e)(3). The
trustee must sign and file a statement of election with the service center in which the S
corporation whose stock is owned by the trust files its income tax return. Treas. Reg. § 1.13611(m)(2)(i). If a trust owns stock in several S corporations, the above rule requires a trustee to file
a statement of election with each service center handling the income tax return of any S
corporation whose stock is held by the trust. Id. However, this requirement only applies at the
time of the initial ESBT election. Id. If the ESBT later acquires stock in an S corporation that
files its income tax return at a different service center, a new ESBT election is not required. Id.
The ESBT election generally must be filed within the time requirements prescribed in Treas.
Reg. § 1.1366-1(j)(6)(iii) for QSST elections. See Treas. Reg. § 1.1361-1(m)(2)(iii).
Protective ESBT Elections Prohibited: Contrary to the rules for QSSTs, a trustee
cannot file a protective ESBT election. Treas. Reg. § 1.1361-1(m)(2)(v). A protective ESBT
election is an election made that will be effective only if the trust does not qualify as a permitted
shareholder under any other provision. The Treasury Department accords different treatment to
QSST and ESBT protective elections because, unlike a protective QSST election, a protective
ESBT election could result in a change in the incidence of taxation from the owner of the trust to
the trust itself.
Prior Guidance: Prior to issuance of the regulations mentioned above, the Service
issued IRS Notice 97-49, 1997-2 C.B. 304, to provide guidance on how a trust elects to be
treated as an ESBT. The regulations apply (and supersede IRS Notice 97-49) for taxable years
of ESBTs beginning on and after May 14, 2002. Treas. Reg. § 1.1361-1(m)(9).
(f)
Taxation of ESBTs
In General: Unlike the other trusts permitted to be shareholders of an S corporation, an
ESBT pays a trust-level income tax separate from its beneficiaries. See Section 641(c). The
portion of any ESBT that consists of stock in one or more S corporations is treated as a separate
trust (the “S portion”).
The S portion of an ESBT is taxed differently than the remaining portion of the ESBT.
Except for net capital gains, the taxable income of the S portion is subject to the highest rate of
tax applicable to trust income. Section 641(c)(2)(A). This provision may dissuade shareholders
from handling their estate planning affairs through ESBTs. Pursuant to the Jobs and Growth Act
of 2003, the top trust income tax rate drops to 35 percent after 2002. However, the top rate will
jump back to 39.6 percent in 2011. Furthermore, capital losses can only offset capital gains.
Section 641(c)(2)(D).
Limited Deductions and Credits for S Portion: The only items of income, loss,
deduction, or credit to be taken into account by the S portion are the following: (i) the passthrough items of the S corporation, (ii) any gain or loss on the disposition of the stock of the S
- 19 corporation, (iii) to the extent provided in regulations, state or local income taxes and
administrative expenses allocable to the items in (i) or (ii) and (iv) (for taxable years beginning
after December 31, 2006) any interest expense paid or accrued on indebtedness incurred to
acquire stock in an S corporation. Section 641(c)(2)(C). No other deduction or credit is allowed.
Id. These rules may cause the S portion to generate additional tax liability, which may require
the ESBT to take a cash distribution from the S corporation in order to pay its S portion tax
liability. If any portion of the cash distribution is treated as an ordinary dividend, the regulations
allocate the income to the non-S portion. See Treas. Reg. § 1.641(c)-1(g)(2), -1(l) ex. 1. As a
result, the cash distribution used to pay the S-portion tax liability may generate tax liability to the
non-S portion.
No AMT Exemption for S Portion: The S portion’s exemption amount for the
alternative minimum tax (“AMT”) is zero. Section 641(c)(2)(B). This particular adjustment
may cause a tax liability problem analogous to the problem discussed above with respect to the
limitation of deductions and credits.
Effects on Taxation of ESBT Beneficiaries: No items taken into account for purposes
of the S portion may be apportioned to any ESBT beneficiary. Section 641(c)(2)(C). For
purposes of determining the tax from the non-S portion of the ESBT and for purposes of
determining the treatment of distributions from an ESBT, the items of income, loss, deduction,
and credit taken into account by the S portion of the ESBT are disregarded. Section 641(c)(3).
(g)
Ceasing To Be an ESBT
A trustee must seek the consent of the Commissioner to revoke its ESBT election. Treas.
Reg. § 1.1361-1(m)(6). A trustee may apply for a revocation only in the form of a letter ruling
request. Id. Furthermore, an ESBT election terminates when either of the following occurs: (i)
the trust ceases to meet the definition of an ESBT; or (ii) the trust disposes of all S corporation
stock unless the trust uses the installment sale method to report gain. See Treas. Reg. § 1.13611(m)(5). Finally, special rules exist for the conversion of an ESBT to an QSST (and vice versa).
See Treas. Reg. § 1.1361-1(j)(12), -1(m)(7).
c.
ESOPs
As mentioned above, an ESOP is now a permissible shareholder.31 Unlike other
permissible tax-exempt shareholders, an ESOP’s pro rata share of S corporation income is not
taken into account in computing its unrelated business taxable income. See Sections 512(e),
1361(b)(1)(B), (c)(6); PLR 199906044.32 Although an ESOP may be a shareholder of an S
corporation, such stock ownership increases the risk of other eligibility problems for the S
31
32
An ESOP was not a permissible shareholder prior to the Small Business Act of 1996.
Furthermore, prior to the TRA of 1997, the ownership of S corporation stock by an
ESOP subjected the ESOP to the unrelated business income tax of Section 511. See Former
Section 512(e).
- 20 corporation, such as having an ineligible shareholder or too many shareholders, because the
ESOP generally must (i) permit ESOP beneficiaries to elect to receive in-kind distributions of the
ESOP’s S corporation stock and (ii) permit beneficiaries to direct the ESOP to make a directrollover contribution from the ESOP to another qualified plan, such as an IRA. See Sections
401(a)(31), 409(h). For example, if an ESOP beneficiary were to elect to receive an in-kind
distribution of S corporation stock and then were to contribute such stock to an IRA (but not in a
direct-rollover transaction), the corporation’s S election would terminate for having an ineligible
shareholder. However, Section 409(h)(2) permits an S corporation to structure an ESOP so that
an ESOP beneficiary’s right to elect to receive in-kind distributions of the S corporation’s stock
is limited by the S corporation’s right to repurchase its distributed stock for fair market value.
This provision permits S corporations to convert an ESOP beneficiary’s stock interest into cash
prior to the time that the beneficiary contributes the stock to an ineligible shareholder, such as an
IRA.
Although Section 409(h)(2) permits S corporations to avoid the problem presented in the
preceding example, Section 409(h)(2) may not permit S corporations to avoid the same problem
when the ESOP beneficiary demands that the in-kind distribution of the S corporation stock be
made to an IRA in a direct-rollover transaction. In order to address this potential problem, the
Service issued Rev. Proc. 2003-23, 2003-1 C.B. 599, and Rev. Proc. 2004-14, 2004-7 I.R.B. 489.
Rev. Proc. 2004-14, which modifies and supersedes Rev. Proc. 2003-23, provides that the
Service will accept the position that a corporation’s S election is not affected as a result of an
ESOP’s distribution of S corporation stock to a beneficiary where the beneficiary elects to have
the stock distributed to an IRA in a direct-rollover transaction if the following conditions are
met: (i) the terms of the ESOP require that the S corporation repurchase its stock immediately
upon the ESOP’s distribution of the stock to an IRA; (ii) either (A) the S corporation actually
repurchases the S corporation stock contemporaneously with, and effective on the same day as,
the distribution or (B) the ESOP is permitted to assume the rights and obligations of the S
corporation to repurchase the S corporation stock immediately upon the ESOP’s distribution of
the stock to an IRA and the ESOP actually repurchases the S corporation stock
contemporaneously with, and effective on the same day as, the distribution; and (iii) no income
(including tax-exempt income), loss, deduction, or credit attributable to the distributed stock
under Section 1366 is allocated to the beneficiary’s IRA. See also PLR 200240038; PLR
200122034.
The Treasury Department and the Service have issued guidance addressing arrangements,
viewed by them as abusive, involving certain ESOPs that hold S corporation stock. See Temp.
Treas. Reg. § 1.409(p)-1T (issued July 18, 2003); Prop. Treas. Reg. § 1.409(p)-1, 68 Fed. Reg.
43058-01 (July 21, 2003); Rev. Rul. 2004-4, 2004-6 I.R.B. 1. Final regulations were issued in
November 2006 retaining the rule that if there is a prohibited allocation during a nonallocation
year, the ESOP fails to satisfy the requirements of Section 4975(e)(7) and ceases to be an ESOP.
Treas. Reg. § 1.409(p)-1 (T.D. 9302), 71 Fed. Reg. 76134-45. Additionally, the final regulations
impose an excise tax on the S corporation under Section 4979A. Id.
In the 2004 JOBS Act, Congress eliminated certain tax differences between a leveraged
ESOP maintained by a C corporation and a leveraged ESOP maintained by an S corporation. In
general, the new provisions permit an ESOP maintained by an S corporation to use a distribution
- 21 made by the S corporation with respect to its stock after December 31, 1997 to make payments
on a loan used to acquire such stock. See section 240, P.L. 108-357.
d.
Ineligible Shareholder Issues
(i)
Transitory Ownership by Ineligible Shareholders
The Service has ruled privately on numerous occasions that transitory ownership of S
corporation stock by a corporation will not result in the termination of the S election. See, e.g.,
GCM 39768 (Dec. 1, 1988) (stating that “an S corporation that momentarily has a corporate
shareholder in the course of a reorganization is not disqualified from being an S corporation
under Section 1361(b)(1)(B)”); PLR 9414016; PLR 9405014; PLR 9404014; PLR 9403031;
PLR 9402029; PLR 9350039; PLR 9344034; PLR 9344022; PLR 9338038. Nevertheless, it is
unclear whether momentary ownership of stock by an ineligible shareholder will disqualify the
corporation as a small business corporation. See Rev. Rul. 80-169, 1980-1 C.B. 188; Rev. Rul.
77-155, 1977-1 C.B. 264; Rev. Rul. 69-168, 1969-1 C.B. 24; Rev. Rul. 59-235, 1959-2 C.B. 192.
(ii)
Incorporating a Partnership
In general, the incorporation of a partnership may occur in five ways. See Rev. Rul.
2004-59, 2004-1 C.B. 1050; Rev. Rul. 84-111, 1984-2 C.B. 88, revoking Rev. Rul. 70-239,
1970-1 C.B. 74; Treas. Reg. § 301.7701-3(c)(1)(i). First, the partnership can transfer its assets to
the corporation in exchange for stock, followed by a termination of the partnership. Second, the
partnership can terminate by distributing its assets to the partners, who then contribute assets to
the corporation in exchange for its stock. Third, the partners can transfer their partnership
interests to the corporation in exchange for its stock. Fourth, the partnership can convert into a
state law corporation under a state law formless conversion statute. Fifth, the partnership can
elect to be treated as an association taxable as a corporation for Federal tax purposes under the
check-the-box regulations. If the incorporation proceeds under the first alternative, the fourth
alternative, or the fifth alternative, the S election technically could not be effective immediately
because the corporation had an ineligible shareholder (the partnership) during a portion of its
initial taxable year – an election would be effective for the next succeeding year. The Service,
however, might disregard the transitory ownership of such an ineligible shareholder.
In fact, pursuant to Rev. Rul. 2009-15, 2009-21 I.R.B. 1035, the Service effectively
disregards the transitory ownership of such an ineligible shareholder under the fourth alternative
and the fifth alternative. In Rev. Rul. 2009-15, an unincorporated entity classified as a
partnership for Federal tax purposes elected to be treated as an association taxable as a
corporation for Federal tax purposes, effective January 1, 2010. On February 1, 2010, the entity
filed an election to be treated as an S corporation, effective January 1, 2010. The ruling provides
that the entity’s election to be classified as an association caused a deemed contribution of the
partnership’s assets and liabilities to the association in exchange for stock in the association,
followed by the partnership’s distribution of the association stock in liquidation. Citing Treas.
Reg. § 301.7701-3(g)(3)(i), the ruling provides that these steps are treated as occurring
immediately before the close of the day before the election is effective, and, therefore, causes the
partnership’s taxable year to end on December 31, 2009 and the association’s first taxable year to
begin on January 1, 2010. Consequently, the ruling concludes that the partnership was not
- 22 deemed to own the stock of the association during any portion of the association’s first taxable
year, and, therefore, the entity was eligible to elect to be an S corporation effective January 1,
2010. The ruling also provided that, because the partnership's taxable year ended immediately
before the close of the day on December 31, 2009 and the association's first taxable year began at
the start of the day on January 1, 2010, the deemed steps would not cause the partnership to have
an intervening short taxable year in which it was treated as a C corporation for Federal tax
purposes. The ruling also contains a fact pattern involving a state law formless conversion of a
partnership into a corporation. The ruling applies the same rationale to that fact pattern as it does
to the fact pattern regarding a check-the-box election conversion, above, and then comes to the
same conclusions as well.
4.
Number of Shareholders
In General: A small business corporation may not have more than 100 shareholders.
Section 1361(b)(1)(A).33 For purposes of determining the number of shareholders, the beneficial
owner of stock generally is treated as the shareholder.34 See PLR 199906044 (ruling that an
ESOP that owns S corporation stock is treated as the shareholder for purposes of the S
corporation eligibility rules, including Section 1361(b)(1)(A), rather than the ESOP’s
beneficiaries). The shareholder is the person who has to include in gross income the dividends
distributed with respect to the S corporation stock. Treas. Reg. § 1.1361-1(e)(1). Thus, where
stock is owned by joint tenants or tenants in common, each tenant is considered a shareholder.
However, stock owned by a partnership is treated as being owned by the partnership and not the
partners.
In general, the attribution rules do not apply. Rev. Rul. 59-187, 1959-1 C.B. 224.
However, there are special rules, described below, for treating family members as a single
shareholder for purposes of the 100-shareholder limit.
33
Section 232(a) of the 2004 JOBS Act amended Section 1361(b)(1)(A) to increase the
number of permissible shareholders from 75 to 100. This provision is effective for taxable years
beginning after December 31, 2004. See section 232(b), P.L. 108-357. The Small Business Act
of 1996 had increased the number of permissible shareholders from 35 to 75. The Revision Act
of 1982 had increased the number of permitted shareholders from 25 to 35 in order to correspond
to the private placement exemption contained in federal securities laws. S. Rep. No. 97-640,
97th Cong., 2d Sess. 7 (1986). The Economic Recovery Tax Act of 1981, P.L. 97-34, increased
the number of permitted shareholders from 15 to 25. Finally, the Revenue Act of 1978, P.L. 95600, increased the number of permitted shareholders from the initial limit of 10 to 15.
34
As noted above, for purposes of subchapter S of the Code, stock that is issued in
connection with the performance of services and that is substantially nonvested is not treated as
outstanding stock, and the holder of that stock is not treated as a shareholder solely by reason of
holding such stock unless the holder makes a Section 83(b) election. Treas. Reg. § 1.13611(b)(3).
- 23 Special Rules for Family Members: For purposes of determining the number of
shareholders, a husband and a wife (and their estates) generally are treated as one shareholder.
Section 1361(c)(1); Treas. Reg. § 1.1361-1(e)(2).
The 2004 JOBS Act amended Section 1361(c)(1) to allow certain “members of the
family” to elect to be treated as one shareholder for purposes of meeting the 100-shareholder
limit.35 Section 231(a), P.L. 108-357. The 2004 JOBS Act amendments were effective for
taxable years beginning after December 31, 2004. The GO-Zone Act made several technical
amendments to the rules that treat family members as one shareholder.36 These technical
amendments are effective for taxable years beginning after December 31, 2004. Section
403(nn), P.L. 109-135. Accordingly, these technical amendments are effective as if they were
included in the 2004 JOBS Act.
Together, the 2004 JOBS Act and the GO-Zone Act made the following changes to
Section 1361(c)(1). First, members of a family that hold stock in an S corporation automatically
will be treated as one shareholder for purposes of meeting the 100-shareholder limit (but not for
any other purpose). Second, the phrase “members of the family” means the common ancestor,
lineal descendants of the common ancestor, and the spouses (or former spouses) of such lineal
descendants of the common ancestor. Third, a common ancestor cannot be more than six
generations removed from the youngest generation of shareholders as of the later of: (i) the date
the S corporation election is made; (ii) the earliest a family member first holds stock in the S
corporation; or (iii) October 22, 2004 (the “six generation test”). Fourth, the estate of a family
member is treated as a member of a family. Fifth, the definition of a child has been broadened
The 2004 JOBS Act defined the phrase “members of the family” as the common
ancestor, lineal descendants of the common ancestor, and the spouses (or former spouses) of
such lineal descendants of the common ancestor. Former Section 1361(c)(1)(B)(i). A “common
ancestor” would not be more than six generations removed from the youngest generation of
shareholders at the time that the S corporation election was made or December 31, 2004,
whichever was later. Former Section 1361(c)(1)(B)(ii).
35
36
The GO-Zone Act made the following changes to Section 1361(c)(1). First, the
requirement that a member of a family elect to have all qualifying members of such family be
treated as one shareholder for purposes of determining the number of S corporation shareholders
has been eliminated. See Section 403(b), P.L. 109-135. Accordingly, all qualifying members of
a family who hold stock are automatically treated as one shareholder. Second, the applicable
date for determining whether a person can be considered a common ancestor is the later of: (i)
the date the S corporation election is made; (ii) the earliest a family member first holds stock in
the S corporation; or (iii) October 22, 2004. See Section 1361(c)(1)(B). Third, the estate of a
family member is treated as a member of a family. Section 1361(c)(1)(A). Fourth, the definition
of a child has been broadened for purposes of determining whether an adopted child is a lineal
descendent and member of a family. Section 1361(c)(1)(C).
- 24 for purposes of determining whether an adopted child is a lineal descendent and member of a
family.37
Special Rules for Trusts: Special rules exist for trusts with respect to the 100shareholder limit. See Section 1361(c)(2)(B). With respect to a grantor trust described in
Section 1361(c)(2)(A)(i) (including a QSST), the deemed owner of the assets of the trust is
treated as the shareholder. See also Section 1361(d)(1)(A). With respect to a grantor trust
described in Section 1361(c)(2)(A)(ii), the estate of the deemed owner of the assets of the trust is
treated as the shareholder. With respect to a testamentary trust described in Section
1361(c)(2)(A)(iii), the estate of the relevant testator is treated as the shareholder. With respect to
a voting trust described in Section 1361(c)(2)(A)(iv), each beneficiary of the trust is treated as a
shareholder. With respect to ESBTs, as mentioned above, each potential current beneficiary of
an ESBT is treated as a shareholder, and the ESBT itself is treated as a shareholder when the
ESBT lacks such beneficiaries.38
37
On August 14, 2008, the Treasury Department and the Service finalized regulations
that clarify certain aspects of the family member rules. See T.D. 9422. Among other
clarifications, the regulations provide that the estate and certain grantor or testamentary trusts
(described in Section 1361(c)(2)(A)(ii) or (iii)) of a deceased member of the family are
considered to be a member of the family during the period in which the estate or such trusts hold
stock in the S corporation. Treas. Reg. § 1.1361-1(e)(3)(ii). The regulations also provide that
members of the family include (i) in the case of an ESBT, each potential current beneficiary who
is a member of the family, (ii) in the case of a QSST, the income beneficiary who makes the
QSST election, if that income beneficiary is a member of the family, (iii) in the case of a voting
trust, each beneficiary who is a member of the family, (iv) the individual for whose benefit an
individual retirement account described in Section 1361(c)(2)(A)(vi) was created, if that
individual is a member of the family, (v) the deemed owner of a grantor trust if that deemed
owner is a member of the family, and (vi) the owner of an entity disregarded as an entity separate
from its owner under Treas. Reg. § 301.7701-3, if that owner is a member of the family. Id. The
regulations also clarify that the “six generation test” applies only at the date specified in Section
1361(c)(1)(B)(iii) for determining whether a person meets the definition of a common ancestor
and will have no continuing significance in limiting the number of generations of a family that
may hold stock in the S corporation and be treated as a single shareholder. Treas. Reg. § 1.13611(e)(3)(i). The regulations are effective on August 14, 2008. Treas. Reg. § 1.1361-1(k)(2)(i).
38
The 2004 JOBS Act added Section 1361(c)(2)(B)(vi), which addresses the treatment of
a beneficiary of an individual retirement account holding stock of an S corporation that is a bank.
Under Section 1361(c)(2)(B)(vi), the beneficiary of such an account is counted toward the 100shareholder limit (as well as being treated as a shareholder for all other purposes of Section
1361(b)(1)). However, note that this provision only applies to bank stock held in an individual
retirement account on October 22, 2004, the date of the enactment of the 2004 JOBS Act.
Section 1361(c)(2)(A)(vi), (B)(vi).
- 25 Test Daily Rather Than Annually: A corporation may have more than 100
shareholders during the year, so long as there are not more than 100 at any one time. See Rev.
Rul. 78-390, 1978-2 C.B. 220.
Note: In Rev. Rul. 77-220, 1977-1 C.B. 263, the shareholders attempted to avoid the
numerical restrictions by forming three corporations, each having the then maximum number of
10 shareholders. The three corporations in turn formed a partnership to conduct a business. The
Service initially ruled that solely for purposes of determining whether an S election could be
made, the three separate corporations would be treated as one corporation. As a single
corporation, an S election could not be made because the number of shareholders in such
corporation exceeded the maximum number permitted.
Subsequently (albeit 14 years later), in Rev. Rul. 94-43, 1994-2 C.B. 198, the Service
reversed its position in Rev. Rul. 77-220, and concluded that the S election of the three separate
corporations should be respected notwithstanding that the principal purpose for the formation of
the separate corporations was to avoid the shareholder limitation. The Service concluded that
administrative simplicity in the administration of the S corporation’s tax affairs is not affected by
the corporation’s participation in a partnership with other S corporation partners. Prior to the
official revocation of Rev. Rul. 77-220, the Service was in effect limiting its applicability. For
example, where valid business reasons support use of a partnership, the S election of corporate
partners should be respected. See PLR 9409027; PLR 9017057; PLR 8916057; PLR 8823027;
PLR 8823023; PLR 8819040; PLR 8804015; PLR 8711020; PLR 8536017; PLR 8527081.
5.
One Class of Stock Requirement
a.
In General
A small business corporation cannot have more than one class of stock. Section
1361(b)(1)(D). A corporation is treated as having only one class of stock if all outstanding
shares of stock of the corporation confer identical rights to distribution and liquidation proceeds.
Treas. Reg. § 1.1361-1(l)(1).39
b.
Differences in Voting Rights
Differences in voting rights among shares of stock are disregarded in determining if a
corporation has more than one class of stock. Section 1361(c)(4). Thus, an S corporation may
have voting and nonvoting common stock without violating the one class of stock requirement.
See PLR 9323033. Furthermore, a class of stock that votes only on certain issues or in
39
On October 5, 1990, the Service issued proposed regulations pertaining to the one class
of stock requirement. In response to the numerous comments and concerns raised by
practitioners and taxpayers concerning the regulations, on August 8, 1991, the Service issued
new proposed regulations (PS-4-73) (the “proposed regulations”). The Service adopted the
proposed regulations as final regulations, with certain revisions, in T.D. 8419 on May 28, 1992
(the “final regulations”). The final regulations are analyzed in this Outline.
- 26 accordance with an irrevocable proxy agreement is not a second class of stock. Similarly, shares
that differ with respect to the right to elect members of the Board of Directors do not give rise to
a second class of stock.
c.
Identical Rights with Respect to Distribution and Liquidation
Proceeds
(i)
General Rule
The determination of whether shares of stock confer identical rights with respect to
distribution and liquidation proceeds is based on an analysis of the rights conferred to the
shareholders by the “governing provisions.” Treas. Reg. § 1.1361-1(l)(2)(i). The term
“governing provisions” refers to the terms and provisions set forth in the following items:
(i) corporate charter, (ii) articles of incorporation, (iii) bylaws, (iv) applicable state law, and
(v) any other binding agreement that relates to distribution and liquidation proceeds. Id.; see,
e.g., Minton v. Comm’r, 94 T.C.M. (CCH) 606 (2007), aff’d, 562 F.3d 730 (5th Cir. 2009) (per
curiam) (holding that, despite disproportionate distributions to a shareholder, such distributions
were not made pursuant to a “binding agreement” in light of state law and the failure of any
formal corporate action; such distributions constituted mere timing differences in respect to the
distributions to the other shareholders); PLR 201129023 (ruling that, if disproportionate
distributions inconsistent with governing provisions resulted in more than one class of stock, the
resulting termination of the company’s S election was inadvertent, and that corrective
distributions did not create a second class of stock); PLR 201017019 (finding that discretionary
distribution provision in stockholder’s agreement, which allowed the S corporation to make a
distribution to each of its shareholders with respect to the S corporation’s post-filing tax
adjustments in accordance with the shareholder’s interest in taxable income or loss for that
taxable year, did not cause the S corporation to have more than one class of stock); PLR
201006026 (disproportionate distributions did not create a second class of stock provided
corrective distributions and payments were made so that each shareholder received distributions
proportionate to their interests in accordance with the governing provisions); PLR 200308035
(ruling that an agreement between an S corporation and its shareholders to make remedial
distributions in order to help the shareholders pay for increased tax liability as a result of the S
corporation amending a prior return does not result in a second class of stock because the S
corporation’s bylaws entitled the shareholders to equal distributions). Thus, commercial
contractual agreements, such as leases, employment contracts, or loan agreements, will not give
rise to a second class of stock unless a principal purpose of the agreement is to circumvent the
one class of stock requirement. Treas. Reg. § 1.1361-1(l)(2)(i); see e.g., PLR 201038001 (ESOP
distribution provision does not create second class of stock); PLR 201015017 (shareholder
agreement and stock option plans did not create second class of stock); PLR 200914019 (ESOP
distribution provisions do not create a second class of stock); PLR 200827008 (same); PLR
199906044 (same); PLR 201016040 (payments by S corporation to compensate shareholders
who suffered financial damages due to inadequate advice received by the S corporation did not
create a second class of stock); PLR 200924019 (employment agreement did not create more
than one class of stock, since it did not constitute a “governing provision”); PLR 9318007 (splitdollar life insurance agreement does not create a second class of stock); PLR 9309046 (same);
PLR 9248019 (same).
- 27 In PLR 199918050, a C corporation acquired an S corporation in a reverse subsidiary
cash merger. In the transaction, a subsidiary of the C corporation merged into the S corporation,
and the S corporation shareholders received cash from the C corporation rather than stock. The
parties intended to make a Section 338(h)(10) election. The agreement provided that the C
corporation would make a payment to each S corporation shareholder to compensate them for
any increased liability for federal and state income taxes resulting from that election (i.e., a
gross-up payment). The amounts of these gross-up payments varied on a per-share basis among
the shareholders. The Service concluded that, solely for purposes of the one class of stock
requirement of section 1361(b)(1)(D), the transaction was treated as a sale of stock by the S
corporation shareholders to the C corporation, and not as a sale of assets followed by a
liquidation of the S corporation. (If treated as an asset sale and a liquidation, the shareholders
could have been deemed to have the right to receive unequal amounts per share due to the
differing per share gross-up payments). Accordingly, the Service concluded that the right to the
unequal gross-up payments did not cause the S corporation to have a second class of stock,
which presumably would have terminated the S corporation’s S election prior to the actual
merger (i.e., at the time the merger agreement was executed). See PLR 199918050.
Although a corporation is not treated as having more than one class of stock as long as
the governing provisions provide for identical distribution and liquidation rights, any distribution
(including actual, constructive, or deemed distributions) that differs in timing or amount is “to be
given appropriate tax effect in accordance with the facts and circumstances.” Treas. Reg. §
1.1361-1(l)(2)(i); see PLR 201234001; PLR 201006026.
The Service has taken the position for several years that it will not rule on whether a state
law limited partnership that validly elects under Treas. Reg. § 301.7701-3 to be treated as an
association taxable as a corporation has more than one class of stock for purposes of Section
1361(b)(1)(D). See Rev. Proc. 2004-3, 2004-1 I.R.B. 114. Rev. Proc. 2004-3 states that this
issue is under “extensive study,” and that the Service will not issue rulings on this issue until it
resolves it through publication of a revenue ruling, revenue procedure, regulations, or otherwise.
Id. Finally, Rev. Proc. 2004-3 states that the Service will treat any request for a ruling on
whether a state law limited partnership is eligible to make an S election as a request for a ruling
on whether the partnership complies with Section 1361(b)(1)(D) (i.e., no ruling will be issued).
Id.
(ii)
Exceptions to General Rule
In certain limited situations, differences in distribution and liquidation rights created by
the governing provisions are nonetheless disregarded in determining if a corporation has more
than one class of stock. These exceptions are discussed below.
(a)
State Law Requirements for Payment and
Withholding of Income Tax
State laws that require a corporation to pay or withhold state income taxes on behalf of
some or all of its shareholders are disregarded in determining if a corporation has more than one
class of stock, provided that, when the constructive distributions resulting from the payment or
withholding of taxes by the corporation are taken into account, the outstanding shares confer
- 28 identical rights to distribution and liquidation proceeds. Treas. Reg. § 1.1361-1(l)(2)(ii); see,
e.g., PLR 200935018 (constructive distributions did not cause termination of corporation’s S
election because shares provided for identical rights to operating and liquidating distributions).
A difference in timing between the constructive distributions and the actual distributions
to the other shareholders does not cause the corporation to be treated as having more than one
class of stock. Id. Thus, if the governing provisions provide for the right to equal distributions
after taking into account the income tax payments made on behalf of the nonresident
shareholders, the corporation’s shares of stock will be treated as conferring identical rights to
distribution proceeds. Treas. Reg. § 1.1361-1(l)(2)(v) ex. 7.
(b)
Buy-Sell and Redemption Agreements
Buy-sell agreements to redeem or purchase stock at the time of death, divorce, disability,
or termination of employment are disregarded in determining whether a corporation’s shares of
stock confer identical rights. Treas. Reg. § 1.1361-1(l)(2)(iii)(B); see, e.g., PLR 200205044
(ruling that an S corporation’s stock purchase agreement containing a floor put right with respect
to some but not all of the S corporation’s stock is disregarded for purposes of determining
whether the S corporation’s outstanding stock confers identical rights).
In addition, buy-sell agreements among shareholders, agreements restricting the
transferability of stock, and redemption agreements also are disregarded unless (i) a principal
purpose of the agreement is to circumvent the one class of stock requirement and (ii) the
agreement establishes a purchase price that, at the time the agreement is entered into, is
significantly in excess of or below the fair market value of the stock. Treas. Reg. § 1.13611(l)(2)(iii)(A); see, e.g., PLR 201218004; PLR 201015017; PLR 200217048; PLR 200205044;
PLR 9404020; PLR 9308006. Agreements that provide for the purchase or redemption of stock
at book value or at a price between fair market value and book value are not considered to
establish a price that is significantly in excess of or below the fair market value of the stock.
Treas. Reg. § 1.1361-1(l)(2)(iii)(A). A good faith determination of fair market value will be
respected unless it can be shown that the value was substantially in error or the determination of
the value was not performed with reasonable diligence. Id. A determination of book value will
be respected if the book value is (i) determined in accordance with generally accepted accounting
principles or (ii) used for any substantial nontax purpose. Treas. Reg. § 1.1361-1(l)(2)(iii)(C).
(c)
Varying Interests
A corporation’s shares of stock will be treated as conferring identical rights with respect
to distribution and liquidation proceeds even if the governing provisions provide that, as a result
of a change in stock ownership, distributions in one taxable year are to be made on the basis of
the shareholders’ varying interests in the S corporation’s income in the immediately preceding
taxable year. Treas. Reg. § 1.1361-1(l)(2)(iv).
d.
Stock Taken Into Account
In general, all outstanding shares of stock of a corporation are taken into account in
determining whether the corporation’s shares of stock confer identical rights to distribution and
- 29 liquidation proceeds. Treas. Reg. § 1.1361-1(l)(3); see PLR 200145026 (ruling that an S
corporation did not have more than one class of stock despite its governing documents providing
for a second class of stock with distribution rights different than the rights accorded the
shareholders of the first class of stock, because the second class of stock was not outstanding).
However, exceptions (discussed below) are provided for restricted stock, deferred compensation
plans, and debt that meets the straight debt safe harbor of Section 1361(c)(5).40
(i)
Restricted Stock
For purposes of subchapter S of the Code, stock that is issued in connection with the
performance of services and that is substantially nonvested (within the meaning of Treas. Reg. §
1.83-3(b)) is not treated as outstanding stock of the corporation. Treas. Reg. § 1.1361-1(b)(3).
Accordingly, the holder of such stock is not treated as a shareholder merely because he or she
holds such stock. Further, such stock is not considered in determining if the corporation has a
second class of stock. Id.
However, if the holder makes an election under Section 83(b), the stock is treated as
outstanding stock of the corporation, and the holder is treated as a shareholder. Such stock will
be viewed as a second class of stock if it does not confer identical rights as to distributions and
liquidation proceeds. Id.
Furthermore, substantially nonvested stock issued on or before May 28, 1992, that has
been treated as outstanding by the corporation is treated as outstanding for purposes of
subchapter S of the Code, and the fact that it is substantially nonvested and no Section 83(b)
election has been made with respect to it will not cause the stock to be treated as a second class
of stock. Treas. Reg. § 1.1361-1(b)(6).
Finally, for taxable years beginning after December 31, 2006, certain stock in an S
corporation bank held by a director of that bank (“restricted bank director stock”) generally is not
taken into account as outstanding stock for purposes of subchapter S of the Code. Section
1361(f); Section 8232(c)(1) of the Iraq Act of 2007. Accordingly, such director is not treated as
a shareholder merely because he or she holds such stock. For any taxable year beginning after
December 31, 2006, such stock is not considered in determining if the corporation has a second
class of stock. Section 6361(f); Section 8232(C)(2) of the Iraq Act of 2007.
(ii)
Deferred Compensation Plans
An instrument, obligation, or arrangement is not treated as outstanding stock if it (i) does
not convey the right to vote; (ii) is an unfunded and unsecured promise to pay money or property
in the future; (iii) is issued to an individual who is an employee in connection with the
40
The provisions in the final regulations pertaining to restricted stock, deferred
compensation plans, and straight debt generally apply to taxable years of a corporation beginning
on or after May 28, 1992. Treas. Reg. § 1.1361-1(b)(6). However, a corporation and its
shareholders may apply these rules to prior taxable years. Id.
- 30 performance of services for the corporation or to an individual who is an independent contractor
in connection with the performance of services for the corporation; and (iv) is issued pursuant to
a plan with respect to which the employee or independent contractor is not taxed currently on
income. Treas. Reg. § 1.1361-1(b)(4); see e.g., PLR 9406017; PLR 9317021; PLR 9317009;
PLR 9247013. A deferred compensation plan that has a current payment feature is not treated as
outstanding stock. Id.
(iii)
Straight Debt
An instrument or obligation that satisfies the definition of straight debt contained in
Treas. Reg. § 1.1361-1(l)(5) is not treated as outstanding stock. The definition of straight debt is
discussed below.
e.
Special Rules for Debt Instruments, Obligations, and Other
Similar Arrangements
(i)
In General
Instruments, obligations, and other similar arrangements (collectively referred to as “debt
arrangements”) issued by an S corporation are not treated as a second class of stock unless they
meet certain tests under Treas. Reg. § 1.1361-1(l) that are described below.
(ii)
Debt Arrangements Treated as Equity under General
Principles
Unless other exceptions apply, a debt arrangement issued by an S corporation is treated
as a second class of stock if (i) the debt arrangement constitutes equity or otherwise results in the
holder being treated as the owner of stock under general tax principles, and (ii) a principal
purpose of issuing or entering into the debt arrangement is to circumvent the rights to
distribution or liquidation proceeds conferred by the outstanding shares of stock or to circumvent
the limitation on eligible shareholders of an S corporation. Treas. Reg. § 1.1361-1(l)(4)(ii)(A).
See Santa Clara Valley Housing Group, Inc. v. United States, 2011-2 USTC ¶ 50,637 (N.D. Cal.
2011) (holding that (i) warrants were not substantially certain to be exercised and thus were not
treated as a second class of stock under Treas. Reg. § 1.1361-1(l)(4)(iii), but (ii) warrants could
be tested for second-class-of-stock issues under Treas. Reg. § 1.1361-1(l)(4)(ii) as well, and (iii)
warrants constituted a second class of stock under Treas. Reg. § 1.1361-1(l)(4)(ii)); Santa Clara
Valley Housing Group, Inc., v. United States, 2012-1 USTC ¶ 50,169 (N.D. Cal. 2012) (on
motion for reconsideration, holding that safe harbor provision of Treas. Reg. § 1.13611(l)(4)(iii)(C) can apply to instruments that would otherwise constitute a second class of stock
under Treas. Reg. § 1.1361-1(l)(4)(ii)); PLR 9308006 (S corporation’s note did not create a
second class of stock since it represented that it did not intend to circumvent the one class of
stock rules).
(a)
Short-Term Unwritten Advances
Unwritten shareholder advances will not create a second class of stock if such advances
(i) do not exceed $10,000 in the aggregate at any time, (ii) are treated as debt by the parties, and
- 31 (iii) are expected to be repaid within a reasonable time. Treas. Reg. § 1.1361-1(l)(4)(ii)(B)(1).
Unwritten shareholder advances that qualify under the safe harbor will not be treated as a second
class of stock even if the advances are considered equity for federal income tax purposes. Id.
Moreover, unwritten shareholder advances that fail to qualify for this safe harbor will result in a
second class of stock only if such advances would be considered a second class of stock under
the general rules applicable to debt arrangements. Id.
(b)
Proportionately Held Obligations
Debt arrangements that are owned solely by the shareholders of an S corporation in the
same proportion as their respective percentage stock ownership interest will not create a second
class of stock, regardless of whether the debt arrangements are considered equity for federal
income tax purposes. Treas. Reg. § 1.1361-1(l)(4)(ii)(B)(2). Obligations owned by the sole
shareholder of a corporation are always held proportionately to the corporation’s outstanding
stock. Id. As with unwritten shareholder advances, S corporation obligations that fail to qualify
for this safe harbor will result in a second class of stock only if such obligations would be
considered a second class of stock under the general rules applicable to debt arrangements. Id.
(iii)
Call Options, Warrants, or Other Similar Instruments
A call option, warrant, or similar instrument (collectively referred to as a “call option”)
issued by an S corporation will not be treated as a second class of stock unless the call option,
after taking into account all the facts and circumstances, is substantially certain to be exercised
and has a strike price substantially below the fair market value of the underlying stock. Treas.
Reg. § 1.1361-1(l)(4)(iii)(A); see Santa Clara Valley Housing Group, Inc. v. United States, 20112 USTC ¶ 50,637 (N.D. Cal. 2011) (holding that (i) warrants were not substantially certain to be
exercised and thus were not treated as a second class of stock under Treas. Reg. § 1.13611(l)(4)(iii), but (ii) warrants could be tested for second-class-of-stock issues under Treas. Reg. §
1.1361-1(l)(4)(ii) as well, and (iii) warrants constituted a second class of stock under Treas. Reg.
§ 1.1361-1(l)(4)(ii)); Santa Clara Valley Housing Group, Inc., v. United States, 2012-1 USTC ¶
50,169 (N.D. Cal. 2012) (on motion for reconsideration, holding that safe harbor provision of
Treas. Reg. § 1.1361-1(l)(4)(iii)(C) can apply to instruments that constitute a second class of
stock under Treas. Reg. § 1.1361-1(l)(4)(ii)); PLR 201015017.
The determination of whether a call option has a strike price substantially below the fair
market value of the underlying stock is made (i) at the time of issuance, (ii) on the date of a
transfer by an eligible shareholder to a person who is not an eligible shareholder of an S
corporation, and (iii) at the time of a material modification of the terms of the call option by the
corporation. Id. If an option is issued in connection with a loan and the time period in which the
option can be exercised is extended in connection with a modification of the terms of the loan,
the extension of time is not considered a material modification. Id. A call option does not have
a strike price substantially below fair market value if the price at the time of exercise cannot,
pursuant to the terms of the instrument, be substantially below the fair market value of the
underlying stock at the time of exercise. Id.
- 32 (a)
Options Issued to Lenders
A call option is not treated as a second class of stock if it is issued to a person that is
actively and regularly engaged in the business of lending and is issued in connection with a loan
to the corporation that is commercially reasonable. Treas. Reg. § 1.1361-1(l)(4)(iii)(B)(1); see
PLR 201043015 (ruling that warrants issued to lenders in debt restructuring of S corporation do
not constitute a second class of stock); PLR 200314016 (ruling that extending the time in which
a warrant on S corporation stock could be exercised subsequent to the discharge of the
underlying loan that served as consideration for the original issuance of the warrant did not
constitute the issuance of a second class of stock).
(b)
Options Issued to Employees
A call option that is issued to an individual who is either an employee or an independent
contractor in connection with the performance of services is not treated as a second class of stock
if the call option is nontransferable within the meaning of Treas. Reg. § 1.83-3(d) and
does not have a readily ascertainable fair market value (as defined in Treas. Reg. § 1.83-7(b)) at
the time the option is issued. Treas. Reg. § 1.1361-1(l)(4)(iii)(B)(2).
(c)
Call Option Safe Harbor Relief
A call option that conveys the right to acquire stock of the corporation at a specified
strike price will not be treated as a second class of stock if the strike price of the call option is at
least 90 percent of the fair market value of the stock with respect to which the call option may be
exercised. Treas. Reg. § 1.1361-1(l)(4)(iii)(C). See Santa Clara Valley Housing Group, Inc. v.
United States, 2011-2 USTC ¶ 50,637 (N.D. Cal. 2011) (holding that (i) warrants were not
substantially certain to be exercised and thus were not treated as a second class of stock under
Treas. Reg. § 1.1361-1(l)(4)(iii), but (ii) warrants could be tested for second-class-of-stock issues
under Treas. Reg. § 1.1361-1(l)(4)(ii) as well, and (iii) warrants constituted a second class of
stock under Treas. Reg. § 1.1361-1(l)(4)(ii)); Santa Clara Valley Housing Group, Inc., v. United
States, 2012-1 USTC ¶ 50,169 (N.D. Cal. 2012) (on motion for reconsideration, holding that safe
harbor provision of Treas. Reg. § 1.1361-1(l)(4)(iii)(C) can apply to instruments that would
otherwise constitute a second class of stock under Treas. Reg. § 1.1361-1(l)(4)(ii)). For this
purpose, the test must be met at the time the option is issued, materially modified, or transferred
by a person who is an eligible shareholder to a person who is not an eligible shareholder. Id. For
purposes of the safe harbor, a good faith determination of fair market value will be respected
unless the value was substantially in error or the determination of the value was not performed
with reasonable diligence. Id. A call option that fails to meet the safe harbor will not necessarily
be treated as a second class of stock. Id.
(iv)
Convertible Debt
A convertible debt instrument is considered a second class of stock if it would be treated
as a second class under the general rules applicable to debt arrangements or the general rules
applicable to call options. Treas. Reg. § 1.1361-1(l)(4)(iv).
- 33 (v)
The Straight Debt Safe Harbor Rules
In General: Any debt that is treated as “straight debt” will not be treated as a second
class of stock. Section 1361(c)(5); Treas. Reg. § 1.1361-1(l)(5); see PLR 9342019; PLR
9308006. The term “straight debt” means a written unconditional obligation to pay a sum certain
on demand or on a specified due date if (i) the interest rate or payment dates are not contingent
on profits, the borrower’s discretion, the payment of dividends with respect to common stock, or
similar factors, (ii) the obligation is not convertible (directly or indirectly) into stock or any other
equity interest of the S corporation, and (iii) the obligation is held by an individual (other than a
nonresident alien), an estate, a trust described in Section 1361(c)(2), or a person that is actively
and regularly engaged in the business of lending money.41 Section 1361(c)(5).
The fact that an obligation is subordinated to other debt of the corporation does not
prevent the obligation from qualifying as straight debt. Treas. Reg. § 1.1361-1(l)(5)(ii). An
obligation that originally qualified as straight debt ceases to so qualify if the obligation is
materially modified so that it no longer satisfies the definition of straight debt or transferred to a
third party who is not an eligible shareholder of an S corporation. Treas. Reg. § 1.1361(l)(5)(iii).
Additional Effects of Satisfying Straight Debt Test: In addition to not being treated as
a second class of stock, an S corporation obligation that satisfies the straight debt safe harbor is
treated as debt and is subject to the applicable rules governing indebtedness for all other tax
purposes. Treas. Reg. § 1.1361-1(l)(5)(iv). Accordingly, interest paid or accrued with respect to
a straight debt obligation is generally treated as interest and does not constitute a distribution
with respect to stock to which Section 1368 applies. Id. However, if a straight debt obligation
bears an interest rate that is unreasonably high, an appropriate portion of the interest may be
recharacterized and treated as a payment that is not interest. Such a recharacterization does not
result in a second class of stock. Id.
If a C corporation has an outstanding obligation that satisfies the definition of straight
debt, but which is considered equity under general tax principles, then the obligation will not be
treated as a second class of stock if the C corporation converts to S corporation status. Treas.
Reg. § 1.1361-1(l)(5)(v). In addition, the conversion from C corporation status to S corporation
status will not be treated as an exchange of debt for stock with respect to such an instrument. Id.
Prior to the Small Business Act of 1996, the definition of “straight debt” in Section
1361(c)(5) did not include otherwise-qualifying debt held by creditors, other than individuals,
that are actively and regularly engaged in the business of lending money. The related final
regulations still contain the pre-Small Business Act of 1996 definition of “straight debt.”
41
- 34 f.
Miscellaneous Provisions
(i)
Inadvertent Terminations
An S corporation that is treated as having more than one class of stock loses its S
corporation status on the date the corporation is treated as having more than one class of stock.
In such cases, the S corporation may apply for inadvertent termination relief pursuant to Section
1362(f). Treas. Reg. § 1.1361-1(l)(6). If granted, the S corporation status will be restored
retroactive to the date the S election was terminated.
(ii)
Effective Dates
The regulations regarding a second class of stock generally apply to taxable years of a
corporation beginning on or after May 28, 1992. Treas. Reg. § 1.1361-1(l)(7). In addition, a
corporation and its shareholders may apply the regulations to prior taxable years. Id.
6.
Permitted Taxable Year
a.
Current Guidance in General
An S corporation’s taxable year must be a “permitted year” or a grandfathered fiscal year.
See Section 1378; Temp. Treas. Reg. § 1.444-1T(a)(3). Currently, a “permitted year” means the
following taxable years: (i) a calendar year, (ii) a Section 444 taxable year, (iii) a 52-53-week
taxable year ending with reference to a calendar year or to a Section 444 taxable year, and (iii) a
taxable year for which the corporation establishes a “business purpose” to the satisfaction of the
Commissioner under Section 442. See Sections 444, 1378; Treas. Reg. § 1.1378-1. Although it
is not certain that the use of a permitted year is a condition of eligibility for S corporation status
(as more fully described below), a closely held business should consider this issue at the time it
considers to operate as an S corporation in order to properly weigh the costs and benefits of such
decision.
b.
Prior Guidance
(i)
Pre-1983
The ability of an S corporation to file its income tax returns on the basis of a fiscal year
has varied over the years. Prior to 1983, S corporations were generally allowed to report on the
basis of a fiscal year other than the calendar year. As a result, shareholders of an S corporation
could effectively defer the recognition of income earned by the S corporation for up to eleven
months (assuming, e.g., a calendar-year shareholder and a January 31 fiscal year S corporation).
(ii)
1983-1986
In an effort to curb this opportunity, the Revision Act of 1982 introduced the concept of a
“permitted year.” See Revision Act of 1982, P.L. 97-354, § 2, 96 Stat. 1669, 1685. Under the
Revision Act of 1982, a corporation making an S election for a taxable year beginning after
December 31, 1982 was required to report its taxable income pursuant to a permitted year. See
Section 1378(a)(2) (1985); Revision Act of 1982, P.L. 97-354, §§ 2, 6, 96 Stat. at 1685, 1697. A
- 35 permitted year was either a calendar year or a year for which a corporation established a business
purpose to the satisfaction of the Secretary. See Section 1378(b) (1985).
The Service provided S corporations several tests under which to establish a business
purpose for a fiscal year. See Rev. Proc. 83-25, 1983-1 C.B. 689. One such test permitted an S
corporation to adopt, retain, or change to a fiscal year if such fiscal year produced a deferral of
income of three months or less to shareholders holding more than one-half of the shares of the S
corporation. See Rev. Proc. 83-25. Assuming calendar-year shareholders, this would permit use
of a September 30 (or later) fiscal year.
c.
Current Guidance in Detail
(i)
Calendar Year or Business Purpose Year
The TRA of 1986 modified the above rules. It generally requires all S corporations to
retain or change to a permitted year. See section 806 of the TRA of 1986; Section 1378(a). Like
the law prior to the TRA of 1986, Section 1378 (as amended) provides that a permitted year is
either a calendar year or any other accounting period for which the corporation establishes a
business purpose to the satisfaction of the Secretary. Pursuant to the regulations under Section
1378, a permitted year also includes a 52-53-week taxable year ending with reference to the
calendar year. Treas. Reg. § 1.1378-1(a).
Unlike the law prior to the TRA of 1986, Section 1378 (as amended) expressly provides
that deferral of income to shareholders is not a reason that may be used to substantiate a business
purpose. Thus, the deferral of income to owners for even a limited period of time, even for three
months or less, is no longer treated as a business purpose. See also H.R. Conf. Rep. No. 99-841,
at II-319 (1986); Rev. Proc. 87-32, 1987-2 C.B. 396.
Although the TRA of 1986 limited the means by which S corporations could establish a
fiscal year under the business purpose test, several ways still exist. See Rev. Proc. 2002-37,
2002-1 C.B. 1030; Rev. Proc. 2002-38, 2002-1 C.B. 1037; Rev. Proc. 2002-39, 2002-1 C.B.
1046; Rev. Rul. 87-57, 1987-2 C.B. 117; Rev. Proc. 87-32, 1987-2 C.B. 396; H.R. Rep. No. 99841, 99th Cong., 2d Sess. II-319 (1986) (conference report to the TRA of 1986); Rev. Proc. 8325, 1983-1 C.B. 689.
(ii)
Section 444 Fiscal Year
In General: The Omnibus Budget Reconciliation Act of 1987, P.L. 100-203, (the
“OBRA of 1987”) provided another limited avenue for S corporations to use a fiscal year. See
Omnibus Budget Reconciliation Act of 1987, P.L. 100-203, § 10206, 101 Stat. 1330-382, 1330397. As part of the OBRA of 1987, Congress enacted Section 444. That Section permits an S
corporation to elect to use certain fiscal years. In exchange for the right to use such a fiscal
year, Section 444 requires the S corporation annually to pay the Treasury Department an amount
intended to eliminate the benefit of any deferral of income by the S corporation shareholders
obtained from the S corporation’s use of such fiscal year. See Section 7519. Because of the
complexity involved in determining the amount of the required payments under Section 7519,
the Section 444 election remains an unpopular option for S corporations seeking to use fiscal
years. See William R. Christian & Irving M. Grant, Subchapter S Taxation, 21-30 (2004). A 52-
- 36 53-week taxable year ending with reference to a Section 444 taxable year is also a permitted
year. Treas. Reg. § 1.1378-1(a).
Section 444 provides that an S corporation that is otherwise required to change to a
calendar year can elect to retain the taxable year it used for its last year beginning in 1986.
Section 444(b)(3). Also, an S corporation may adopt or change to a fiscal year, but only if the
deferral period with respect to the new year generally is no longer than three months as
compared to the otherwise required year. Section 444(b)(1), (4). For example, if a taxable year
of December 31 is otherwise required under Section 1378, a fiscal year ending September 30
may be elected under Section 444. The deferral period of the elected taxable year is the
maximum three months.
New Deferral Period Must Be Shorter Than Current Deferral Period: However,
where the S corporation is changing its taxable year, a further limitation applies. Under Section
444(b)(2), a Section 444 election may be made only if the deferral period is not longer than the
deferral period currently enjoyed. For additional guidance, see Treas. Reg. §§ 1.444-1T, -2T and
-3T; IRS Notice 88-49, 1988-1 C.B. 532; and IRS Notice 88-10, 1988-1 C.B. 478.
Special Rule for Tiered Structures: Nevertheless, an S corporation that is in a “tiered
structure” generally may not qualify to elect a Section 444 fiscal year. See Section 444(d)(3).
What constitutes a “tiered structure” for these purposes is described in Temp. Treas. Reg. §
1.444-2T.
Election and Termination: The Section 444 election is made at the S corporation level.
Section 444(d); see also Temp. Treas. Reg. § 1.444-3T (describing the timing requirements for
filing the Section 444 election). The relief provisions of Treas. Reg. § 301.9100-3 may be used
in case of an untimely Section 444 election. See PLR 200326022; PLR 200313006. The
election remains in effect until the S corporation changes its taxable year or otherwise terminates
such election. See Section 444(d).
An S corporation wishing to terminate its Section 444 election and change to the required
year does so by filing a tax return for the resulting short taxable year in the time prescribed for
the filing of a tax return for a taxable year of 12 months ending on the date the short taxable year
ends. TAM 9419002. Other election terminating events include (i) willfully failing to comply
with the requirements of Section 7519, and (ii) becoming a member of certain tiered structures.
See Section 7519(f)(4)(C); Temp. Treas. Reg. § 1.444-1T(a)(5). However, an S corporation
cannot affirmatively terminate its Section 444 election by determining that it willfully failed to
comply with the requirements of Section 7519 (i.e., only the Service may assert this ground).
TAM 9419002.
(iii)
Grandfathered Fiscal Year
An S corporation may also use a fiscal year that qualifies as a “grandfathered fiscal year.”
See Temp. Treas. Reg. § 1.444-1T(a)(3); Rev. Proc. 2002-38, 2002-1 C.B. 1037 (clarifying,
modifying, amplifying, and superseding Rev. Proc. 87-32); Rev. Proc. 87-32, 1987-2 C.B. 396,
400. A grandfathered fiscal year is a fiscal year that an S corporation received permission to use
on or after July 1, 1974 and which did not result in a deferral of income of three months or less
- 37 (i.e., such year resulted in a deferral of income for more than three months). See Rev. Proc.
2002-38; Rev. Proc. 87-32. Thus, S corporations with calendar-year shareholders that previously
had received permission to use taxable years ending September 30, October 31, or November 30
do not have grandfathered fiscal years because these fiscal years produce deferral of income of
three months or less. As a result, an S corporation with calendar-year shareholders may have a
grandfathered fiscal year only if the S corporation has a fiscal year ending January 31 through
August 31.
(iv)
Procedural Requirements Relating to Permitted
Taxable Years
(a)
Treasury Regulations
Temporary regulations under Section 1378 were published on January 26, 1983. See
T.D. 7872, 48 Fed. Reg. 3,590 (1983). Proposed regulations were published on June 13, 2001.
See 66 Fed. Reg. 31,850-02. The temporary regulations eventually were removed on May 17,
2002, and replaced with final regulations (the “current regulations”). See T.D. 8996, 2002-1
C.B. 1127 (May 17, 2002). The current regulations are effective for taxable years ending on or
after May 17, 2002. Treas. Reg. § 1.1378-1(f). The current regulations are discussed below.
A corporation (i.e., an S corporation or an electing S corporation) may automatically
change to a calendar year to comply with the permitted year requirement if the corporation
complies with administrative procedures published by the Commissioner (i.e., Rev. Proc. 200237, Rev. Proc. 2002-38, and Rev. Proc. 87-32). See Treas. Reg. § 1.1378-1(c).
A new corporation that makes an S election will adopt the taxable year that it uses with
respect to the filing of its first tax return, except that an S corporation must get approval from the
Commissioner to adopt a taxable year other than a calendar year, a Section 444 taxable year, and
a 52-53-week taxable year ending with reference to a calendar year or a Section 444 taxable
year. See Treas. Reg. §§ 1.441-1(c), 1.1378-1(b).
If a corporation wishes to adopt, change to, or retain a taxable year other than a calendar
year when it elects to be an S corporation, the corporation must request approval from the
Commissioner on the S corporation election form (Form 2553). See Treas. Reg. § 1.13781(e)(2). The corporation’s S election will be effective if approval as to the chosen fiscal year is
given. See Treas. Reg. § 1.1378-1(e)(2). If the request is denied, the S election will be
ineffective unless the corporation agrees to adopt, change to, or retain a calendar year or, if
applicable, a Section 444 taxable year. See Treas. Reg. § 1.1378-1(e)(2).
(b)
Other Guidance
On May 10, 2002, the Service issued Rev. Proc. 2002-37, 2002-1 C.B. 1030, Rev. Proc.
2002-38, 2002-1 C.B. 1037,42 and Rev. Proc. 2002-39, 2002-1 C.B. 1046 (collectively, the “2002
42
Rev. Proc. 2002-38 clarifies, modifies, amplifies, and supersedes Rev. Proc. 87-32,
1987-2 C.B. 396, which provided guidance to S corporations and corporations electing to be an S
(Continued …)
- 38 administrative guidance”). The 2002 administrative guidance provides procedures by which
corporations may obtain (i) automatic approval for adopting, changing to, or retaining a taxable
year or (ii) a ruling that approves the adoption, change to, or retention of a taxable year.
Generally, the 2002 administrative guidance is effective for adoptions, changes to, or retentions
of taxable years for which the first effective taxable year ends on or after May 10, 2002. The
Service has slightly modified the 2002 administrative guidance with subsequent guidance. See
Rev. Proc. 2003-34, 2003-1 C.B. 856; IRS Notice 2002-72, 2002-2 C.B. 843.43
d.
Failure to Adopt, Change To, or Retain Permitted Year
(i)
Validity of S Election
As discussed above, in order to elect to become an S corporation, a corporation must
meet the definition of a “small business corporation.” See Sections 1361, 1362. The statutory
definition of a small business corporation does not include a requirement that a corporation
report its taxable income pursuant to a permitted year under Section 1378.
Prior to 1987, however, Former Section 1378(a)(2) expressly stated that use of a
permitted year was a condition precedent for an S election. Thus, Former Section 1378(a)(2)
provided a statutory link between the eligibility requirements to make an S election and the
permitted year provision of Section 1378. The TRA of 1986 removed Former Section
1378(a)(2). Compare Section 1378 with Section 1378(a)(2) (1985). The legislative history of
current Section 1378(a) does not explain this revision. Nevertheless, the removal of Former
Section 1378(a)(2) eliminated the only statutory provision linking the use of a permitted year and
eligibility to make an S election. Accordingly, it appears that the failure to report pursuant to a
permitted year at the time of the S election does not invalidate a corporation’s S election.
Prior to May 17, 2002, temporary regulations issued under Section 1378 in 1983 – before
the removal of Former Section 1378(a)(2) in 1986 -- provided that no corporation may make an
election to be an S corporation for any taxable year unless that taxable year was a permitted year.
See Temp. Treas. Reg. § 18.1378-1(a) (1983). Proposed regulations issued in 2001 contained
similar language. See Prop. Treas. Reg. § 1.1378-1(a), 66 Fed. Reg. 31,850-02 (June 13, 2001)
corporation that desired to adopt, retain, or change their taxable year. Rev. Proc. 87-32 had
modified Rev. Proc. 83-25 consistent with the TRA of 1986 and had superseded Rev. Proc. 8325 to the extent of any modification. Rev. Proc. 87-32 had also been modified by Temp. Treas.
Reg. §§ 301.9100-1T to -3T as of June 27, 1996; the modification related to applications for
relief under Section 9100 for requests to change an accounting period.
43
The Service has provided a procedure under which certain S corporation shareholders
may elect to take into account ratably over four taxable years their pro rata share of income from
an S corporation that is attributable to a short taxable year of the S corporation ending on or after
May 10, 2002, and before June 1, 2004, where such short taxable year was generated by the S
corporation changing its taxable year under certain limited conditions pursuant to Rev. Proc.
2002-38 or Rev. Proc. 2002-39. See Rev. Proc. 2003-79, 2003-2 C.B. 1036.
- 39 (extending the rule in the temporary regulations to Section 444 taxable years). However, in final
regulations published on May 17, 2002, the Treasury Department removed this language and, as
a result, suggested that the use of a permitted year may no longer be a condition precedent to a
valid S election. Compare Treas. Reg. § 1.1378-1(a) with Prop. Treas. Reg. § 1.1378-1(a), 66
Fed. Reg. 31,850-02 (June 13, 2001), and Temp. Treas. Reg. § 18.1378-1(a) (1983).
Informal discussions with officials from the Service also suggest that the failure to report
pursuant to a permitted year generally should not invalidate an S corporation’s S election from
its inception. Instead, it appears that the Service generally would require the S corporation to
refile its prior income tax returns on a permitted-year basis.
Note, however, that Treas. Reg. § 1.1378-1(e)(2) (finalized in 2002) provides as follows:
“Special rules for electing S corporations. An electing S corporation that wants to adopt, change
to, or retain a taxable year other than its required taxable year must request approval of the
Commissioner on Form 2553, ‘Election by a Small Business Corporation,’ when the election to
be an S corporation is filed pursuant to Section 1362(b) and § 1.1362-6. See § 1.1362-6(a)(2)(i)
for the manner of making an election to be an S corporation. If such corporation receives
permission to adopt, change to, or retain a taxable year other than its required taxable year, the
election to be an S corporation will be effective. Denial of the request renders the election
ineffective unless the corporation agrees that, in the event the request to adopt, change to, or
retain a taxable year other than its required taxable year is denied, it will adopt, change to, or
retain its required taxable year or, if applicable, make an election under section 444.” Treas.
Reg. § 1.1378-1(e)(2). Query whether this provision supports the view that the use of a
permitted year continues to be a condition precedent to a valid S election, notwithstanding the
removal of Former Section 1378(a)(2). Cf. Prop. Treas. Reg. § 1.1378-1(e)(2), 66 Fed. Reg.
31,850-02 (June 13, 2001) (similar language); Temp. Treas. Reg. § 18.1378-1(b)(2)(ii) (1983)
(similar language).
A case from the United State Tax Court suggests that the use of a permitted year is a
condition precedent to a valid S election. In Arnold v. Commissioner, 56 T.C.M. (CCH) 185
(2005), the taxpayers requested a taxable year ending January 31 in their S election filed on April
20, 1993. In 1998, the Service informed the taxpayers that their S election was invalid. The
court ruled that, since the requested taxable year was not the corporation’s natural business year
pursuant to Rev. Proc. 87-32, the corporation had not used a permitted year as defined in Section
1378 for any year. The court stated that the corporation “failed to qualify as an S corporation
because it did not use a tax year permitted under section 1378(a)….” The court’s analysis,
however, did not address the Section 1378 regulations or the fact that there is no statutory link
between the use of a permitted year and eligibility to make an S election.
(ii)
Termination of S Election
As discussed below in Section V., an S corporation’s S election can be terminated only
under the circumstances specified in Section 1362(d). See Section 1362(c). The failure to report
taxable income pursuant to a permitted year is not one of the specific circumstances for S
election termination. See Section 1362(d).
- 40 Like the requirements for an S election, a statutory link does not exist between the
requirements for an S election termination and the permitted year provision of Section 1378.
Thus, it appears that the failure to report pursuant to a permitted year does not terminate an S
election. In one case, the Service concluded that the failure of an S corporation to file income
tax returns under a permitted year is not an event justifying termination of the S election. See
TAM 9505003.
Informal discussions with officials from the Service suggest that an S corporation’s
failure to report pursuant to a permitted year generally should not result in the termination of the
corporation’s S election. The officials suggested that an S corporation in these circumstances
should start filing on a calendar-year basis.
However, some authority exists to support the position that an S election could terminate
under these circumstances. See Farmers Gin, Inc. v. Comm’r, 69 T.C.M. (CCH) 1696 (1995)
(holding that the failure to maintain a fiscal year authorized under former Section 1378
terminated a corporation’s S election).
B.
The S Election
1.
Making the Election
The S election is made by filing a completed Form 2553, Election by a Small Business
Corporation. Treas. Reg. § 1.1362-6(a)(2)(i).
a.
Timing
In General: Under Section 1362(b)(1), a small business corporation must make its S
election for any taxable year either during the preceding taxable year or before the 16th day of the
third month of the taxable year (i.e., during the first two and one-half months of the year). Treas.
Reg. § 1.1362-6(a)(2)(ii)(A). An S election made during the taxable year, but after the first two
and one-half months, will be treated as having been made for the following year, provided that
the corporation meets all the requirements of Section 1361(b) at the time the election is made.
Treas. Reg. § 1.1362-6(a)(2)(ii)(A). An election made for a taxable year of two and one-half
months or less (i.e., a short year) will be effective if made within two and one-half months after
the first day of the taxable year. Section 1362(b)(4). Thus, an election made at any time during
such a short year will be effective for that year. Treas. Reg. § 1.1362-6(a)(2)(ii)(A), (iii) ex. 2.
The timing rules for filing the election have been interpreted by the courts very strictly.
See, e.g., Simons v. United States, 208 F. Supp. 744 (D. Conn. 1962) (election invalid where
filed one day late); Pestcoe v. Comm’r, 40 T.C. 195 (1963). Prior to the Small Business Act of
1996, no extensions were permitted. Rev. Rul. 60-183, 1960-1 C.B. 625; PLR 8637062.
Relief for Late Elections: The Small Business Act of 1996 authorized the Service to
treat a late S election as timely where the Service determines that there was reasonable cause for
the failure to make a timely S election. See Section 1362(b)(5). This provision applies with
respect to S elections for taxable years beginning after December 31, 1982.
- 41 Currently, there are three ways to obtain relief from a late S election. First, if the
corporation can demonstrate that it had reasonable cause for its failure to make a timely S
election and can satisfy certain timing requirements, the corporation may request relief under
either Rev. Proc. 2007-62, 2007-41 I.R.B. 786, or Rev. Proc. 2003-43, 2003-1 C.B. 998.44
Second, the corporation may request relief under Rev. Proc. 97-48, 1997-2 C.B. 521. However,
a corporation is eligible for this relief only if the Service failed to notify the corporation of any
problem within 6 months of the due date on which the corporation filed a timely S corporation
return for the first year it intended to be an S corporation. Third, the corporation may request
relief by filing a private letter ruling request pursuant to Section 1362(b)(5). Similar to the
requirements of Rev. Proc. 2007-62 and Rev. Proc. 2003-43, the corporation must demonstrate
that it had reasonable cause for its failure to make a timely S election.
For recent examples of situations where the Service granted relief under the late S
election rules, see PLR 201219014, PLR 201216030, PLR 201151005, PLR 200323039, PLR
200323031, PLR 200323021, PLR 200029045, PLR 200027033, PLR 200026018, PLR
200025033, PLR 199914039, and PLR 199914021. For an example of a situation where the
Service did not grant relief under the late S election rules, see PLR 200333017 (ruling that
granting such relief would prejudice the interests of the government since the statute of
limitations on assessment had expired with respect to the return of the corporation’s sole
shareholder who (but for the statute of limitations) would have to include additional income in
such return if relief from a late S election were granted).
b.
Consent Required
In General: An S election will be valid only if all persons who are shareholders of the
corporation on the day on which the election is made consent to the election. Section 1362(a)(2);
Treas. Reg. § 1.1362-6(b)(3); see Garavaglia v. Comm’r, 102 T.C.M. (CCH) 286 (2011)
(rejecting the Service’s argument to apply judicial doctrines (taxpayers bound by form of
transaction they choose and the duty of consistency) to overcome taxpayers’ failure to comply
44
Rev. Proc. 2007-62 supplements Rev. Proc. 2003-43 by providing an additional
simplified method to request relief for a late S election. Prior to the issuance of Rev. Proc. 200343, the Service had issued Rev. Proc. 97-40, 1997-2 C.B. 488, and Rev. Proc. 97-48, 1997-2 C.B.
521, to provide procedures by which taxpayers could request relief for late S elections. Rev.
Proc. 97-40 was superseded by Rev. Proc. 98-55, 1998-2 C.B. 645, and Rev. Proc. 97-48 was
partially superseded and updated by Rev. Proc. 98-55. Under Rev. Proc. 98-55, a valid S
election must have been filed within twelve months of the original due date for the S election
(but in no event later than the due date for the tax return (excluding extensions) for the first year
the corporation intended to be an S corporation) and the corporation must have had reasonable
cause for failing to make a timely S election. Rev. Proc. 98-55 also provided procedures by
which taxpayers could request relief for late qualified subchapter S subsidiary (“QSub”)
elections (discussed below), QSST elections, and ESBT elections. Effective June 9, 2003, Rev.
Proc. 98-55 was superseded by Rev. Proc. 2003-43. Rev. Proc. 2003-43 also provides
procedures by which taxpayers can request relief for late QSub elections, QSST elections, and
ESBT elections.
- 42 with the shareholder consent requirements of Treas. Reg. § 1.1362-6(b)(3)(i)). If stock is held by
an ESBT, then the trustee of the ESBT must consent to the S election, but the ESBT
beneficiaries need not consent. See IRS Notice 97-12, 1997-1 C.B. 385. If there is more than
one trustee of the ESBT, the trustee or trustees with authority to legally bind the trust must
consent to the S election. Treas. Reg. § 1.1362-6(b)(2)(iv). Furthermore, if the ESBT is also a
grantor trust, the deemed owner must also consent to the S election if the portion of the trust the
person is deemed to own holds stock in the electing S corporation. Id.
If stock is owned by husband and wife as community property (or the income from the
stock is community property), each person having a community interest in the stock (or income)
must consent to the S election. Treas. Reg. § 1.1362-6(b)(2)(i). If stock is owned by tenants in
common, joint tenants, or tenants by the entirety, each tenant in common, joint tenant, and tenant
by the entirety must consent to the S election. Id. There also are special rules for estates,
minors, and trusts other than ESBTs that own stock. See Treas. Reg. § 1.1362-6(b)(2)(ii)-(iv).
Where an S election is made during the first two and one-half months of the year, any
departing shareholders who held stock during such portion of year must give their consent to
such election. If such consent is not obtained, the S election will be treated as having been made
for the following taxable year. Section 1362(b)(2); Treas. Reg. § 1.1362-6(a)(2)(ii)(B)(2).
Relief for Failure To Obtain Consents: The Small Business Act of 1996 granted the
Service statutory authority to waive the effect of an invalid S election caused by an inadvertent
failure to obtain the required shareholder consents. See Section 1362(f). Treas. Reg. § 1.13626(b)(3)(iii) contains the general procedure for obtaining the Service’s waiver for this type of
invalid S election. Rev. Proc. 2004-35, 2004-23 I.R.B. 1, provides special automatic relief from
an invalid S election solely due to a failure to include the consent of a community property
spouse who was a shareholder solely pursuant to state community property law. For recent
examples of situations where the Service granted relief for an invalid S election that was
inadvertent, see PLR 201144018, PLR 200324050, PLR 200010034, PLR 199933035, and PLR
199918045.
c.
Qualification as a Small Business Corporation
If Election Made in Prior Year: If an S election is made during the preceding taxable
year, the corporation must be a small business corporation both at the time of the election and on
the first day of the taxable year for which the election is to be effective. Section 1362(a)(1); Rev.
Rul. 86-141, 1986-2 C.B. 151. Cf. Section 1362(d)(2) (election terminated if corporation
becomes ineligible on or after first effective date).
Where an S election is made during the preceding year, a corporation may cease to
qualify as a small business corporation any time after the day on which the election is filed and
before the first effective date of the election. Treas. Reg. § 1.1362-2(b)(2). For example, if an
election is made on November 15, 1999 to be effective on January 1, 2000, the electing
corporation apparently may cease to qualify at any time from November 16 through December
31, 1999 without affecting the S election for 2000.
- 43 If Election Made During First S Year: If an S election for a taxable year is made
during the first two and one-half months of the year, the corporation must qualify as a small
business corporation on each day of the pre-election period of the year. If the corporation does
not so qualify, the election will be treated as having been made for the following taxable year.
Section 1362(b)(2); Treas. Reg. § 1.1362-6(a)(2)(ii)(B)(1). Furthermore, if an S election for a
taxable year is made during the year but after the first two and one-half months of the year, the
election will be treated as having been made for the following taxable year. Section 1362(b)(3).
In that case, as discussed above, the corporation must qualify as a small business corporation
both at the time of the election and on the first day of the following taxable year.
Relief for Failure To Qualify: The Small Business Act of 1996 granted the Service
statutory authority to waive the effect of an invalid S election caused by an inadvertent failure to
qualify as a small business corporation. See Section 1362(f); Rev. Proc. 2003-43 (superseding
Rev. Proc. 98-55 effective June 9, 2003); IRS Ann. 97-4, 1997-3 I.R.B. 14; see also Rev. Proc.
2007-62, 2007-41 I.R.B. 786; Rev. Proc. 2004-48, 2004-2 C.B. 172. For examples of situations
where the Service granted relief for an invalid S election that was inadvertent, see PLR
200217048, PLR 200010034, PLR 199933035, and PLR 199918045.
Note that the failure to file a timely QSST or ESBT election may cause a corporation to
fail to qualify as a small business corporation from inception as a result of having an
impermissible trust shareholder. Section 1362(f) or Rev. Proc. 2003-43 could provide relief in
these circumstances if the corporation and the trust can demonstrate that the failure to file a
timely QSST or ESBT election was inadvertent.
2.
New Election After Termination
a.
Five-Year Waiting Period
In General: If an S election is terminated (under Section 1362(d)), the former S
corporation and any “successor corporation” will not be eligible to make a new S election for any
taxable year beginning before its fifth taxable year after the first taxable year in which the
termination is effective, unless the Secretary consents to an earlier election. Section 1362(g);
Treas. Reg. § 1.1362-5(a); see Section V., below. In other words, an S election is barred for the
remaining portion of the year in which the terminating event took place and the next four taxable
years as well.
For example, on July 1, 1998, an ineligible shareholder acquires stock of an S
corporation. Assuming that ownership of the S stock is not disregarded as being transitory, the S
election terminates on July 1, 1998. Section 1362(d)(2)(B). A new S election will not be
effective before January 1, 2003, the fifth taxable year beginning after the short taxable year
ending on December 31, 1998. See, e.g., PLR 9634021.
Consent To File Earlier Election: The corporation requesting consent to make a new S
election before the expiration of such five-year period has the burden of establishing that, under
the relevant facts and circumstances, the Commissioner should consent to such an election. See
Treas. Reg. § 1.1362-5(a). For purposes of determining whether consent should be granted to
file an S corporation election within the five-year period of the termination of an S election, the
- 44 fact that more than 50 percent of the stock in the corporation is owned by persons who did not
own any stock in the corporation on the date of the termination tends to establish that consent
should be granted. See Treas. Reg. § 1.1362-5(a). But see PLR 199952072 (even though more
than 50 percent of the stock in the relevant corporation changed hands, the Commissioner did not
consent to a new S election due to the particular facts presented by the ruling and the
government’s concern that consent would have allowed the corporation’s shareholders to avoid
the application of other Code provisions).
b.
Successor Defined
In General: Section 1362(g) does not define the term “successor corporation.”
However, the regulations under Section 1362(g) define a successor corporation as any
corporation (the “Successor”) that satisfies the following two requirements: (i) 50 percent or
more of the Successor’s stock is owned, directly or indirectly, by the same persons who, on the
date of termination, owned 50 percent or more of the stock of the small business corporation
whose S election was terminated; and (ii) the Successor acquires a “substantial portion” of the
assets of the small business corporation, or a “substantial portion” of the Successor’s assets were
assets of such small business corporation. Treas. Reg. § 1.1362-5(b). The regulations do not
define the term “substantial.” The apparent purpose of restricting S elections by successor
corporations is to prevent avoidance of Section 1362(g) by merely transferring assets to a newly
established corporation that could make an S election within the proscribed five-year period for
making a new S election.
As a result of the regulations, a corporation generally will not be a successor to a
terminated S corporation unless there is both a continuity of shareholder interest of at least 50
percent and (i) the new corporation acquires a “substantial portion” of the assets of the S
corporation or (ii) a “substantial portion” of the assets it holds are the former S corporation’s
assets. Thus, where more than 50 percent of the stock of the former S corporation is owned by
new unrelated shareholders, the Service has consented to an earlier S election. See PLR
200334035; PLR 200029043; PLR 200025022; PLR 200019007; PLR 199918031; PLR
199916032; PLR 9419010; PLR 934400; PLR 9340047.
Planning Issues: A terminated S corporation cannot cleanse a Section 1362(g) taint by
reincorporating under Section 368(a)(1)(F). See IRS Ann. 86-128, 1986-51 I.R.B. 22. An
acquisitive D reorganization also will not avoid Section 1362(g). However, it appears that a
corporation can avoid successor status by issuing sufficient stock so that the 50 percent
continuity of interest test is not met. Query whether a terminated S corporation could avoid
Section 1362(g) by acquiring sufficient C corporation assets so that former S corporation assets
no longer represent a substantial portion of the assets held.
Furthermore, in Rev. Rul. 77-155, 1977-1 C.B. 264, the Service ruled that where the
acquiring corporation bought stock of an S corporation from unrelated shareholders, and
liquidated the target S corporation (under Former Section 334(b)(2)), the acquiring corporation
was not treated as a successor corporation, and thus could make an S election without the
Service’s consent.
- 45 Comparison to Section 381 Definition: The definition of “successor corporation”
contained in the regulations differs from that contained in Section 381. A transferee of assets in
a merger transaction qualifies as a successor under Section 381 but not under Section 1362
unless, in general, the target shareholders hold 50 percent or more of the acquiror (e.g., a reverse
acquisition).
Asset Transfers to an S Corporation: Note that Section 1362(g) only prevents a new
election by the former S corporation and its successors. Thus, if an S corporation’s election is
terminated, or is about to terminate (e.g., as a result of excess passive investment income, which
is discussed below in Section V.A.2.), its assets may be transferred to a pre-existing corporation
that has an S election already in effect. Section 1362(g) would not affect the pre-existing
corporation’s S election. However, if the termination in fact became effective and the assets then
were transferred to the pre-existing S corporation in a carryover basis transaction that did not
terminate the transferee’s S election, the transferee S corporation apparently would not be subject
to Section 1362(g). However, in that scenario, the transferee S corporation would be subject to
Section 1374 (discussed below in Section IV.A.) with respect to the transferred assets. See IRS
Ann. 86-128, 1986-51 I.R.B. 22.
Section 338 Issue: Since Treas. Reg. § 1.338-1(b) generally treats “new T” as a new
corporation unrelated to “old T” (in each case within the meaning of Treas. Reg. § 1.338-2(b))
for purposes of Subtitle A of the Code, “new T” should be able to make an S election without
regard to the five-year reelection prohibition of Section 1362(g) (i.e., “new T” should not be
treated as the successor of “old T”). See PLR 200453007 (Section 338(h)(10) context).
c.
New Election after Invalid Election or Retroactive Revocation
of Election
If an S election is invalid or an S corporation revokes its S election effective on the first
day of the first taxable year for which its S election was to be effective, Section 1362(g) does not
prohibit the filing of a new election within the five-year waiting period. See Treas. Reg. §
1.1362-5(c); Rev. Rul. 71-549, 1971-2 C.B. 319; Info. Ltr. 20040096. In such cases, automatic
consent is given by the Service to make an early election. Treas. Reg. § 1.1362-5(c). However,
as noted above, the Small Business Act of 1996 provided that the Service may waive the effect
of an invalid election caused by an inadvertent failure to qualify as a small business corporation
or to obtain the required shareholder consents (including elections regarding QSSTs and ESBTs),
or both. See Section 1362(f); PLR 200010034; PLR 200008021; PLR 200007016; PLR
199933035; PLR 199918045.
III.
EFFECTS OF AN S ELECTION
A.
Pass-Through of S Corporation Items
1.
In General
Once a valid S election is in effect, the corporation generally is not subject to tax, and
most of its items of income, loss, deduction, and credit are passed through to its shareholders.
The S corporation, with certain modifications, computes its income as if it were an individual.
- 46 See Section 1363(b). Such income is passed through to the shareholders under Section 1366.
Subject to certain exceptions discussed below, an S corporation is not subject to taxes imposed
under chapter 1 of the Code. Section 1363; Treas. Reg. § 1.1363-1(a)(1).
Thus, an S corporation is not subject to income tax under Section 11, the accumulated
earnings tax under Section 531, or the personal holding company tax under Section 541. In
addition, an S corporation is not subject to the AMT. Instead, tax preference items are passed
through to the shareholders under Section 1366. The book income adjustment and “ACE”
adjustment under Section 56(f) and (g) do not apply to S corporations.
Section 1248: Similarly, the Service has ruled that when an S corporation sells its
interest in a controlled foreign corporation to another corporation and reports some gross income
from the sale as a dividend under Section 1248(a), the limitation under Section 1248(b) applies
to the S corporation shareholders and Section 1248 applies at the shareholder level. See PLR
199908045.
Section 291: Section 291 will apply to the computation of S corporation income if the S
corporation (or any predecessor) was a C corporation for any of the 3 immediately preceding
taxable years. This provision is designed to prohibit C corporations from avoiding the increase
in tax attributable to corporate preferences by converting to an S corporation.
Section 1237: The Small Business Act of 1996 applies the present-law capital gains
presumption for land held by a noncorporate taxpayer to land held by S corporations. Section
1237(a). The legislative history indicates that it is expected that rules similar to the attribution
rules for partnerships will apply to S corporations. Cf. Treas. Reg. § 1.1237-1(b)(3) (a taxpayer
is considered as holding property which he owns as a member of a partnership).
2.
Operation of the Pass-Through Rules
In General: Under Section 1366(a), each shareholder45 must take into account his pro
rata share of (1) separately stated items of income, loss, deduction, and credit, and (2)
nonseparately computed income or loss. Treas. Reg. § 1.1366-1(a).46 If the shareholder dies (or
if the shareholder is an estate or trust that terminates) before the end of the S corporation’s
taxable year, the shareholder’s pro rata share of these items is taken into account on the
shareholder’s final return. Id.
45
As noted above, for purposes of subchapter S of the Code, stock that is issued in
connection with the performance of services and that is substantially nonvested is not treated as
outstanding stock, and the holder of that stock is not treated as a shareholder solely by reason of
holding such stock unless the holder makes a Section 83(b) election. Treas. Reg. § 1.13611(b)(3).
46
The Service issued final regulations under Section 1366 relating to pass-through rules
for S corporations on December 21, 1999. T.D. 8852, 64 Fed. Reg. 71,641 (Dec. 22, 1999). The
regulations apply to S corporation taxable years beginning on or after August 18, 1998.
- 47 -
Separately stated items are those items that, if taken into account separately 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. Section 1366(a)(1)(A); Treas. Reg. §
1.1366-1(a)(2). Items described in Sections 702(a)(4) or (6) are included. For example, these
items include, but are not limited to: (i) capital gains and losses, (ii) Section 1231 gains and
losses, (iii) charitable contributions, (iv) tax-exempt interest, and (v) foreign taxes paid by the
corporation. See Treas. Reg. § 1.1366-1(a)(2).
Nonseparately computed income or loss is gross income minus the allowable deductions,
determined by excluding the separately stated items. Section 1366(a)(2); Treas. Reg. § 1.13661(a)(3). In other words, this amount represents “bottom line” income or loss. This Outline may
refer to separately stated items of income, loss, deduction, or credit and nonseparately computed
income or loss as “income (loss) items.”
Passive Loss Rules: An S corporation must report, and each shareholder must take into
account, the shareholder’s pro rata share of the S corporation’s items for each of the
corporation’s activities defined in Section 469 and its corresponding regulations. Treas. Reg. §
1.1366-1(a)(4).
Character Issues: The character of separately stated items is determined at the
corporate level. Section 1366(b); S. Rep. No. 97-640, supra, at 17 (1982); Treas. Reg. § 1.13661(b)(1). The final regulations give the following example: If an S corporation has capital gain
from 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. Treas. Reg. § 1.1366-1(b)(1).
Note that 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 any shareholder or group of shareholders would not have produced any capital gain if
sold or exchanged by the shareholder(s), then the gain recognized by the S corporation is not
treated as a capital gain. Treas. Reg. § 1.1366-1(b)(2). By contrast, 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(s) would have produced a
capital loss if sold or exchanged by the shareholder(s), 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(s) exceeded the fair market value of the property. Treas. Reg. § 1.1366-1(b)(3).
Section 1374 Tax: If an S corporation is subject to the Section 1374 tax, such tax will be
treated as a loss sustained by the S corporation during the year the tax is imposed. The character
of the loss is determined by allocating the loss proportionately among the recognized built-in
gains that gave rise to the tax. See Section 1366(f)(2).
Section 1375 Tax: In general, the amount of S corporation gain passed through to the
shareholders is reduced by the amount of tax imposed on the S corporation under Section 1375.
- 48 Specifically, if any tax is imposed under Section 1375 on the S corporation’s excess net passive
investment income, each item of passive investment income shall be reduced by an amount
which bears the same ratio to the amount of the Section 1375 tax as the amount of each item
bears to the total passive investment income for the taxable year. Thus, each item of passive
investment income is reduced proportionally by the Section 1375 tax. Then, such items are
passed through to the shareholders under Section 1366. See Section 1366(f)(3).
Income in Respect of a Decedent: Section 1313 of the Small Business Act of 1996
(amending Section 1367(b) of the Code) provided that a person acquiring S corporation stock
from a decedent must treat as income in respect of a decedent (“IRD”) the pro rata share of any
item of income of the corporation that would have been IRD if that item had been acquired
directly from the decedent.
Bankruptcy of S Corporation: If an S corporation files a bankruptcy petition (pursuant
to either chapter 7 or chapter 11 of the U.S. Bankruptcy Code), each shareholder of the S
corporation continues to take its pro rata share of the S corporation’s items into account as if the
S corporation had not filed for bankruptcy. See Mourad v. Comm’r, 121 T.C. 1 (2003); In re
Stadler Associates, Inc., 186 B.R. 762 (Bankr. S.D. Fla. 1995); see also Section V.B., below.
3.
Taxable Year of Inclusion
Each S shareholder must report his pro rata share of S corporation items in the taxable
year in which, or with which, the S corporation’s taxable year ends. Section 1366(a)(1). In the
case of S termination years, it is unclear whether income (loss) items are passed through at the
close of the S short year (i.e., the short taxable year, if any, prior to the termination of an S
election) or the S termination year (i.e., generally, the full taxable year in which a corporation
has its S election terminate, which includes an S short year and a C short year). The concepts of
an “S termination year,” an “S short year,” and a “C short year” are discussed in detail below.
See Sections III.A.4.c., V.B., below. The regulations indicate that pass-through is postponed
until the S termination year closes. See Section III.A.4.c., below.
4.
Allocation of Items
a.
Per-Share Per-Day Rule
The general rule is that income (loss) items are allocated on a per-share per-day basis.
That is, all items are allocated equally to each day of the year, and each of such allocated items
then is assigned to shares outstanding on that day. Compare Section 1377(a)(1) with Section
382(b)(3), (h)(5) (following an ownership change, certain recognized built-in gains not allocated
on a daily basis) and Section 706(d). But see Williams v. Comm’r, 123 T.C. 144 (2004) (ruling
that (i) losses incurred by an S corporation, during a year in which one of the S corporation’s
shareholders commenced a bankruptcy case, accrued to the shareholders on the last day of the
corporate tax year since the bankrupt shareholder did not elect to bifurcate his taxable year under
Section 1398(d)(2) and, consequently, (ii) the bankrupt shareholder’s pro rata share of such
losses accrued to the shareholder’s bankruptcy estate rather than the shareholder personally
pursuant to Section 1398(e)(1)); CCA 200217003 (similar).
- 49 For example, on July 1, 1999, an S corporation sells assets to an unrelated buyer and
recognizes $365,000 in gain. The S corporation has no other income for the year. On August
31, 1999, individual B buys 40 percent of the S corporation stock. In 1999, the gain is assigned
to each day of the year, or $1,000 per day. The per day amount is then allocated to the shares
outstanding on that day. The actual shares outstanding on July 1, 1999 are relevant only to the
extent of gain assigned to that date. Under the per-share per-day allocation rule, B will be
assigned $49,200 in income ($123,000 (or (123/365) x $365,000) x 40 percent).
In addition to stock sales, other changes such as redemptions or issuances of stock will
affect the amount of income (loss) allocated under this rule.
b.
Election To Close the Books
(i)
Termination of Shareholder’s Interest
In General: Section 1377(a)(2) provides that where a shareholder “terminates his
interest” in the corporation during the taxable year, an election may be made to close the books
as of the date the shareholder terminated his interest. The per-share per-day rule is applied
separately to the two periods created with respect to the taxable year, but only with respect to the
“affected shareholders.” Section 1377(a)(2)(A); Treas. Reg. § 1.1377-1(c) ex. 2.47 An “affected
shareholder” is any shareholder whose interest is terminated and all shareholders to whom such a
shareholder has transferred shares during the taxable year. Section 1377(a)(2)(B). If a
shareholder transferred shares to the corporation, the term “affected shareholders” includes all
persons who are shareholders during the taxable year. Id.
Election: This election is made by the S corporation. Treas. Reg. § 1.1377-1(b)(5).
However, an officer of the S corporation must state under penalties of perjury that the
corporation and all “affected shareholders” consent to the election. Id.48 Furthermore, the
election is irrevocable. Treas. Reg. § 1.1377-1(b)(1).49
47
Final regulations were issued under Section 1377 on December 20, 1996. These
regulations apply to taxable years of an S corporation that begin after December 31, 1996.
(Temp. Treas. Reg. § 18.1377-1 correspondingly was removed on December 20, 1996.)
48
In order to eliminate regulatory impediments to the electronic submission of tax returns
and other forms filed by corporations, Treas. Reg. § 1.1377-1(b)(5)(i)(C) provides that, for
taxable years beginning after December 31, 2002, the required statement need not be signed by
the officer. Instead, the signature on the related Form 1120S filed by the S corporation will
suffice. Id.
49
Prior to the Small Business Act of 1996, an election under Former Section 1377(a)(2)
affected all the shareholders of an S corporation. As a result, Former Section 1377(a)(2)
required all persons who were shareholders during the taxable year to agree to the election.
However, the Small Business Act of 1996 amended Former Section 1377(a)(2) to limit its effect
to only “affected shareholders,” and thus also amended the consent rule to require only the
(Continued …)
- 50 -
Nonshareholder-Capacity Permitted: The regulations state that the election is
available for any taxable year in which any shareholder terminates his or her entire interest as a
shareholder. Treas. Reg. § 1.1377-1(b). Apparently, a shareholder can remain in another
capacity (e.g., as a creditor or employee).
Note: Under this election, the books are closed as of the date of termination. In contrast,
in the case of an S termination year, the S short year closes on the day before the day the election
is terminated. See Section 1362(e)(1); see also Section III.A.4.c., below.
(ii)
Dispositions of Substantial Amounts of Stock
In General: In the case of a “qualifying disposition” that is not described in Section
1377(a)(2), a corporation may elect to treat the year as if there are two separate years, the first of
which ends on the date of disposition. Treas. Reg. § 1.1368-1(g). Unlike Section 1377(a)(2),
closing the books for a “qualifying disposition” affects all shareholders (not just “affected
shareholders”). Id. A “qualifying disposition” means:

a disposition by a shareholder of 20 percent or more of the stock of the
corporation during any 30-day period during the taxable year;50

a redemption (which is treated as an exchange under Sections 302(a) or
303(a)) of 20 percent or more of the outstanding stock of the corporation
from a shareholder in one or more transactions during any 30-day period
during the taxable year; or

an issuance of an amount of stock equal to or greater than 25 percent of
the previously outstanding stock to one or more new shareholders during
any 30-day period during the taxable year.
Treas. Reg. § 1.1368-1(g)(2)(i). A corporation making this election treats the taxable year as
separate taxable years for purposes of allocating income and loss (as well as for other purposes).
Treas. Reg. § 1.1368-1(g)(2)(ii).
Election: The S corporation makes the election to close the books for a qualifying
disposition. Treas. Reg. § 1.1368-1(g)(2)(iii). However, an officer of the S corporation must
consent of the “affected shareholders” and the corporation. See section 1306 of the Small
Business Act of 1996.
50
See CCA 200217003 (finding that the transfer of stock from a shareholder to the
shareholder’s bankruptcy estate pursuant to Section 1398(f) is not treated as a disposition for
purposes of any provision of the Code, including Section 1377).
- 51 state under penalties of perjury that each shareholder who held stock in the corporation during
the taxable year consented to the election. Id.51 Furthermore, the election is irrevocable. Id.
c.
Allocation in an S Termination Year
Special allocation rules apply in the case of an “S termination year,” which generally is
the full taxable year in which a corporation has its S election terminate and includes a S short
year and a C short year. For the specific definition of an “S termination year,” see Section V.D.,
below.
The general rule is that income (loss) items are assigned an equal portion to each day in
the S termination year (i.e., a pro rata method). See Section 1362(e)(2). However, in certain
circumstances, the allocation of income (loss) items between the S and C short years in an S
termination year are based on actual results. For example, the pro rata method of allocating
income items does not apply to Section 338 gain or loss. Section 1362(e)(6)(C). Furthermore,
the pro rata method does not apply to an S termination year if there is a sale or exchange of 50
percent or more of the stock in the S corporation during the S termination year. Section
1362(e)(6)(D).
Special Election to Close the Books: Under Section 1362(e)(3), an election may be
made to forego the use of the pro rata allocation rules. Under this election, items of income
(loss) are to be assigned to the S short year and the C short year based on the S corporation’s
normal tax accounting rules. An election under Section 1362(e)(3) is valid only if all persons
who are shareholders in the corporation at any time during the S short year and all persons who
are shareholders in the corporation on the first day of the C short year consent to the election.
Section 1362(e)(3)(B).
Allocation Within the S Short Year: Apparently, once items are assigned to the S short
year – whether based on actual results or pro rata allocation – the items are allocated within the S
short year according to the per-share per-day rule of Section 1377(a)(1).
d.
Special Allocations
Compared to partnerships, a major disadvantage of an S corporation is that special
allocations of income (loss) items are not possible. Compare Sections 1362(e)(2), 1377 with
Section 704. However, it may be possible to organize the capital structure of the S corporation
to produce results similar to special allocations.
51
In order to eliminate regulatory impediments to the electronic submission of tax returns
and other forms filed by corporations, Treas. Reg. § 1.1368-1(g)(2)(iii) provides that, for
elections for taxable years beginning after December 31, 2002, the required statement need not
be signed by the officer. Instead, the signature on the Form 1120S filed by the S corporation will
suffice. Id.
- 52 For example, assume that, with respect to investors A and B, the parties seek to allocate
initial losses (or initial income where the shareholder is in an NOL position) of the S corporation
in favor of investor A. To accomplish this result, investor A contributes cash to the S
corporation in exchange for stock. Investor B contributes cash in exchange for convertible debt,
options, and a lesser amount of stock. Until the options are exercised and/or debt converted, A
will receive a greater share of the income (loss) items generated by the S corporation. The terms
of the convertible debt and the options must be structured so that they would not be considered a
second class of stock under Section 1361.
5.
Limitations on Deductibility of Losses
Although items of loss and deduction (“loss items”) pass through to the shareholder,
deductibility at the shareholder level may be limited by several Code provisions. The
shareholder must pass the following hurdles in order to deduct a loss item incurred by the S
corporation. Before applying any of the loss disallowance rules, the loss item must be allocated
to the shareholder. Then, the loss disallowance rules must be applied in the following order: (i)
Section 1366(d), (ii) Section 465, and (iii) Section 469.
a.
Allocation of Loss Items
As discussed above, loss items first must be allocated to the shareholder as provided
under Sections 1362, 1366, and 1377. See CCA 200217003.
b.
Section 1366(d)
(i)
In General
Allocated loss items are deductible only to the extent of the shareholder’s adjusted basis
in stock in the S corporation and indebtedness owed by the S corporation to the shareholder.
Section 1366(d)(1); see also Treas. Reg. § 1.1366-2(a)(1); Parrish v. Comm’r, 168 F.3d 1098
(8th Cir. 1999). The use of S corporation indebtedness owed to a shareholder to support loss
deductions under subchapter S of the Code is analogous to the use of partnership debt to support
loss deductions under subchapter K of the Code. However, subchapter K of the Code appears to
provide more flexibility because, for loss deduction purposes, it takes into account partnership
debt owed to third parties as well as partnership debt owed to a partner. See also Section III.E.4.,
below, for a discussion on the deductibility of charitable contributions of appreciated property by
S corporations and partnerships.
Proposed regulations issued on June 11, 2012 provide that, in order to increase a
shareholder’s basis of S corporation indebtedness, a loan must represent bona fide indebtedness
of the S corporation that runs directly to the shareholder. Prop. Treas. Reg. § 1.1366-2; 77 Fed.
Reg. 34,884 (June 12, 2012). The proposed regulations also state that a shareholder acting as a
guarantor of S corporation indebtedness does not create or increase the basis of its indebtedness
from the S corporation simply by becoming a guarantor. The determination of whether
indebtedness is bona fide will be made under general Federal tax principles and all facts and
circumstances. The preamble indicates that, if a loan transaction represents bona fide
indebtedness, it need not otherwise satisfy the court-made “actual economic outlay” doctrine. Id.
- 53 (ii)
Basis Adjustments
For purposes of determining whether an allocable loss item is deductible by a
shareholder, the adjusted basis of the shareholder’s stock is determined 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) for the taxable year. The shareholder disregards decreases in
basis under Section 1367(a)(2)(B) and (C) for the taxable year. Treas. Reg. § 1.1366-2(a)(3).
Thus, noncapital, nondeductible expenses (and certain oil and gas depletion deductions) reduce
basis that otherwise would permit a shareholder to deduct loss items. However, a shareholder
may elect to use its basis for deductible loss items first. See Treas. Reg. § 1.1367-1(g); see also
Section III.B.4.a.(ii), below.
Furthermore, the shareholder’s adjusted basis in indebtedness of the corporation is
determined without regard to any adjustment under Section 1367(b)(2)(A) for the taxable year.
Treas. Reg. § 1.1366-2(a)(3)(ii). The basis adjustment rules are discussed below. See Section
III.B., below.
(iii)
Carryover of Disallowed Losses
In General: Any loss or deduction which is disallowed by reason of the basis limitation
contained in Section 1366(d)(1) may be carried forward indefinitely and treated as incurred by
the corporation in the succeeding taxable year, and subsequent taxable years, with respect to that
shareholder. Section 1366(d)(2); Treas. Reg. §1.1366-2(a)(2). Any disallowed losses or
deductions are personal to the shareholder, and generally may not be transferred to another
person. Treas. Reg. § 1.1366-2(a)(5). If a shareholder transfers some, but not all, of its stock in
the corporation, the amount of any disallowed loss or deduction is not reduced and the transferee
does not acquire any portion of the disallowed loss or deduction. Id. If a shareholder transfers
all of its stock, the disallowed loss or deduction ordinarily is permanently disallowed. Id.
Exception for Transfers of Stock Between Spouses or to a Former Spouse Incident
to Divorce: The 2004 JOBS Act amended Section 1366(d)(2)(A) and added Section
1366(d)(2)(B) to carve out a limited exception to the general rule that disallowed losses carried
forward from previous years are lost when an S corporation shareholder transfers its stock to
another person. Section 235(a), P.L. 108-357. These provisions cause such carryover losses to
be treated as incurred by the S corporation in succeeding taxable years with respect to a
transferee spouse where (i) such spouse received stock from the other spouse or (ii) such spouse
is a former spouse who received stock from the transferor spouse incident to a divorce, as
described in Section 1041(a). This exception was effective for “taxable years beginning” after
December 31, 2004. Section 235(b), P.L. 108-357. The GO-Zone Act amended this effective
date so that Section 1366(d)(2) is effective for “transfers” after December 31, 2004. Section
403(c), (nn), P.L. 109-135. On August 14, 2008, the Treasury Department and the Service
finalized regulations that provide that losses and deductions carried over to the year of the
relevant transfer that are not used by the transferor spouse in such year will be prorated between
the transferor spouse and the transferee spouse based on their stock ownership at the beginning
of the succeeding taxable year. T.D. 9422; Treas. Reg. § 1.1366-2(a)(5)(ii). These regulations
are effective on August 14, 2008. Treas. Reg. § 1.1366-5.
- 54 Post-Termination Transition Period: If a shareholder has a suspended loss for the last
year in which a corporation is an S corporation, such loss may be treated as incurred by the
shareholder on the last day of the “post-termination transition period.” See Sections V.C.,
X.A.4.e., below. The aggregate amount of losses cannot exceed the shareholder’s adjusted basis
in stock (not debt) determined as of such last day. Section 1366(d)(3); Treas. Reg. § 1.13662(b)(2); see FSA 200223052 (concluding that a shareholder of a target S corporation, who is also
a shareholder of the acquiring C corporation, is permitted to apply losses suspended under
Section 1366(d) against the shareholder’s historic basis in the stock of the acquiring C
corporation); cf. FSA 200207015. Any losses and deductions in excess of the shareholder’s
adjusted stock basis are permanently disallowed. Treas. Reg. § 1.1366-2(b)(2). If the aggregate
amount of losses and deductions incurred by the shareholder during the post-termination
transition period exceeds the adjusted basis of the shareholder’s stock, the limitation on losses
and deductions under Section 1366(d)(3)(B) must be allocated among each loss or deduction.
Treas. Reg. § 1.1366-2(b)(3).
Section 355 Transactions: A special allocation rule applies when an S corporation
transfers part of its assets to another corporation in a D reorganization, and immediately
thereafter distributes the stock and securities of the controlled corporation in a transaction to
which Section 355 applies. Any loss or deduction disallowed by Treas. Reg. § 1.1366-2(a) 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 may 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 S
corporation and the controlled corporation immediately after the distribution; a method based on
the relative adjusted basis of the assets in the distributing S corporation and the controlled
corporation immediately after the distribution; or in the case of losses and deductions clearly
attributable to either the distributing S corporation or the controlled corporation, any method that
allocates such losses and deductions accordingly. Treas. Reg. § 1.1366-2(c)(2). An analogous
allocation rule applies to a similar transaction involving a qualified subchapter S subsidiary. See
Treas. Reg. §§ 1.1361-5(b)(2), 1.1366-2(c)(2); see also Section III.H.4., below.
Other Tax-Free Asset Transfers: 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 Treas. Reg. § 1.1366-2(a) with respect to a shareholder of the distributor or transferor S
corporation is available to that shareholder as a shareholder of the acquiring corporation. Treas.
Reg. § 1.1366-2(c)(1). If 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. Id.
However, if the acquiring corporation is a C corporation, a post-termination transition
period arises the day after the last day that the S corporation was in existence and the special
rules for carryover of disallowed losses and deductions for the post-termination transition period,
described above, apply with respect to any shareholder of the acquired S corporation that is also
a shareholder of the acquiring C corporation after the transaction. Id.
- 55 -
Comment: It appears that, unless the special election under Treas. Reg. § 1.1367-1(g) is
made, noncapital, nondeductible expenses that are not taken into account by a shareholder
because of a lack of basis are not carried over under Section 1366(d)(2). Section 1366(d)(2) only
carries forward certain types of items (i.e., losses and deductions) that could be taken into
account by a shareholder under Section 1366(a). Apparently, Section 1366(a) does not include
noncapital, nondeductible items. Furthermore, if noncapital, nondeductible items were carried
forward pursuant to Section 1366(d)(2), there would appear to be no need for the rule in Treas.
Reg. § 1.1367-1(g) that requires the carry forward of such items when the special election under
that regulation is made. See Section III.B.4.a.(ii), below.
c.
At-Risk Limitation – Section 465
In General: Certain persons are limited in their ability to deduct amounts not at risk in
an activity. These persons are: (i) individuals (including individual partners and shareholders of
S corporations) and (ii) closely held C corporations (i.e., C corporations more than 50 percent of
the value of which is owned by 5 or fewer individuals at any time during the last half of the
taxable year).
A taxpayer is at risk in an activity to the extent of the amount of money and the adjusted
basis of property contributed by that taxpayer to the activity. In addition, a taxpayer is at risk
with respect to amounts borrowed for use in an activity, but only if the lender is not a person
with an interest in the activity (other than as a creditor), the lender is not related to a person
(other than the taxpayer) with an interest in the activity (other than as a creditor), and (i) the
taxpayer is personally liable with respect to the borrowed amounts, or (ii) the taxpayer has
pledged property not used in the activity as security for the borrowed amounts (to the extent of
the net fair market value of the taxpayer’s interest in the property). See, e.g., Oren v. Comm’r,
357 F.3d 854 (8th Cir. 2004) (holding that a circular lending arrangement among an individual
who was a shareholder in three S corporations and those S corporations did not increase the
amount of funds at risk with respect to that shareholder under Section 465). With respect to the
activity of holding real estate, a taxpayer will be considered at risk with respect to certain
qualified nonrecourse financing as well.
Carryover of Disallowed Losses: Losses disallowed in one taxable year because of the
at-risk limitation are suspended and treated as deductions allowable with respect to the same
activity in the next taxable year. See Section 465(a)(2). Furthermore, the Small Business Act of
1996 amended Section 1366(d)(3) of the Code to provide that losses of an S corporation that are
suspended under the at-risk rules of Section 465 are carried forward to the S corporation’s posttermination transition period under rules similar to those applicable to disallowed losses
generally.
Query: Where a closely held C corporation had previously recognized losses that were
suspended by operation of the at-risk rules prior to conversion to S corporation status, does the
decision in St. Charles Investment Co. v. Commissioner, 232 F.3d 773 (10th Cir. 2000), provide
substantial authority under Section 6662 for the shareholders to take into account those losses
pursuant to the at-risk rules after conversion? See discussion at Section III.E.2., below.
- 56 d.
Passive Loss Limitation – Section 469
In General: Certain persons, including shareholders of S corporations, are limited in
their ability to currently deduct losses from passive activities. Generally, a shareholder of an S
corporation may deduct losses from all passive activities only to the extent of income from all
passive activities. The excess is deemed a “passive activity loss” that is disallowed for the
taxable year.
Definition of a “Passive Activity”: A “passive activity” is any activity which involves
the conduct of any trade or business and in which the taxpayer does not “materially participate”
(i.e., is not involved on a regular, continuous, and substantial basis). Section 469(c)(1).
Temporary regulations dealing with the passive loss rules provide seven tests for determining
material participation in an activity. The material participation tests are applied to each
shareholder each year. Under Temp. Treas. Reg. § 1.469-5T(a)(1), an individual who
participates in an activity for more than 500 hours during the taxable year will be treated as
materially participating. The rental of tangible property is generally passive activity for section
469 purposes. Section 469(j)(8). The rental of property for use in a trade or business in which
the taxpayer materially participates is, however, not considered to be passive activity. Treas.
Reg. § 1.469-2(f)(6). See also Dirico v. Comm’r, 139 T.C. No. 1616202-09 (Nov. 13, 2012)
(holding that taxpayer’s income from rental of land and telecommunications towers to his wholly
owned S corporation, which then leased tower access to unrelated third parties, constituted
passive income and did not fall within self-rental rule).
Portfolio Income Excluded: Income from passive activities generally does not include
portfolio income earned by the taxpayer. See Section 469(e). Portfolio income generally
includes gross income from interest, dividends, annuities, or royalties not derived in the ordinary
course of a trade or business, reduced by non-interest expenses directly allocable to such gross
income and reduced by any interest expense properly allocable to such gross income. See id.
Special rules, however, apply to self-charged items of income and expense with respect to
lending transactions (i) between an S corporation and one of its shareholders and (ii) between
two identically owned S corporations. In general, these special rules permit interest income that
is allocable to a loan the proceeds of which are used for a passive activity to be recharacterized
as passive income. These rules permit the recipient of such income to offset such income against
the related passive interest expense. See Treas. Reg. § 1.469-7; see also Treas. Reg. § 1.46911(a)(4), (c)(1) (providing that Treas. Reg. § 1.469-7 is effective generally for taxable years
ending after December 31, 1986).
Character: The character of each item of gross income and deduction allocated to a
taxpayer from an S corporation generally is determined by reference to the participation of the
taxpayer in the activity that generated such item. See Temp. Treas. Reg. § 1.4692T(c)(3)(iii)(B)(3), (e). Participation is determined for the taxable year of the S corporation
rather than the taxable year of such taxpayer. See id. Furthermore, the Service has stated that
determining whether income is from a passive activity under Section 469 is entirely independent
from determining whether such income constitutes passive investment income under the special
passive investment income rules applicable to S corporations. See Sections 1362(d)(3)(A)(i),
1375; see also Sections IV.B., V.A.2., below.
- 57 Carryover of Disallowed Losses: A passive activity loss from one taxable year is
treated as a deduction allocable to the same passive activity in the next taxable year. Section
469(b). The Tenth Circuit has ruled that this carryover rule also allows a passive activity loss
that arises in a year in which a corporation is taxed as a C corporation to be carried forward to a
year in which the corporation is taxed as an S corporation. See St. Charles Investment Co. v.
Comm’r, 232 F.3d 773 (10th Cir. 2002); see also discussion at Section III.E.2., below.
In addition, any passive activity loss that arises in a prior year or the current year is
generally deductible as a loss not from a passive activity when the taxpayer disposes of the
taxpayer’s entire interest in the activity to an unrelated person. See Section 469(g); see, e.g., St.
Charles Investment Co., 232 F.3d 773 (applying this rule to passive activity losses that arose
during C years). Thus, if an S corporation sells the activity from which the passive activity loss
arose to a person unrelated to a particular shareholder, that shareholder presumably can deduct
its passive activity loss attributable to such activity as a loss not from a passive activity. See
Section 469(g); see also discussion at Section III.E.2., below.
Disposition of S Corporation Stock: Under temporary regulations, the character of the
gain or loss on the disposition of S corporation stock must be determined by allocating the gain
or loss among the S corporation’s trade or business, rental, and investment activities. See Temp.
Treas. Reg. § 1.469-2T(e)(3). Thus, the gain or loss on S corporation stock is treated as gain or
loss from the disposition of interests in each activity in which the S corporation has an interest.
Accordingly, if a shareholder with a suspended passive activity loss attributable to a passive
activity conducted by the S corporation sells his entire interest in the S corporation to an
unrelated person, the shareholder presumably should be able to deduct such loss as a loss not
from a passive activity. See Section 469(g).
If all of a taxpayer’s stock in an S corporation is sold under the installment sale method,
allocable passive activity losses are not fully deductible in the year of sale. See Section
469(g)(3). Instead, the losses are deductible over the same period that installment gain is
recognized. See id.
B.
Basis Adjustments
As noted above (see Section III.A.5.b.), a shareholder’s basis in stock and certain debt is
a major factor in determining the deductibility of losses passed through from the S corporation.
Stock basis (but not debt basis) is also important for purposes of determining the extent to which
distributions may be received tax-free under Section 1368.52
52
The Service confirmed that stock of an S corporation held by an ESOP is subject to the
same basis adjustments as stock held by any other shareholder. See Rev. Rul. 2003-27, 2003-1
C.B. 597. Adjustments to the basis of S corporation stock held by an ESOP affects the amount
of income recognized by an ESOP beneficiary when the beneficiary receives such stock in an
ESOP distribution. See Sections 72, 402; Treas. Reg. § 1.402(a)-1(b)(2).
- 58 1.
Stock
a.
Increases
Under Section 1367(a)(1), the basis of each shareholder’s stock in an S corporation is
increased by the sum of the following:

separately stated items of income (Section 1367(a)(1)(A));

nonseparately computed income (Section 1367(a)(1)(B)); and

depletion deductions in excess of the basis of property subject to depletion
(Section 1367(a)(1)(C)).53
For items required to be shown on the shareholder’s return as income, the increase in basis is
contingent upon the inclusion of such items in the shareholder’s gross income (either on the
shareholder’s return or through a subsequent audit adjustment). Section 1367(b)(1).
The basis of a shareholder’s share of stock is increased by an amount equal to the
shareholder’s pro rata portion of the items described in Section 1367(a)(1) that is attributable to
that share, determined on a per-share, per-day basis in accordance with Section 1377(a). Treas.
Reg. § 1.1367-1(b)(2). After years of uncertainty and conflicting court decisions, the U.S.
Supreme Court ruled that where an S corporation realizes discharge of indebtedness income that
is excluded from the corporation’s gross income under Section 108, the shareholder can increase
its basis in the corporation’s stock to reflect the shareholder’s pro rata share of such excluded
income. See Gitlitz v. Comm’r, 531 U.S. 206 (2001). However, Congress enacted legislation in
2002 that effectively overturned Gitlitz for discharges of indebtedness occurring after October
11, 2001 that are taken into account in taxable years after such date. See Section III.E.1., below.
In CCA 201114017, the Service rejected the taxpayers’ argument that, upon an election
by an S corporation to treat its wholly owned subsidiary as a qualified subchapter S subsidiary
(“QSub”), the shareholders of the S corporation could increase their stock bases under Section
1367(a)(1)(A) by the amount of the S corporation’s built-in gain in the stock of the subsidiary as
a result of the subsidiary’s deemed liquidation under Section 332. The taxpayers primarily
contended that Sections 61(a)(3) and 331(a) applied to the QSub election/deemed liquidation to
produce an item of income under Section 1366(a)(1)(A), and that such income was tax-exempt
under Section 332. The taxpayers’ argument relied on the Supreme Court’s holding in Gitlitz for
its broad interpretation of “income” under Section 1366(a)(1)(A).
The Service determined that the taxpayers’ position was incorrect and that their reliance
on Gitlitz was misplaced. The Service found that the legislative history of Section 332
demonstrates that a Section 332 liquidation changes only the form of property ownership and,
53
The basis adjustment for depletion does not include the depletion deduction attributable
to oil or gas property. See Treas. Reg. § 1.1367-1(b)(1).
- 59 thus, does not provide an item of income under Section 1366. The Service also determined that
the taxpayers’ reliance on Gitlitz was improper, because that case involved discharge of
indebtedness income which, unlike the current facts, represented a clear accession to wealth.
Lastly, the Service asserted that the taxpayers’ position would frustrate the congressional intent
underlying Sections 332 and 1374. The taxpayers’ position often would result in a permanent
exclusion from income, which was inconsistent with the timing benefit Congress intended to
provide under Section 332. Similarly, the taxpayers’ position would allow for the avoidance of
two levels of tax on recognized gain under Section 1374.
b.
Decreases
Under Section 1367(a)(2), the basis of each shareholder’s stock in an S corporation is
decreased (but not below zero) by the sum of the following:

tax-free distributions under Section 1368 (Section 1367(a)(2)(A));

separately stated items of loss and deduction and nonseparately computed
losses (Section 1367(a)(2)(B), (C));

nondeductible expenses that are not properly chargeable to a capital
account (Section 1367(a)(2)(D)); and

depletion deductions for oil and gas property held by an S corporation to
the extent such deductions do not exceed the basis of the property (Section
1367(a)(2)(D)).
The basis decrease for non-capital, nondeductible expenses relates to those items for which no
loss or deduction is allowable and do not include items for which a deduction is deferred to a
later taxable year. Treas. Reg. § 1.1367-1(c)(2). See also the discussion in Section III.E.4.,
below, on how a charitable contribution of appreciated property by an S corporation affects stock
basis.
The basis of a shareholder’s share of stock is decreased by an amount equal to the
shareholder’s pro rata portion of the items described in Section 1367(a)(2) attributable to that
share determined on a per-share, per-day basis in accordance with Section 1377(a). Treas. Reg.
§ 1.1367-1(c)(3). However, in determining the amount of decrease in the basis of individual
shares, the regulations adopt a “spillover rule” – if the amount attributable to a share exceeds its
basis, the excess is applied to reduce (but not below zero) the remaining basis of all other shares
of stock in the corporation owned by the shareholder in proportion to the remaining basis of each
of these shares. Treas. Reg. § 1.1367-1(c)(3).
For example, assume individual A owned 50 shares of S corporation stock with a basis of
$100 on December 31, 1993 ($2 basis per share). On January 1, 1994, A buys an additional 25
shares of stock for $300 ($12 basis per share). The S corporation subsequently distributes $375
to A. Without the spillover rule adopted in the regulations, the adjusted basis of each share of
stock would be decreased by $5 ($375/75 shares). However, the decrease in basis attributable to
the original 50 shares would exceed the $2 per share basis of such stock by $3 per share, which
- 60 would cause A to recognize $3 of gain per share. Under the spillover rule, the basis of A’s initial
50 shares is decreased by $2 per share (to zero). The $150 excess is applied to reduce the
remaining basis of the purchased 25 shares by an additional $6 per share. Thus, the original 50
shares have a zero basis, and the purchased 25 shares have a $1 basis (for an aggregate basis of
$25). See Treas. Reg. § 1.1367-1(h) ex. 3.
2.
Debt
a.
Decreases
If the amount of the aggregate decrease (absent distributions) to a shareholder’s basis in
stock exceeds such basis, the excess is applied to reduce (but not below zero) the basis of debt
owed from the S corporation to the shareholder (“shareholder S corporation debt”). Section
1367(b)(2)(A). Any shareholder S corporation debt that has been satisfied by the S corporation,
or disposed of or forgiven by the shareholder, during the taxable year is not subject to basis
reduction. Treas. Reg. § 1.1367-2(b)(1). However, if a shareholder terminates its interest in the
S corporation during the taxable year, the basis reduction rules are applied to any shareholder S
corporation debt held by the shareholder immediately prior to the termination of the
shareholder’s interest. Treas. Reg. § 1.1367-2(b)(2).
If the shareholder holds more than one shareholder S corporation debt at the close of the
corporation’s taxable year, the basis reduction rule is applied to each debt instrument based on
their relative percentage of basis. Treas. Reg. § 1.1367-2(b)(3). However, separate shareholder
advances not evidenced by separate written instruments are treated as a single shareholder S
corporation debt. Treas. Reg. § 1.1367-2(a).
Comment: Note that the repayment (in part or in full) of shareholder S corporation debt
will trigger gain for the shareholder if the basis of such debt has been reduced (and not restored)
by Section 1367(b)(2). Thus, an S corporation in this situation should refrain from making
principal payments on such debt until the basis in such debt is restored, as described below. For
a detailed discussion of the rules with respect to the taxation of shareholder S corporation debt,
see Section III.D.1.b.(i) below.
b.
Increases (or Restoration)
General Rule: Once the basis of S corporation debt owed to a shareholder has been
reduced under Section 1367(b)(2)(A), any future “net increase” is first applied to restore the
basis of the debt before it increases the shareholder’s basis in stock. Section 1367(b)(2)(B);
Treas. Reg. §§ 1.1367-1(b)(1), 1.1367-2(c)(1). This rule helps a shareholder holding shareholder
S corporation debt to avoid gain on the repayment of such debt. Thus, although this rule reduces
a shareholder’s ability to receive cash in a tax-free distribution because it slows the increase to
stock basis, it does not affect the shareholder’s ability to receive cash from the S corporation in a
tax-free manner because a repayment of shareholder S corporation debt is effectively the same as
a tax-free distribution of cash.
“Net Increase”: A “net increase” is not synonymous with taxable income or net income.
It means, with respect to a shareholder for a taxable year, the amount by which the shareholder’s
- 61 pro rata share of the items described in Section 1367(a)(1) (i.e., income items and excess
depletion deductions) exceeds the shareholder’s pro rata share of the items described in Section
1367(a)(2) (i.e., loss items, other expenses, oil and gas depletion deductions, and nondividend
distributions54). See Treas. Reg. § 1.1367-2(c)(1). Thus, with respect to a taxable year, stock
basis will be increased prior to the restoration of shareholder S corporation debt basis when the S
corporation generates net income in an amount that does not exceed the amount of nondividend
distributions made during such year because such distributions erase any potential “net increase.”
See, e.g., Treas. Reg. § 1.1367-2(e) ex. 4. Furthermore, with respect to a taxable year, such debt
basis may only be restored partially before stock basis is increased if the S corporation makes
any nondividend distributions during such year. See, e.g., Treas. Reg. § 1.1367-2(e) ex. 5.
Overall, taking into account nondividend distributions in the definition of “net increase”
effectively increases the ability of an S corporation to make tax-free nondividend distributions at
the cost of decreasing its ability to make tax-free shareholder S corporation debt repayments.
Applicable Debt: The above basis restoration rules apply only to shareholder S
corporation debt held by the shareholder on the first day of the taxable year in which the “net
increase” arises. See Treas. Reg. § 1.1367-2(c)(1).
Multiple S Corporation Debts: If a shareholder holds more than one shareholder S
corporation debt as of the beginning of the S corporation’s taxable year, any “net increase” is
applied first to restore the reduction of basis in any such debt repaid in that taxable year, but only
to the extent necessary to offset any gain that would otherwise be realized on repayment of such
debt. Treas. Reg. § 1.1367-2(c)(2). Any remaining “net increase” is applied to restore each
outstanding shareholder S corporation debt in proportion to the amount that the basis of each
such debt has been reduced under Section 1367(b)(2)(A) and not restored. Id.
Overall Limit on Increase to Basis in S Corporation Debt: Basis in shareholder S
corporation debt cannot be restored beyond the adjusted basis of the debt (as determined under
Section 1016(a) without regard to prior adjustments under Section 1367) determined as of the
beginning of the taxable year in which the “net increase” arises. Treas. Reg. § 1.1367-2(c)(1).
Comment: Note that Sections 1366 and 1367 and the regulations thereunder do not
appear to require that the relevant debt owed from the S corporation be debt that was originated
when the corporation was an S corporation. Thus, it appears that Sections 1366 and 1367 should
also apply to a loan that was made by a shareholder to a C corporation prior to the C
corporation’s conversion to S corporation status.
Comment: Note also that Sections 1366 and 1367 and the regulations thereunder do not
appear to require that the same shareholder who held shareholder S corporation debt when the
basis in such debt was decreased must continue to hold it in order to restore basis in such debt.
However, it does appear that the new debt holder also must be a shareholder in order to receive
shareholder S corporation debt basis restoration. See Section 1367(b)(2)(B).
A “nondividend distribution” is a distribution that is not treated as a dividend under
Section 1368. See Section III.C.2., below.
54
- 62 -
3.
Timing of Adjustments
a.
Stock
The basis adjustments of Section 1367(a) are determined as of the close of the
corporation’s taxable year, and the adjustments generally are effective as of that date. Treas.
Reg. § 1.1367-1(d)(1). However, if a shareholder disposes of stock during the taxable year, the
adjustments with respect to that stock are effective immediately prior to the distribution. Id. In
addition, if an election is made under Section 1377(a)(2) (to terminate the year in the case of the
termination of a shareholder’s interest) or under Treas. Reg. § 1.1368-1(g)(2) (to terminate the
year in the case of a qualifying disposition), the timing of the basis adjustments are made as if
the taxable year consisted of separate taxable years, the first of which ends at the close of the day
on which either the shareholder’s interest is terminated or a qualifying disposition occurs,
whichever the case may be. Treas. Reg. § 1.1367-1(d)(3).
b.
Debt
General Rule: Debt basis is adjusted (and the amount of such adjustments are
determined) as of the close of the S corporation’s taxable year. Treas. Reg. § 1.1367-2(d)(1).
Exceptions: However, if the shareholder terminates its interest in the S corporation prior
to the close of such taxable year, debt basis is adjusted immediately before such termination (but
it is based on the amount of adjustments determined as of the close of the corporation’s taxable
year). Id. Furthermore, the same timing rules that apply for stock basis adjustments with respect
to elections under Section 1377(a)(2) or Treas. Reg. § 1.1368-1(g)(2) also apply to debt basis
adjustments. See Treas. Reg. § 1.1367-2(d)(2).
Furthermore, if a debt is disposed of or repaid in whole or in part before the close of the
taxable year, the basis of that debt is restored by the net increase determined as of the close of the
S corporation’s taxable year, to the extent permitted, effective immediately before the disposition
or the first repayment on the debt during such year. Treas. Reg. § 1.1367-2(d)(1), (e) ex. 3. This
rule limits the realization of gain on the disposition of S corporation debt.
Bad Debts: Section 1367(b)(3) requires that all basis adjustments to shareholder S
corporation debt must be made prior to applying the bad deduction rule of Section 166(d) and the
worthless security rule of Section 165(g).
4.
Ordering Rules for Basis Adjustments
a.
Stock
The ordering rules for stock basis adjustments have changed over the years since 1982.
Consequently, issues involving stock basis (such as the taxability of S corporation distributions
and deductibility of S corporation losses) should be evaluated in light of the stock basis
adjustment rules that applied during the relevant years at issue. This Outline reviews the
ordering rules for stock basis adjustments as they have changed over the years since 1982.
- 63 -
(i)
General Rules
(a)
Taxable Years Beginning Before January 1, 1997
(i.e., Prior to the Small Business Act of 1996)
Under Treas. Reg. § 1.1367-1(e), for taxable years beginning before January 1, 1997, the
adjustments to stock basis generally are made in the following order:

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);

any decrease in basis attributable to nondeductible, noncapital expenses
(under Section 1367(a)(2)(D)) and the oil and gas depletion deduction
(under Section 1367(a)(2)(E));

any decrease in basis attributable to items of loss or deduction described in
Section 1367(a)(2)(B) and (C); and

any decrease in basis attributable to a non-taxable distribution by the
corporation in accordance with Section 1367(a)(2)(A).
See TAM 9304004 (current year’s net income increases the shareholder’s stock basis, thereby
allowing the deduction of suspended losses from prior years until the stock basis equals zero, so
that any later distributions result in gain).
(b)
Taxable Years Beginning on or after January 1,
1997, and Before August 18, 1998
For taxable years beginning on or after January 1, 1997 (generally the effective date of
the Small Business Act of 1996), 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. Treas. Reg. § 1.1367-3.55 Return positions consistent with the final regulations effective
for taxable years beginning on or after August 18, 1998 will be considered reasonable. Id.
55
In 1992, the Service issued proposed regulations under Section 1367 addressing the
basis adjustment rules for stock and indebtedness of an S corporation. See 57 Fed. Reg. 24,42603 (June 9, 1992). The final regulations issued in January 1994 generally provided the same
rules as the proposed regulations. See T.D. 8508. On August 18, 1998, the Service issued
proposed regulations that amended the 1994 final regulations by adding a section on the ordering
of adjustments to the basis of a share of stock. See 63 Fed. Reg. 44,181-01 (Aug. 18, 1998).
Final regulations were issued in December 1999 in roughly the same form as the regulations
proposed in 1998, thereby adding rules relating to the ordering of stock basis adjustments. See
T.D. 8852.
- 64 -
(c)
Taxable Years Beginning on or after August 18,
1998
Under Treas. Reg. § 1.1367-1(f), for taxable years beginning on or after August 18, 1998,
the adjustments to stock basis generally are made in the following order:

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);

any decrease in basis attributable to a nontaxable distribution by the
corporation described in Section 1367(a)(2)(A) (relating to distributions
that were not includible in the shareholder’s income under Section 1368);

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

any decrease in basis attributable to items of loss or deduction described in
Section 1367(a)(2)(B) and (C).
(ii)
Elective Ordering Rule
A shareholder may elect to decrease basis for items attributable to separately and
nonseparately stated losses and deductions prior to decreasing basis for nondeductible,
noncapital expenses and oil and gas depletion deductions if the shareholder agrees that the
noncapital, nondeductible expenses and the oil and gas depletion deductions in excess of basis
will reduce basis in the succeeding taxable year. See Treas. Reg. § 1.1367-1(g). This election
applies to all future taxable years unless the Commissioner permits otherwise. Id.
This elective ordering rule permits a shareholder to take into account immediately more
deductible expense and loss items. For example, assume that the sole shareholder (“A”) of an S
corporation has (i) a $100 basis in S corporation stock prior to taking into account any S
corporation items for the year and (ii) a pro rata share of deductible expenses of $100. The S
corporation also has a noncapital, nondeductible expense of $100. Under the normal ordering
rules, A will not take into account the $100 of deductible expenses because the noncapital,
nondeductible expense will exhaust A’s stock basis first. If, instead, A makes an election under
Treas. Reg. § 1.1367-1(g), A will be able to use immediately the $100 of deductible expenses.
See Section III.A.5.b., above.
(iii)
Effects of Change to Stock Basis Adjustment Rules
Prior to the Small Business Act of 1996, the relevant rules favored the deductibility of S
corporation losses over tax-free S corporation distributions during loss years, which effectively
created character mismatch issues (i.e., the shareholder would take into account its pro rata share
of the S corporation’s ordinary deductions, but the shareholder would take into account capital
- 65 gain upon the distribution of cash from the S corporation during the same year). Pursuant to the
Small Business Act of 1996, the relevant rules shifted to favor tax-free S corporation
distributions over the deductibility of S corporation losses during loss years. Thus, at the price of
deferred deductibility of S corporation losses, character mismatches are avoided.
(iv)
Comparison to Partnership Interest Basis Adjustment
Rules
The conference report to the Small Business Act of 1996 suggests that the Small Business
Act of 1996 conforms the ordering rules for stock basis adjustments to the ordering rules for
partnership interest basis adjustments. See H.R. Conf. Rep. No. 104-737, at 225 (1996).
However, there is considerable uncertainty regarding in what order adjustments are made to the
basis of a partnership interest. See Sections 704(d) (providing that a partner’s distributive share
of loss is allowed only to the extent of basis in the partner’s partnership interest “at the end of the
partnership year”), 705(a) (providing that basis is increased and decreased for the partner’s
distributive share of income and loss items “for the taxable year”), 731(a) (providing that the
amount of partner gain generated upon a partnership cash distribution is measured against the
basis in the partnership interest that existed “immediately before the distribution”); Treas. Reg. §
1.731-1(a)(1)(ii) (providing that advances or draws against a partner’s distributive share of
income are treated as distributions made on the last day of the partnership’s taxable year). Thus,
caution should be exercised when using guidance interpreting the partnership interest basis
adjustment rules to interpret the S corporation stock basis adjustment rules.
b.
Debt
Unlike stock basis adjustments, there are no special ordering rules for adjustments to
shareholder S corporation debt. Presumably, this is because basis in such debt cannot support
tax-free distributions (although, such basis can support tax-free debt repayments).
C.
Distributions
1.
Corporate-Level Effects
a.
Appreciated Property
Pursuant to Section 1371, the provisions of subchapter C apply to the recognition of gain
and loss in the case of distributions56 by S corporations.57 Thus, if an S corporation distributes
For purposes of this Outline, the term “distributions” and the phrase “distributions
made with respect to stock” include redemptions of stock that are described in Section 302(d) as
well, unless otherwise clear from the context. See infra Section III.C.2.a. (discussing the effects
of an S corporation distribution).
56
The Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647, (the “TAMRA
of 1988”) repealed the special distribution rules contained in Former Section 1363(d) and (e) as
statutory deadwood.
57
- 66 appreciated property, gain must be recognized by the S corporation as if it sold the property to
the distributee at its fair market value. See Sections 311(b)(1), 336(a); PLR 8908016. Without
this rule, appreciated assets could be distributed tax-free and sold by the shareholder at fair
market value without a current tax on the appreciation being imposed, since the distributee
shareholder obtains a fair market value basis in distributed property under Sections 301(d) and
334(a).
Where property distributed is subject to a liability, or a shareholder assumes a liability,
Sections 336(b) and 311(b)(2) provide that the fair market value of such property shall be treated
as not less than the amount of such liability. Accordingly, if a distributee shareholder does not
assume all (or a portion of) a recourse liability that is related to property that is distributed to
such shareholder, Section 336 treats the corporation as if it sold the distributed property at fair
market value, even if such value may be less than the entire amount of the recourse liability.
Sections 1239, 1245, and 1250 may convert capital gain recognized by the S corporation
on a distribution of appreciated property to ordinary income. If an S corporation distributes
installment obligations, the character of gain on installment obligations should be the same as the
gain on the sale of the underlying property. Finally, Section 1374 may also apply to distributions
of appreciated property. See Section IV.A., below.
Sections 311(b)(1) and 336(a) (or Former Section 1363(d)) do not contemplate special
allocations of gain to contributing shareholders. Compare Section 704(c). Gain recognized by
the S corporation on a distribution generally is allocated to the shareholders under Sections 1366
and 1377 (discussed above).
b.
Depreciated Property
With respect to depreciated (loss) property, Section 311 (applicable to nonliquidating
distributions) and Section 336 (applicable to liquidating distributions) again should control.
Under Section 311, losses generally are not recognized. PLR 8908016. The result is that a
distribution of depreciated property will cause a step-down in basis without any benefit of loss
recognition, since the distributee shareholder obtains a fair market value basis in the distributed
property. Section 301(d). Under Section 336, losses are recognized unless the limitations on
loss recognition contained in Section 336(d) apply.
One apparent exception to this rule is Section 453B(a), which provides a loss may arise in
a distribution of an installment note having a value less than its basis. However, loss recognition
is uncertain if the installment note is distributed in a nonliquidating distribution since Section
311(a) (as modified by the TRA of 1986) does not explicitly carve out Section 453B, as did its
predecessor. Even if Section 311(a) is interpreted to not prohibit loss recognition in this case,
Section 267 could disallow the loss if the S corporation and the distributee shareholder are
related under Section 267(b).
c.
Other Corporate-Level Effects
At the corporate level, a distribution made with respect to stock that is not treated as a
dividend should reduce the “accumulated adjustment account” (“AAA”) by the fair market value
- 67 of the distribution. See Rev. Rul. 95-14, 1995-1 C.B. 169; PLR 200402009. Moreover,
corporate-level gain resulting from a nondividend distribution or a dividend distribution will
increase the AAA. In the case of a redemption of stock that is described in Sections 302(a) or
303, the AAA is reduced in direct proportion to the number of shares redeemed. Section
1368(e)(1)(B). The AAA is discussed in detail below at Section III.C.2.b.(v).
Dividend distributions under Section 1368(c)(2) should reduce accumulated earnings and
profits of the S corporation. See Section 1371(c)(3).
2.
Shareholder Effects
In general, the amount of a distribution from an S corporation to a shareholder will be
equal to the sum of the money and the fair market value of property distributed. Section
301(b)(1); S. Rep. No. 97-640, at 20.58 Whether that amount generates taxable income to the
distributee shareholder depends on the following issues: (i) whether the S corporation has
accumulated earnings and profits, (ii) whether the S corporation has an AAA, (iii) whether the
shareholder has sufficient stock basis, and (iv) whether the shareholder’s pro rata share of S
corporation items is subject to adjustment under the AMT.
An S corporation will not generate current earnings and profits during the time it is an S
corporation (assuming post-1982 years). Section 1371(c)(1). However, an S corporation may
have accumulated earnings and profits either (i) from former C corporation years, (ii) from pre1983 S corporation years (i.e., previously taxed income, which is discussed below),59 (iii) by
operation of Section 381, or (iv) through Section 312(h).60
58
In January 1994, the Service issued final regulations under Section 1368 that dealt with
the treatment of distributions from an S corporation. The final regulations under Section 1368
generally provided the same rules as the proposed regulations that were issued in June 1992. In
response to the Small Business Act of 1996, the Service issued new final regulations amending
Former Treas. Reg. § 1.1368-2 in December 1999.
59
Note that, if an S corporation was an S corporation for its first taxable year beginning
after 1996, the Small Business Act of 1996 permitted the S corporation to reduce its accumulated
earnings and profits by the earnings and profits accumulated in any taxable year beginning
before January 1, 1983, for which the corporation was an S corporation. See Staff of J. Comm.
on Taxation, 108th Cong., Background and Proposals Relating to S Corporations (Comm. Print
2003). Section 8235 of the Iraq Act of 2007 provides that, in the case where an S corporation
was not an S corporation for its first taxable year beginning after December 31, 1996, the
accumulated earnings and profits of the corporation (for the first taxable year beginning after
May 25, 2007, is reduced by the accumulated earnings and profits accumulated in any taxable
year beginning before January 1, 1983, for which the corporation was an S corporation).
Section 1371(c)(2) provides that “proper adjustment” is to be made to the earnings and
profits in the case of any transaction involving the application of subchapter C of the Code to the
S corporation. For example, if an S corporation forms a wholly owned subsidiary and
immediately thereafter distributes all the stock of that subsidiary in a transaction to which
(Continued …)
60
- 68 -
If an S corporation does not have accumulated earnings and profits, the rules are
straightforward. However, if an S corporation has accumulated earnings and profits, there are
several hurdles to jump before a shareholder knows whether it received a tax-free distribution, a
taxable capital gain distribution, a taxable ordinary income dividend, or a taxable capital gain
dividend.
Finally, a distributee shareholder may not know the character of a distribution until
several months after the close of the S corporation’s taxable year because such character depends
on corporate-level accounts and corporate-level items that are determined after year-end.
a.
Most S Corporation Distribution Rules Apply to Section 301(c)
Distributions Only
Before reviewing in detail the special rules applicable to a distribution made with respect
to stock in Section 1368 and its regulations, note that most of those special rules apply only if
Section 301(c) would apply to the distribution but for Section 1368. Section 1368(a). Thus, in
order for most of Section 1368 and its regulations to apply, a distribution made with respect to
stock must not constitute a redemption of stock that is described in Sections 302(a) or 303. See,
e.g., Rev. Rul. 95-14, 1995-1 C.B. 169 (applying the special distribution rules of Section 1368
and its regulations to a redemption of stock described in Section 302(d)); PLR 200451021
(same); PLR 200402009 (same). Accordingly, for purposes of this Outline, the term
“distributions” and the phrase “distributions made with respect to stock” include redemptions of
stock that are described in Section 302(d) but do not include redemptions of stock described in
Sections 302(a) or 303, unless otherwise clear from the context.
b.
S Corporation Having No Earnings and Profits
In the case of a corporation having no accumulated earnings and profits, a distribution of
property made with respect to stock is treated as a tax-free distribution to the extent of the
recipient shareholder’s basis in the stock of the S corporation. Section 1368(b)(1). The amount
of the distribution that exceeds basis, if any, is treated as gain from the sale or exchange of
property. Section 1368(b)(2). Presumably, the gain is either long-term or short-term capital
gain, depending on the holding period of the stock. Note that, for any taxable year ending on or
after May 6, 2003 and not beginning after December 31, 2008, the tax rate for net capital gains is
reduced from 20 percent to 15 percent. See Section 1(h); sections 301 and 303 of the Jobs and
Growth Act of 2003. If the corporation is collapsible, it is unclear whether the gain will be
ordinary in nature with respect to taxable years ending on or before December 31, 2002. For
taxable years ending after December 31, 2002 and not beginning after December 31, 2008, the
Jobs and Growth Act of 2003 repeals the collapsible-corporation rules. See sections 302 and 303
of the Jobs and Growth Act of 2003.
Sections 355 and 368(a)(1)(D) applies, the earnings and profits of the distributing S corporation
will be allocated between the distributing S corporation and such subsidiary. See Treas. Reg. §§
1.312-10(a), 1.1368-2(d)(3).
- 69 -
c.
S Corporation Having Earnings and Profits
Distributions from an S corporation having accumulated earnings and profits are treated
as follows.
(i)
First Layer
To the extent the amount of the distribution does not exceed the S corporation’s AAA,
the distribution is taxed according to the same rules applicable to distributions from an S
corporation having no accumulated earnings and profits (i.e., in accordance with Section
1368(b)). Section 1368(c)(1). Accordingly, distributions from this layer are tax-free to the
extent of basis and then treated as gain from the sale or exchange of property. Section 1368(b).
As discussed below, the AAA is a corporate-level account intended to keep track of
undistributed post-1982 S corporation income that has been taken into account by the S
corporation’s shareholders. Since the AAA is a corporate-level account, this treatment
apparently applies regardless of when or how the shareholder acquired his S corporation stock.
See S. Rep. No. 97-640, at 20.
(ii)
Second Layer
The portion of the distribution that exceeds the AAA is treated as a dividend to the extent
that it does not exceed the accumulated earnings and profits of the corporation. Section
1368(c)(2). Note that, for taxable years beginning after December 31, 2002 and not beginning
after December 31, 2008, such portion of a distribution generally is treated as net capital gain
and generally is taxed at a 15 percent rate. See Section 1(h)(11); section 303 of the Jobs and
Growth Act of 2003. The Service has ruled that distributions from this layer qualify as portfolio
income under Section 469(e)(1)(A) (i.e., dividends) even though the S corporation’s income or
loss passed through to its shareholders would otherwise be treated as passive. See PLR 8752017;
see also Staff of Joint Comm. on Taxation, General Explanation of the Tax Reform Act of 1986,
at 231 n. 24.
(iii)
Third Layer
The portion of the distribution still remaining (i.e., in excess of both the AAA and the
corporation’s accumulated earnings and profits), if any, is again treated according to Section
1368(b). Thus, such remaining portion of the distribution is treated as a tax-free distribution that
reduces the basis of stock in the S corporation. To the extent such portion exceeds the recipient’s
stock basis, the distribution is treated as gain from the sale or exchange of property. Section
1368(c)(3).
(iv)
S Corporations with Previously Taxed Income
In the case of distributions made by an S corporation with both accumulated earnings and
profits and previously taxed income (“PTI”) (within the meaning of Former Section 1375(d)(2),
- 70 as in effect prior to its amendment by the Revision Act of 1982),61 the portion remaining after the
application of Section 1368(c)(1) (i.e., the first layer) is treated in accordance with Section
1368(b) (relating to S corporations without accumulated earnings and profits) to the extent that
portion is a distribution of money and does not exceed the shareholder’s net share of the
corporation’s PTI. Treas. Reg. § 1.1368-1(d)(2). Such portion does not reduce the AAA or the
accumulated earnings and profits of the S corporation. Id. Any distribution remaining after the
application of Treas. Reg. § 1.1368-1(d)(2) is treated in the manner provided in Section
1368(c)(2) (i.e., the second layer) and Section 1368(c)(3) (i.e., the third layer). Id.
(v)
The Accumulated Adjustments Account
In general, the AAA is a device to keep track of undistributed, post-1982 S corporation
income that already has been taken into account by the S corporation’s shareholders. See Rev.
Rul. 2008-42, 2008-30 I.R.B. 175. As the priority system outlined above indicates, the AAA
allows tax-free nondividend distributions to be made before dividend distributions to the extent
of the recipient’s stock basis. See id. Furthermore, distributions out of the AAA that exceed the
recipient’s stock basis are also nondividend distributions, but they generate capital gain, which is
usually taxed at a lower rate than an ordinary income dividend distribution. However, for
taxable years beginning on or after December 31, 2002 and not beginning after December 31,
2010, dividend distributions generally are taxed at the same rate as nondividend distributions that
generate capital gain.
The AAA is a corporate-level account and is not apportioned among shareholders. Treas.
Reg. § 1.1368-2(a)(1). Thus, with the exception of a redemption, the AAA is generally not
affected by shareholder transfers of stock.
Final regulations issued in 1999 amended Treas. Reg. §§ 1.1367-1 and 1.1368-2 to
provide that for taxable years of the corporation beginning on or after August 18, 1998, the
adjustments to the AAA are made in a different order than the adjustments to the basis of a share
of stock. Compare Treas. Reg. § 1.1368-2(a)(5) (ordering rules for AAA) with Treas. Reg. §
1.1367-1(f) (ordering rules for stock basis) (discussed above).
(a)
Increases to the AAA
The AAA is increased for the taxable year by the sum of the following items:
61
PTI is the predecessor to the AAA. Unlike the AAA, a PTI account was a shareholderlevel account. A shareholder’s PTI account generally tracked the amount of S corporation
income that (i) had been taken into account by such shareholder and (ii) not distributed to such
shareholder. See Former Section 1375(d). Like the AAA, a PTI account supported tax-free
distributions to shareholders. See id.
- 71 
the separately stated items of income under Section 1366(a)(1)(A) other
than tax-exempt income;62

any nonseparately computed income determined under Section
1366(a)(1)(B); and

the excess of the depletion deductions over the basis of the property
subject to depletion (except for certain oil and gas property).
Treas. Reg. § 1.1368-2(a)(2). The AAA is increased for the items described above before it is
decreased for the items listed in Section III.C.2.b.(v)(b) below for the taxable year. Treas. Reg. §
1.1368-2(a)(4)(i), (a)(5)(i).
(b)
Decreases to the AAA
i)
Items Other Than Distributions
The AAA is decreased for the taxable year by the sum of the following items:

the separately stated items of loss or deduction under Section
1366(a)(1)(A);

any nonseparately computed loss determined under Section 1366(a)(1)(B);

any noncapital, nondeductible expense other than federal taxes attributable
to any taxable year in which the corporation was a C corporation, and
expenses related to tax-exempt income;63 and

the sum of the shareholders’ deductions for depletion for any oil or gas
property held by the corporation described in Section 1367(a)(2)(E).
Treas. Reg. § 1.1368-2(a)(3)(i). The AAA may be decreased below zero for items other than for
distributions. Treas. Reg. § 1.1368-2(a)(3)(ii). The AAA is 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 otherwise. Id.
62
For example, insurance proceeds received by reason of the death of the insured from an
S corporation employer-owned life insurance policy (a “key-man policy”) that is excluded from
gross income by reason of Section 101 does not increase the S corporation’s AAA, since such
proceeds constitute tax-exempt income. See Rev. Rul. 2008-42, 2008-30 I.R.B. 175.
63
For example, premiums paid by an S corporation for an employer-owned life insurance
policy, of which the S corporation is a beneficiary (i.e., a “key-man policy”), do not reduce the S
corporation’s AAA, since such premiums are noncapital, nondeductible expenses related to taxexempt income (by reason of Section 101). See Rev. Rul. 2008-42, 2008-30 I.R.B. 175.
- 72 -
ii)
For Distributions
The AAA is decreased (but not below zero) by any portion of a distribution to which
Section 1368(b) or (c)(1) applies. Treas. Reg. § 1.1368-2(a)(3)(iii). The AAA is decreased for
items other than distributions before it is decreased for the distributions themselves. Treas. Reg.
§ 1.1368-2(a)(4)(ii) and (5)(ii). Pursuant to the Small Business Act of 1996, in determining the
amount in the AAA for purposes of determining the tax treatment of distributions made during a
taxable year by an S corporation having accumulated earnings and profits, a net negative
adjustment (i.e., the excess of the decreases in the AAA other than for distributions over the
increases in the AAA) for that taxable year is disregarded. See Section 1368(e)(1)(C).
iii)
For Distributions in Excess of the AAA
If an S corporation makes more than one distribution of property in a year in which the
AAA has a positive balance at the close of the year, and the sum of the distributions made during
the corporation’s taxable year exceeds the balance of the AAA at the close of the year, the AAA
is allocated on a pro rata basis among the distributions made during the year. Treas. Reg. §
1.1368-2(b)(1). The amount of the AAA allocated to each distribution is determined by
multiplying the balance of the AAA at the close of the current taxable year by a fraction, the
numerator of which is the amount of the distribution and the denominator of which is the amount
of all non-dividend distributions made during the taxable year. Treas. Reg. § 1.1368-2(b)(2).
iv)
Distributions of Money and Loss
Property
If (i) an S corporation distributes money and property with basis in excess of its fair
market value, (ii) the S corporation has accumulated earnings and profits, and (iii) the overall
distribution of money and property exceeds the amount of AAA otherwise allocable to the
distribution, the AAA must be allocated further between the money and the property distributed.
The additional allocation is based on the proportion of the money or the fair market value of the
property to the amount of the total distribution. Treas. Reg. § 1.1368-2(c).
(c)
Effect of Debt Basis Adjustments
Query whether the S corporation items that adjust shareholder S corporation debt also
adjust the AAA? Section 1368(e)(1)(A) provides that the AAA shall be adjusted “in a manner
similar to the adjustments under Section 1367.” Because the rules for adjustments to the basis of
such debt are included in Section 1367, it appears that the AAA should be adjusted in those
circumstances as well. This conclusion appears consistent with the general definition of the
AAA as an account that tracks generally the amount of undistributed earnings taken into account
by the S corporation’s shareholders since the shareholders will take such earnings into account
under Section 1366 regardless of whether such earnings increase debt basis or stock basis.
- 73 (d)
Ordering Rules for Adjustments to the AAA
For taxable years beginning before January 1, 1997, under Treas. Reg. § 1.1368-2(a)(4),
the adjustments to the AAA are made in the following order:

the AAA is increased by the sum of the following items: (i) separately
stated items of income under Section 1366(a)(1)(A) other than tax-exempt
income, (ii) any nonseparately computed income under Section
1366(a)(1)(B), and (iii) the excess of the depletion deductions over the
basis of the property subject to depletion (except for certain oil or gas
property);

the AAA is decreased by the sum of the following items: (i) separately
stated items of loss or deduction under Section 1366(a)(1)(A), (ii) any
nonseparately stated loss under Section 1366(a)(1)(B), (iii) any noncapital,
nondeductible expense other than (a) federal taxes attributable to any
taxable year in which the corporation was a C corporation and (b)
expenses related to tax-exempt income, and (iv) the sum of the
shareholders’ deductions for depletion for any oil or gas property held by
the corporation described in Section 1367(a)(2)(E);

the AAA is decreased (but not below zero) by any portion of an ordinary
distribution to which Section 1368(b) or (c)(1) applies; and

the AAA is adjusted (whether positive or negative) for redemption
distributions under Treas. Reg. § 1.1368-2(d)(1).
For any taxable year beginning on or after August 18, 1998, under Treas. Reg. § 1.13682(a)(5), the adjustments to the AAA are made in the following order:

the AAA is increased by the sum of the following items: (i) separately
stated items of income under Section 1366(a)(1)(A) other than tax-exempt
income, (ii) any nonseparately computed income under Section
1366(a)(1)(B), and (iii) the excess of the depletion deductions over the
basis of the property subject to depletion (except for certain oil or gas
property);

the AAA is decreased by the sum of the following items (without taking
into account any net negative adjustment (as defined in Section
1368(e)(1)(C)(ii))): (i) separately stated items of loss or deduction under
Section 1366(a)(1)(A), (ii) any nonseparately stated loss under Section
1366(a)(1)(B), (iii) any noncapital, nondeductible expense of the
corporation other than (a) federal taxes attributable to any taxable year in
which the corporation was a C corporation and (b) expenses related to taxexempt income, and (iv) the sum of the shareholders’ deductions for
depletion for any oil or gas property held by the corporation described in
Section 1367(a)(2)(E);
- 74 
the AAA is decreased (but not below zero) by any portion of an ordinary
distribution to which Section 1368(b) or (c)(1) applies;

the AAA is decreased by any net negative adjustment (as defined in
Section 1368(e)(1)(C)(ii)); and

the AAA is adjusted (whether positive or negative) for redemption
distributions under Treas. Reg. § 1.1368-2(d)(1).
For 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. Treas. Reg. § 1.13684. The AAA adjustment order applicable for taxable years beginning after August 18, 1998 will
be considered reasonable. Id.
(e)
Adjustments to AAA for Redemptions,
Reorganizations, Divisions, and Year
Terminations
i)
Redemptions
In the case of a distribution that is treated as a redemption under Sections 302(a) or
303(a), the AAA of the corporation is adjusted in an amount equal to the ratable share of the
corporation’s AAA (negative or positive) attributable to the redeemed stock as of the redemption
date. Treas. Reg. § 1.1368-2(d)(1)(i).64 If the redemption occurs in a year in which the S
corporation makes ordinary distributions, the AAA is adjusted first for any ordinary distributions
and then for any redemption distributions. Treas. Reg. § 1.1368-2(d)(1)(ii).
ii)
Reorganizations
An S corporation that acquires the assets of another S corporation in a transaction to
which Section 381(a)(2) applies succeeds to the AAA of the transferor S corporation as of the
effective date of the reorganization. Thus, the AAA of the acquiring corporation after the
transaction is the sum of the AAAs of the two corporations prior to the transaction. Treas. Reg.
§ 1.1368-2(d)(2).
64
This rule simplifies the rule that was set out in the proposed regulations, which
required the S corporation to determine the ratable share of the AAA attributable to the redeemed
stock in the manner used to determine the pro rata portion of current earnings and profits of a C
corporation. See Rev. Rul. 74-338, 1974-2 C.B. 101; Rev. Rul. 74-339, 1974-2 C.B. 103.
- 75 iii)
Corporate Divisions under Section
368(a)(1)(D)
In the case of a corporate separation under Section 368(a)(1)(D), the AAA of the
distributing corporation immediately before the transaction is allocated between the distributing
corporation and the controlled corporation in a manner similar to the manner in which earnings
and profits of the distributing corporation are allocated under Section 312(h). Treas. Reg. §
1.1368-2(d)(3); see, e.g., PLR 201050013; PLR 201033001; PLR 201030017; PLR 200906032;
PLR 200852025; PLR 200826030; PLR 200236038.
iv)
Year Terminations
Prior to the Small Business Act of 1996, if an election was made under Section
1377(a)(2) (to terminate the year in the case of a termination of a shareholder’s interest) or under
Treas. Reg. § 1.1368-1(g)(2) (to terminate the year in the case of a disposition of substantial
amounts of stock), the AAA rules applied to all shareholders as if the taxable year consisted of
two separate taxable years. Treas. Reg. § 1.1368-2(e). Pursuant to the Small Business Act of
1996, however, if an election is made under Section 1377(a)(2), the closing of the books applies
only to the “affected shareholders” (as defined above). Treas. Reg. § 1.1377-1(a)(3)(i). A
termination of a year pursuant to an election under Treas. Reg. § 1.1368-1(g)(2) still affects all
shareholders.
(f)
Which S Corporations Must (Should) Maintain
an AAA?
Only S corporations with earnings and profits are required to maintain an AAA.
However, every S corporation should maintain an AAA, even though the S corporation will
generate no earnings and profits of its own accord during S corporation years. This is the case
because the S corporation may inherit in a subsequent Section 381 transaction accumulated
earnings and profits from (i) a C corporation or (ii) a pre-1982 S corporation. Also, once S
corporation status terminates, distributions of cash in the post-termination transition period may
be tax-free but only if (and to the extent) the corporation has a positive AAA. See Section
1371(e).
(vi)
Elections Relating to AAA Distribution Rules
An S corporation can elect to modify the general AAA distribution rules as follows.
(a)
Election to Distribute Earnings and Profits First
Under Section 1368(e)(3), an S corporation with accumulated earnings and profits can
elect to treat all distributions made during the taxable year as made first from earnings and
profits. Distributions in excess of the amount of earnings and profits are treated as coming from
the AAA, with any remainder being treated as a return of stock basis or gain from the sale or
exchange of stock in accordance with Section 1368(b). Treas. Reg. § 1.1368-1(f)(2)(i). The
election applies to all distributions made during the year for which the election is made. S
corporations usually make this election in order to avoid the Section 1375 tax on excess passive
- 76 investment income and the termination of its S election pursuant to Section 1362(d)(3) (both
provisions apply only if an S corporation has accumulated earning and profits at the end of a
taxable year.). See Sections 1362(d)(3), 1375(a).
(b)
Election to Make a Deemed Dividend
An S corporation that elects to distribute earnings and profits may also elect to distribute
such earnings and profits through a deemed dividend. Treas. Reg. § 1.1368-1(f)(3). The deemed
distribution is treated as having been made to all shareholders holding stock on the last day of the
taxable year (in proportion to their stock ownership), received by the shareholders, and
immediately contributed by the shareholders, all on that day. Id. The amount of the deemed
dividend may not exceed the subchapter C earnings and profits of the corporation on the last day
of the taxable year, reduced by any actual distributions of subchapter C earnings and profits
made during the taxable year. Id. An election to make a deemed dividend automatically triggers
an election to distribute earnings and profits first. Id.
(c)
Election to Forego PTI
As previously discussed, if an S corporation with accumulated earnings and profits also
has PTI, any distribution made in excess of the AAA is treated as made out of PTI before it is
treated as made out of accumulated earnings and profits. The regulations permit an S
corporation to elect to forego distributions of PTI. Treas. Reg. § 1.1368-1(f)(4).
(vii)
Planning Issue for S Corporation Having Earnings and
Profits and Insufficient AAA
If (i) the shareholders of an S corporation have made capital contributions and loans to
their S corporation, (ii) they need cash from the S corporation, and (iii) the S corporation has
accumulated earnings and profits and negative AAA, it appears that the S corporation should
make debt repayments to the shareholders rather than distributions with respect to their stock.
This should prevent the transfer of the cash from the S corporation to the shareholders from
being treated as a dividend under Section 1368. Rather, this technique should cause the transfer
of such cash to be tax-free if each shareholder has full basis in its shareholder S corporation debt
(or partially tax-free for a shareholder who has less than a full basis in its shareholder S
corporation debt). Furthermore, any gain recognized on the repayment of a shareholder S
corporation debt may be capital. See Section III.D.1.b.(i), below.
d.
Special Elections
(i)
Termination of Shareholder’s Interest
If an election is made under Section 1377(a)(2) (to terminate the taxable year when a
shareholder terminates his or her interest in the S corporation), Section 1368 applies as if there
are two taxable years, the first of which ends on the day the shareholder terminates his or her
interest in the S corporation. Treas. Reg. §§ 1.1368-1(g)(2)(iv), 1.1377-1(b). See Section
III.A.4.b. above for a detailed discussion of this election.
- 77 (ii)
Dispositions of Substantial Amounts of Stock
In the case of a qualifying disposition that is not described in Section 1377(a)(2), a
corporation may elect to treat the year as if there are two separate years, the first of which ends
on the date of disposition. Treas. Reg. §1.1368-1(g). A corporation making this election treats
the taxable year as separate taxable years for purposes of (i) allocating income and loss, (ii)
making adjustments to the AAA, earnings and profits, and basis, and (iii) determining the tax
effect of distributions under Section 1368(b) and (c). Treas. Reg. § 1.1368-1(g)(2)(ii). See
Section III.A.4.b. above for a detailed discussion of this election.
D.
Structuring Financing
1.
Maximizing Basis
Stock basis and the basis of shareholder S corporation debt are important because they
serve as a limitation (along with Sections 465 and 469) on the use of losses generated by the S
corporation. See Section 1366(d). However, only stock basis may be used to absorb unused
losses at the close of the post-termination transition period after the termination of an S
corporation’s S election. See Section 1366(d)(3)(B); see also Section III.A.5.b.(iii), above.
Furthermore, stock basis (but not debt basis) serves as a limitation on the amount of cash that
may be distributed tax-free. See Section 1368. Thus, if possible, financing should be channeled
through the shareholders of the S corporation in order to obtain maximum basis. Discussed
below are methods of achieving this goal.
a.
Contributions from Shareholders
The most obvious method of obtaining basis is through a transfer of cash by the
shareholder in exchange for stock of the S corporation (i.e., a Section 351 exchange or purchase
of stock). A subsequent capital contribution of cash to the S corporation may also be made. A
shareholder may also contribute property (other than cash) to the S corporation. In this case,
although not entirely clear, the shareholder’s basis in the stock probably will reflect the adjusted
basis of the contributed property, if no gain is recognized by the shareholder. See Sections 358,
1371(a). However, a non pro rata contribution of cash or other property is not likely because the
benefits of such a contribution redound, in part, to the benefit of other shareholders.
The contribution of a shareholder’s personal note presumably does not create basis. See
Rev. Rul. 81-187, 1981-2 C.B. 167 (demand note did not result in any new investment by the
shareholder). But cf. Peracchi v. Comm’r, 143 F.3d 487 (9th Cir. 1998) (ruling that a
shareholder in a C corporation increased its basis in the stock of the C corporation when it
executed and contributed a personal note to the C corporation because the note represented a
genuine economic outlay in favor of the C corporation).
A shareholder’s purchase of long-term debt from the corporation in exchange for the
shareholder’s personal note may not create basis if the purchase is done on a pro rata basis. See
Perry v. Comm’r, 54 T.C. 1293 (1970). A cost basis may result if the purchase is non pro rata
and a valid purpose exists for the purchase.
- 78 b.
Loans from Shareholders
A shareholder may loan needed financing to an S corporation and obtain basis in the
receivable created (i.e., a shareholder S corporation debt). See Perry v. Comm’r, 49 T.C. 508
(1968), acq., 1968-2 C.B. 2. However, the shareholder should keep in mind that allocations of
income (loss) will not be made with respect to a shareholder’s debt instrument (i.e., Section
1377(a) defines “pro rata share” of each S corporation item by reference to the number of “shares
outstanding” on each day). Thus, if initial losses are expected, a stock investment by the
shareholder – as opposed to a lending arrangement – will cause a greater share of losses to be
allocated to the shareholder.
Loans from a related entity ordinarily will not generate basis for the shareholder. The
loan must be made directly from the shareholder to the corporation. See Prop. Treas. Reg. §
1.1366-2; Bergman v. United States, 474 F.3d 928 (8th Cir. 1999); Hitchins v. Comm’r, 103 T.C.
711, 715 (1994); Frankel v. Comm’r, 61 T.C. 343 (1973); Prashker v. Comm’r, 59 T.C. 172
(1972); Kerzner v. Comm’r, 97 T.C.M. (CCH) 1375 (2009); Russell v. Comm’r, 96 T.C.M.
(CCH) 302 (2008), supplemented 97 T.C.M. (CCH) 1122 (2009), aff’d, 619 F.3d 908 (8th Cir.
2010) (per curiam); Burnstein v. Comm’r, 47 T.C.M. (CCH) 1100 (1984); Rev. Rul. 69-125,
1969-1 C.B. 207.
(i)
Taxation of Shareholder S Corporation Debt
Before loaning money to an S corporation, shareholders should understand that special
rules apply to the taxation of debt instruments. Although a review of the rules for original issue
discount, market discount, market premium, contingent payment debt instruments, and imputed
interest is beyond the scope of this Outline, some of the generally applicable rules are discussed
briefly below.
When a shareholder loans money to an S corporation, the shareholder generally obtains a
basis in the receivable equal to the amount loaned to the S corporation. See Section 1012. As
the S corporation repays the debt, the shareholder’s basis in the receivable is reduced by the
amount of principal repaid. See Section 1016; Treas. Reg. § 1.1272-1(g). Any amount of the
repayment that is treated as interest is ordinary income to the shareholder. See Section 61.
Under Section 1367(b)(2), as discussed above in Section III.B.2., the shareholder’s basis
in the receivable may also be reduced (but not below zero) by S corporation items (other than
distributions) that otherwise would have decreased the shareholder’s stock basis. If the S
corporation repays its debt when the basis of the receivable is still reduced pursuant to Section
1367(b)(2), the shareholder recognizes gain equal to the difference between the payment
received from the S corporation and the amount of the current basis in the receivable that is
allocated to such payment. See Sections 1001, 1271(a)(1); Smith v. Comm’r, 424 F.2d 219 (9th
Cir. 1970); see also Nathel v. Comm’r, 131 T.C. 262 (2008), aff’d, 615 F.3d 83 (2nd Cir. 2010)
(rejecting argument that shareholders’ capital contributions constituted income to the S
corporation that increased or restored the shareholders’ tax basis in loans made by the
shareholders to the S corporation, which prevented the contributions from offsetting the ordinary
income resulting from loan repayments made by the S corporation to the shareholders); Rev. Rul.
64-162, 1964-1 C.B. 304. The amount of the current basis in the receivable allocated to a
- 79 particular debt payment is the amount of the current basis multiplied by a fraction the numerator
of which is the amount of the particular debt payment and the denominator of which is the sum
of the amount of the particular debt payment plus the aggregate amount of all future debt
payments. See Rev. Rul. 64-162. Thus, these rules effectively recapture the prior S corporation
losses taken into account by the shareholder through its basis in shareholder S corporation debt.
The gain from such retirement of shareholder S corporation debt will be capital gain if
such debt is evidenced by a note or other evidences of indebtedness. See id.; see also Barr v.
Comm’r, 39 T.C.M. (CCH) 834. However, such gain will constitute ordinary income if such
debt was originated on an open account. See, e.g., Barr; Rev. Rul. 68-537, 1968-2 C.B. 372.
Under Treas. Reg. § 1.1367-2(a), “open account debt” is treated as a single indebtedness
for purposes of determining when and by what amount the basis of shareholder S corporation
debt should be adjusted. “Open account debt” is described as “shareholder advances not
evidenced by separate written instruments and repayment on the advances.” Id. Thus, with
respect to any year, a shareholder that has a zero basis in both S stock and shareholder S
corporation debt that constitutes open account debt (due to S corporation losses from prior years)
will recognize ordinary income upon the S corporation’s repayment of any portion of such open
account debt unless the shareholder makes additional open account advances to the S corporation
in the same year in an amount at least equal to the repayment amount. See, e.g., Brooks v.
Comm’r, 56 T.C.M. (CCH) 127 (2005) (holding that the repayment of zero-basis open account
debt in the beginning of a relevant year did not cause the taxpayers to recognize gain, because
the taxpayers made open account debt advances in excess of such repayments by the end of such
year); Cornelius v. Comm’r, 53 T.C. 427 (1972), aff’d, 494 F.2d 465 (5th Cir. 1974) (holding
that similar advances did not prevent gain recognition from earlier repayments since the relevant
shareholder S corporation debts did not constitute open account debt).
On October 20, 2008, the Treasury Department and the Service issued final regulations
amending Treas. Reg. § 1.1367-2 with respect to open account debt. See T.D. 9428. The
regulations are meant to narrow the definition of “open account debt” in order to prevent the
perceived abuse in Brooks. The preamble to the final regulations states that the “treatment of
open account debt as interpreted in Brooks permits tax consequences that are inconsistent with
the original purpose of § 1.1367-2 and is not conducive to sound tax administration.” See
Preamble, T.D. 9428.
The regulations define “open account debt” of a shareholder as such shareholder’s
advances (and repayments of those advances) not evidenced by separate written instruments for
which the aggregate outstanding principal does not exceed $25,000 of indebtedness of the S
corporation to the shareholder at the close of the S corporation’s taxable year. Treas. Reg.
§1.1367-2(a)(2)(i). If the aggregate outstanding principal amount does not exceed $25,000 at the
end of the S corporation’s taxable year, such advances and repayments would constitute open
account debt, would be treated as a single indebtedness, and would be accounted for at the close
of the taxable year of the S corporation. Treas. Reg. § 1.1367-2(a), (d). If, however, the
aggregate outstanding principal amount exceeds the $25,000 threshold at the end of the S
corporation’s taxable year, the entire outstanding principal amount would be considered as not
open account debt. Treas. Reg. § 1.1367-2(a)(2)(ii). This outstanding principal amount then
- 80 would be treated as indebtedness evidenced by a written instrument and would be accounted for
under the general rules applicable to shareholder S corporation debt for subsequent taxable years.
Id.
The regulations also change the way in which repayments of open account debt are
accounted for under Treas. Reg. § 1.1367-2. Under Treas. Reg. § 1.1367-2(d)(2), at the end of
the S corporation’s taxable year, each shareholder has to net all advances and repayments
without regard to the outstanding principal amount of the open account debt. If a shareholder
has received a net repayment, such repayment must be taken into account at the close of the S
corporation’s taxable year under the general rules applicable to shareholder S corporation debt in
Treas. Reg. § 1.1367-2. Treas. Reg. § 1.1367-2(d)(2)(i). If a shareholder has made a net
advance, the net advance is combined with the outstanding principal balance of the open account
debt, the amount of which is carried forward to the S corporation’s subsequent taxable year. Id.
These amendments to the rules applicable to shareholder S corporation debt apply to any
shareholder advances to the S corporation made on or after October 20, 2008, and repayments on
those advances by the S corporation. Treas. Reg. §1.1367-3.
(ii)
Contribution of Shareholder S Corporation Debt
Section 61(a)(12) provides that gross income includes cancellation of indebtedness
(“COD”) income.65 Section 108(e)(6) provides a special rule to determine a debtor corporation’s
COD income when it acquires its debt from a shareholder as a contribution to capital. That
provision provides that Section 118 shall not apply, and the debtor corporation is treated as if it
satisfied the debt with an amount of money equal to the shareholder’s adjusted basis in such
debt.66 Thus, a shareholder’s contribution of shareholder S corporation debt ordinarily does not
create COD income for the debtor corporation.
However, absent Section 108(d)(7)(C) (described immediately below), the operation of
the debt basis reduction provision in Section 1367(b)(2)(A) could change this result. As
previously discussed, see supra Section III.B.2, where a shareholder has reduced its basis in its
stock of an S corporation to zero, it is then required to reduce its basis (but not below zero) in
shareholder S corporation debt. See Section 1367(b)(2)(A). Accordingly, if a shareholder were
to contribute shareholder S corporation debt with a basis reduced by Section 1367(b)(2)(A), the
debtor corporation would realize COD income equal to the difference between the amount of
such debt and the amount of the shareholder’s basis in such debt. However, Section
108(d)(7)(C) provides that, for purposes of determining COD income under Section 108(e)(6),
the shareholder should not take into account adjustments to its basis in shareholder S corporation
65
Section 108(a)(1) generally excludes from gross income such COD income in certain
circumstances, such as where the debtor is insolvent.
Compare Section 108(e)(8) (treating a debtor corporation, upon a shareholder’s
exchange of shareholder S corporation debt for additional stock of the debtor corporation, as
satisfying its debt for an amount equal to the fair market value of the additional stock).
66
- 81 debt due to Section 1367(b)(2). Thus, a shareholder’s contribution of shareholder S corporation
debt to the debtor S corporation generally should not cause the debtor corporation to realize
COD income.
Example: Assume shareholder John has previously loaned his S corporation $1,000,000.
Over the years, John’s bases in his stock and shareholder S corporation debt have been reduced
to zero. John wants to contribute to the capital of the debtor S corporation his shareholder S
corporation debt. Section 108(e)(6) provides that the S corporation will be treated as if it
satisfied the $1,000,000 debt with an amount of cash equal to John’s basis in the debt (i.e., $0).
Accordingly, absent Section 108(d)(7)(C), the S corporation generally would have $1,000,000 of
COD income. However, pursuant to Section 108(d)(7)(C), the amount deemed paid by the S
corporation would be equal to John’s unreduced basis in the debt, $1,000,000. Thus, the S
corporation would not realize any COD income due to John’s contribution of the debt.67
c.
Back-to-Back Loans
If third-party financing is to be obtained (e.g., banks), the loan should be made to a
shareholder if possible, and not to the S corporation.68 The shareholder can then reloan the
proceeds to the corporation and obtain basis in the receivable (i.e., the shareholder S corporation
debt). See Miller v. Comm’r, 56 T.C.M. (CCH) 544 (2006); Oren v. Comm’r, 357 F.3d 854 (8th
Cir. 2004) (“[A] shareholder who borrows money in an arm’s length transaction and then loans
the funds to the S corporation is entitled to an increase in basis.”); TAM 200619021; PLR
8747013; cf. Prop. Treas. Reg. § 1.465-10 (regarding the application of the at-risk rules in a
back-to-back loan scenario). But see Kaplan v. Comm’r, 56 T.C.M. (CCH) 143 (2005) (denying
an increase in basis where the shareholder engaged in a series of back-to-back loans: he
borrowed funds from an unrelated bank, loaned them to his S corporations, those S corporations
re-loaned the funds back to the shareholder, and he used those funds to repay the original bank
loan 11 days after his original borrowing from the bank).
Proposed regulations issued on June 11, 2012 provide that an S corporation shareholder
may only increase its basis of shareholder S corporation debt if the indebtedness is bona fide and
runs directly to the shareholder. Prop. Treas. Reg. § 1.1366-2. The preamble to the proposed
regulations states that they were issued in part because the “frequency of disputes between S
corporation shareholders and the government regarding whether certain loan transactions
67
68
Note that this treatment is solely for purposes of Section 108.
Loans directly to the S corporation from third-party lenders do not increase the basis of
a shareholder’s stock in the S corporation. In this regard, the S corporation compares
unfavorably with the partnership inasmuch as a partner generally may obtain basis in its
partnership interest for third-party partnership debt. See Section 752; see also Luiz v. Comm’r,
87 T.C.M. (CCH) 838 (2004) (rejecting the argument that a shareholder guarantee of S
corporation third party debt should generate basis in the S corporation stock held by the
shareholder since Section 752 would provide such basis to a partner in a partnership in a similar
situation and S corporations are similar to partnerships).
- 82 involving multiple parties, including back-to-back loan transactions, create shareholder basis of
indebtedness demonstrates the complexity of and uncertainty about this issue for both
shareholders and the government.” 77 Fed. Reg. 34,884 (June 12, 2012).
If the outside lender will not accept a mere pledge of the S corporation stock as security
for the loan to the shareholder, the shareholder first should obtain security from the corporation
on the shareholder’s loan to the corporation. The shareholder can then reassign this security
interest to the lender or otherwise use it as collateral to satisfy the lender. Cf. TAM 8443002.
Alternatively, the shareholder could use unrelated property as collateral.
A direct pledge of corporate assets to secure a shareholder loan should not be made since,
in such a case, the loan may be treated as being made directly to the S corporation. See
Harrington v. United States, 605 F. Supp. 53 (D. Del. 1985); cf. PLR 8546110; PLR 8542020;
PLR 8539056.
Finally, if a shareholder borrows money from a related party and then loans that money to
the S corporation, the issue of whether the second loan generates basis for the shareholder may
rest on whether the first loan is viewed as an arm’s length loan between the lender and the
shareholder. See Oren v. Comm’r, 357 F.3d 854 (8th Cir. 2004) (holding that circular loans
among a shareholder and three S corporations that the shareholder controlled did not generate
basis for the shareholder). If the lender and the shareholder are related, a court will require
“other elements [that] clearly establish the bona fides of the transactions and their economic
impact.” Id. at 858.
d.
Shareholder Guarantees
A guaranty by a shareholder of debt owed by the S corporation to a third party has not
been a successful basis generating technique. See e.g., Weisberg v. Comm’r, 99 T.C.M. (CCH)
1223 (2010); Bean v. Comm’r, 268 F.3d 553 (8th Cir. 2001); Brown v. Comm’r, 706 F.2d 755
(6th Cir. 1983); Maloof v. Comm’r, T.C. Memo. 2005-75 (2005), aff’d, 456 F.3d 645 (6th Cir.
2006); Luiz v. Comm’r, 87 T.C.M. (CCH) 838 (2004); Jackson v. Comm’r, 81 T.C.M. (CCH)
1294 (2001). Most courts require an actual “economic outlay” by the shareholder to obtain
basis. See, e.g., Oren v. Comm’r, 357 F.3d 854 (8th Cir. 2004) (“Only where the shareholder
provides his own money (or money he is directly liable for) to the S corporation, will basis
increase.”); Underwood v. Comm’r, 535 F.2d 309 (5th Cir. 1976); Estate of Leavitt v. Comm’r,
90 T.C. 206 (1988), aff’d, 875 F.2d 420 (4th Cir. 1989); Maloof, T.C. Memo. 2005-75, aff’d,
456 F.3d 645 (6th Cir. 2006); PLR 9403003 (lack of actual economic outlay prevents taxpayer
from increasing its basis under Section 1366(d)); see also Kevin Keyes, Shareholder Debt
Guarantees Do Not Create Basis, J. Small Bus. Tax’n (Sept./Oct. 1988) at 40.
However, where the evidence indicates that the lender was looking to the shareholder for
payment, guaranteed debt may be treated as if the money was lent directly to the shareholder
who then made a capital contribution to the corporation. See Selfe v. United States, 778 F.2d
769 (11th Cir. 1985); Plantation Patterns, Inc. v. Comm’r, 462 F.2d 712 (5th Cir. 1972).
According to Selfe, the issue generally is a factual one: whether the lender was looking
primarily to the shareholder/guarantor for payment.
- 83 Actual payment by a shareholder of guaranteed corporate debt should give rise to basis in
the year of payment (and not sooner). See Maloof, T.C. Memo. 2005-75, aff’d, 456 F.3d 645
(6th Cir. 2006); Rev. Rul. 71-288, 1971-2 C.B. 319; Rev. Rul. 70-50, 1970-1 C.B. 178; see also
Prop. Treas. Reg. § 1.1366-2. In this case, the corporation becomes directly indebted to the
shareholder through subrogation. Furthermore, the substitution of the shareholder’s note in
satisfaction of the corporation’s obligation may generate basis for the shareholder. See Gilday v.
Comm’r, 43 T.C.M. (CCH) 1295 (1982); Rev. Rul. 75-144, 1975-1 C.B. 277. But see
Underwood v. Comm’r, supra.
e.
Sales Financing
Sales financing should be treated as other third-party debt of the corporation. Thus, a
shareholder will not receive an increased basis where the S corporation acquires property from a
third party in exchange for the corporation’s own notes. As an alternative, the shareholder may
consider purchasing the property directly from the seller and then contributing such property to
the S corporation. As another alternative, the shareholder may consider making a loan to the S
corporation in an amount of the sales price of the property to be acquired by the S corporation
from the third party.
2.
Creating Priority for Investors
Priority Between Shareholders and Debt Holders: Because an S corporation may
have only one class of stock outstanding, creative planning is required to provide investors with
desired priority. Investors may obtain priority over shareholders by loaning money to the S
corporation. If the debt satisfies the straight debt safe harbor in Section 1361(c)(5), it will not be
recharacterized as a second class of stock. Furthermore, the loans may be non pro rata.
Priority Between Different Debt Holders: Priority between creditors may also be
created. Interest rates may vary. Thus, priority may be reached by setting a higher interest rate
than that carried on other debt instruments or by giving fixed interest rates to some creditors and
variable rates to others. Subordinated debt may also be used to create priority without such debt
being treated as a second class of stock. See Treas. Reg. § 1.1361-1(1)(5)(ii).
Equivalent Transactions: The equivalent of priority may be obtained if two or more S
corporations form a partnership to acquire assets. For example, investor A and investor B wish
to acquire the assets of a target corporation. However, A will not participate unless A can be
assured of obtaining priority with respect to distributions. Accordingly, A and B form
corporations S-1 and S-2, respectively. Both corporations make an S election. S-1 and S-2 form
a partnership to acquire and operate the assets of a target business. The partnership agreement
provides that S-1 is to receive priority on partnership distributions and liquidations. S-l’s
partnership interest is functionally equivalent to a preferred stock interest.
With the issuance of Rev. Rul. 94-43, 1994-2 C.B. 198, which, as discussed in Section
II.A.4. above, revoked Rev. Rul. 77-220, there is significantly less risk that the Service will treat
the two corporations as one for purposes of determining eligibility for an S election. However, if
the Service were to treat the two entities as a single corporation, the combined entity would not
be eligible for an S election because the different distribution rights between A and B amount to
- 84 two classes of stock. The Service may view this structure as an attempt to circumvent the one
class of stock restriction.
E.
Special Effects of an S Election
1.
Cancellation of Indebtedness Income and Sections 108 and 1366
In Gitlitz v. Commissioner, 531 U.S. 206 (2001), the U.S. Supreme Court settled a
conflict between several Circuits and the Tax Court regarding the treatment of COD income of
an insolvent S corporation. In Gitlitz, two shareholders each owned 50 percent of an insolvent S
corporation. The S corporation realized COD income in 1991 as a result of taking into account
its distributive share of COD income attributable to a partnership in which it held an interest. As
a result of the S corporation’s insolvency, such COD income was excludable from the S
corporation’s gross income. See Section 108(a)(1)(B), (d)(6), (d)(7). Consequently, pursuant to
Sections 1366 and 1367, each of the two shareholders treated its pro rata share of the S
corporation’s COD income as excludable from their gross income and increased their stock bases
accordingly. The increase in stock basis allowed the shareholders to utilize previously
suspended S corporation losses and deductions.
The Commissioner determined that the shareholders could not use their pro rata share of
the S corporation’s excludable COD income to increase their stock basis because presumably
such income did not meet the definition of “items of income (including tax-exempt income)”
under Section 1366(a)(1)(A), which is the Code provision that effectively permits a shareholder
to increase its stock basis for income items (including tax-exempt income items) under Section
1367. The Tax Court held for the Commissioner. See Gitlitz v. Comm’r, 75 T.C.M. (CCH)
1840 (1998). The court ruled that, with respect to S corporations and their shareholders, the
Section 108 income exclusion and tax attribute reduction rules apply at the corporation level
rather than the shareholder level. As a result, excludable COD income of an S corporation never
passes through to shareholders and thereby never increases stock basis. The court also ruled that
Section 1367 does not require a basis increase for excludable COD income of an S corporation
because such income is a form of tax-deferred income rather than tax-exempt income, since the
Section 108(b) tax attribute reduction rules effectively preserve the income potential formerly
represented by the COD income.
The Tenth Circuit also held for the Commissioner, but under a slightly different rationale.
The Tenth Circuit ruled that the Section 108 attribute reduction rules apply before any remaining
excluded COD income passes through to shareholders, and it assumed that excluded COD
income constituted tax-exempt income. See Gitlitz v. Comm’r, 182 F.3d 1143 (10th Cir. 1999).
In effect, the Tenth Circuit permitted the shareholders to avoid a current tax on the S
corporation’s COD income at the price of losing (i) their right to take into account their
suspended S corporation losses and deductions and (ii) their ability to increase stock basis for
such COD income to the extent that such income reduced their suspended S corporation losses
and deductions under Section 108(b). However, any amount of excluded COD income that
exceeded the shareholders’ suspended S corporation losses and deductions (and any other S
corporation tax attributes) would increase stock basis.
- 85 Supreme Court Majority: The U.S. Supreme Court reversed the Tenth Circuit and held
as follows: (i) The plain language of Sections 61 and 108 establish that excluded COD income is
an “item of income” (regardless whether such item constitutes tax-exempt income or taxdeferred income) which passes through to shareholders and increases their bases in S corporation
stock; and (ii) Section 108 expressly directs that excluded COD income is passed through to
shareholders before Section 108 reduces an S corporation’s tax attributes. Thus, the Court
effectively ruled that (i) excluded COD income passes through to an S corporation’s
shareholders, (ii) such income is not subject to tax pursuant to Section 108(a), (iii) such income
increases stock basis prior to Section 108(b) reducing any suspended S corporation losses and
deductions, (iv) Section 1366 permits the S corporation’s shareholders to take into account their
suspended S corporation losses and deductions to the extent of their stock bases, and (v) after
such losses and deductions are taken into account, Section 108(b) reduces tax attributes, if any
remain. The Supreme Court noted: “[C]ourts have discussed the policy concern that, if
shareholders were permitted to pass through the discharge of indebtedness before reducing any
tax attributes, the shareholders would wrongly experience a ‘double windfall’: They would be
exempted from paying taxes on the full amount of the discharge of indebtedness, and they would
be able to increase basis and deduct their previously suspended losses. Because the Code’s plain
text permits the taxpayers here to receive these benefits, we need not address this policy
concern.” Id. at 709-10.
Supreme Court Dissent: Justice Breyer wrote the lone dissenting opinion. Justice
Breyer wrote, similar to the Tax Court, that Section 108 required that the COD income exclusion
and the tax attribute reduction rules must be applied only at the corporation level. Thus,
excluded COD income should never flow through to shareholders and thereby should never
increase stock basis. Justice Breyer stated, “The arguments from plain text on both sides here
produce ambiguity, not certainty. And other things being equal, we should read ambiguous
statutes as closing, not maintaining, tax loopholes....Here, other things are equal, for, as far as I
am aware, the Commissioner’s literal interpretation of [Section 108] as exclusive would neither
cause any tax-related harm nor create any statutory anomaly.” Id. at 711.
Query: Does Gitlitz suggest that Treas. Reg. § 1.1366-1(a)(2)(viii) may be invalid?
Treas. Reg. § 1.1366-1(a)(2) states, “The separately stated items of the S corporation include, but
are not limited to, the following items- .... (viii) The corporation’s tax-exempt income. For
purpose 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)...is tax-exempt income, while income that is excludible from gross income under
section 108 (income from discharge of indebtedness)...is not tax-exempt income.”
Gitlitz involved a tax year (1991) prior to the issuance (and effective date) of Treas. Reg.
§ 1.1366-1(a)(2)(viii) (discussed in the preceding paragraph). That regulation applies to taxable
years of an S corporation beginning on or after August 18, 1998. Treas. Reg. § 1.1366-5.
However, the Treasury Department published the regulation on December 21, 1999, more than
one year prior to the U.S. Supreme Court decision in Gitlitz. The Court’s language may support
the view that the regulation is invalid. The Court wrote: “Second, the Commissioner argues that
excluded discharge of indebtedness is not ‘tax-exempt’ income under § 1366(a)(1)(A), but rather
- 86 ‘tax-deferred’ income.... Implicit in the Commissioner’s labeling of such income as ‘tax
deferred,’ however, is the erroneous assumption that § 1366(a)(1)(A) does not include ‘tax
deferred’ income. Section 1366 applies to “items of income.” This section...is worded broadly
enough to include any item of income, even tax-deferred income.... Thus, none of the
Commissioner’s contentions alters our conclusion that discharge of indebtedness of an insolvent
S corporation is an item of income for purposes of § 1366(a)(1)(A).” Gitlitz, 531 U.S. at 707-08.
Effective Reversal of Gitlitz: On March 9, 2002, Congress effectively reversed Gitlitz.
See P.L. 107-147, § 402, 116 Stat. 21, 40 (2002). Section 402 of the Job Creation and Worker
Assistance Act of 2002 amends Section 108(d)(7)(A) by adding the following underlined phrase:
“In the case of an S corporation, subsections (a), (b), (c), and (g) shall be applied at the corporate
level, including by not taking into account under section 1366(a) any amount excluded under
subsection (a) of this section.” Apparently, Congress intended that this language would prevent
S corporation shareholders from treating excluded COD income as an item of income under
Section 1366(a). Under this view, shareholders apparently would be unable to use their allocable
portion of pass-through excluded COD income to increase stock basis in a manner similar to the
Tax Court’s Gitlitz opinion. As a result, it appears that a shareholder in the Gitlitz situation will
benefit only from the exclusion of COD income under Section 108(a). Because such excluded
COD income will never increase stock basis, the shareholder’s previously suspended S
corporation losses and deductions will be reduced under Section 108(b). See Section
108(d)(7)(B). This amendment generally applies to discharges of indebtedness occurring after
October 11, 2001 that are taken into account in taxable years ending after such date.
Query: Should Congress have merely provided that tax attribute reduction under Section
108(b) should apply prior to passing through any remaining S corporation COD income to S
corporation shareholders? This was the result reached by the Tenth Circuit in Gitlitz.
Query: What effect does the above amendment have on Treas. Reg. § 1.13661(a)(2)(viii)?
Tax Attribute Reduction: On October 30, 2009, the Treasury Department and the Service
issued final regulations detailing how an S corporation with excluded COD income should
reduce its tax attributes under Section 108. See T.D. 9469. Under the regulations, the S
corporation’s net operating loss tax attribute (the “deemed NOL”) includes the aggregate amount
of the shareholders’ losses and deductions disallowed under Section 1366(d)(1) for the taxable
year of the discharge. Treas. Reg. § 1.108-7(d)(1). This amount also includes disallowed losses
and deductions of a shareholder that transferred all of the shareholder’s stock in the S
corporation during such year. Id.
If the amount of the S corporation’s deemed NOL exceeds the amount of the S
corporation’s excluded COD income, the regulations provide that such excess (the “excess
deemed NOL”) is allocated to the S corporation’s shareholders as losses and deductions
disallowed under Section 1366(d)(1). Treas. Reg. 1.108-7(d)(2)(i). If an S corporation has
multiple shareholders, the regulations allocate the amount of the S corporation’s excess deemed
NOL based on the percentage of the shareholder’s “excess amount” to the total “excess amount”
of all shareholders. Treas. Reg. § 1.108-7(d)(2)(ii)(A)-(C). The shareholder’s “excess amount”
- 87 is the amount by which the shareholder’s losses or deductions disallowed under Section
1366(d)(1), before any reduction under Treas. Reg. § 1.108-7(a)(1), exceed the amount of COD
income that would have been taken into account by that shareholder under Section 1366(a) had
the COD income not been excluded under Section 108(a). Treas. Reg. § 1.108-7(d)(2)(ii)(A).
Any amount of the S corporation’s excess deemed NOL that is allocated to a shareholder that
transferred all of the shareholder’s stock in the corporation during the taxable year of the
discharge is permanently disallowed under Treas. Reg. § 1.1366-2(a)(5), unless the transfer of
stock is described in Section 1041(a). Treas. Reg. § 1.108-7(d)(2)(iii).
The regulations also provide a method for determining the character of the amount of the
S corporation’s excess deemed NOL that is allocated to a shareholder that is consistent with the
method for determining the character of a shareholder’s losses and deductions under Section
1366(d). Under this approach, the S corporation’s excess deemed NOL that is allocated to a
shareholder consists of a proportionate amount of each item of the shareholder’s loss or
deduction that is disallowed for the taxable year of the discharge under Section 1366(d)(1).
Treas. Reg. § 1.108-7(d)(3).
If an S corporation excludes COD income under Section 108(a), the regulations require
each shareholder of an S corporation to provide to the S corporation the amount of the
shareholder’s losses and deductions that are disallowed for the taxable year of the discharge
under Section 1366(d)(1). Treas. Reg. § 1.108-7(d)(4). If a shareholder fails to report this
information, or if the S corporation knows that the amount reported by the shareholder is
inaccurate (or the information, as provided, appears to be incomplete or incorrect), the
regulations allow the S corporation to rely on its own books and records, as well as other
information available to the S corporation, to determine a shareholder’s disallowed losses or
deductions under Section 1366(d)(1). Id. In such an instance, the S corporation must know, or
reasonably believe, that its information presents an accurate reflection of the shareholder’s
disallowed losses and deductions under Section 1366(d)(1). Id. The regulations also require the
S corporation to provide to each shareholder the amount of the S corporation’s excess deemed
NOL that is allocated to that shareholder, even if that amount is zero. Id.
The regulations apply to discharges of indebtedness occurring on or after October 30,
2009.
2.
Passive Activity Losses Under Section 469
In St. Charles Investment Co. v. Commissioner, 232 F.3d 773 (10th Cir. 2000), rev’g 110
T.C. 46 (1998), St. Charles was a closely held C corporation under Section 469(j)(1). During
1988-1990, St. Charles engaged in the real estate rental business. St. Charles’s real estate rental
business qualified as a passive activity under Section 469(c). In each of the years from 19881990, St. Charles’s passive activities generated non-deductible passive activity losses (PALs)
under Section 469(a), which St. Charles suspended and carried forward pursuant to Section
469(b).
On January 1, 1991, St. Charles converted to an S corporation. In the same year, St.
Charles sold several rental properties that had suspended PALs. St. Charles, pursuant to Section
- 88 469(g)(1)(A), claimed a deduction on its 1991 tax return in the amount of the suspended PALs
allocable to the sold rental properties. In 1995, St. Charles converted back to a C corporation.
The Commissioner disallowed the deductions for 1991, arguing that Section 1371(b)(1)
prohibits S corporations from carrying forward PALs created in its C years to S years. (Section
1371(b)(1) states, “No carryforward, and no carryback, arising for a taxable year for which a
corporation is a C corporation may be carried to a taxable year for which such corporation is an S
corporation.”) The Tax Court agreed that Section 1371(b)(1) trumped the application of the PAL
carryover provision of Section 469(b), which provided that, except as otherwise provided in
Section 469, any loss or credit from an activity which is disallowed under Section 469(a) shall be
treated as a deduction or credit allocable to such activity in the next taxable year.
The Tenth Circuit reversed the Tax Court. The Tenth Circuit held that Section 469(b)
permits St. Charles to use its C year PALs to offset income in its 1991 S year (i.e., Section
1371(b)(1) does not limit Section 469(b)). The court ruled as follows: (i) Although Congress
enacted Section 1371(b)(1) to prevent corporate losses incurred prior to S corporation status
from inuring to the benefit of shareholders after an S election is made, Section 469(b) provides
that the only exceptions to the PAL carryover rule are those exceptions within Section 469; and
(ii) Because Section 1371(b)(1) is not an express exception to Section 469(b), Section 1371(b)(1)
does not apply to suspended PALs.
The court rejected the argument that a windfall would be created in favor of the
shareholders of St. Charles by allowing one taxpayer (the shareholders) to offset income with the
losses of a different taxpayer (the corporation), stating: “While we have sympathy for the
Commissioner’s position, we find that in this case the language of Section 469 is sufficiently
unequivocal to require this result.”
3.
Determination of Alternative Minimum Taxable Income
In Allen v. Commissioner, 118 T.C. 1 (2002), an S corporation incurred wages that
qualified for the targeted jobs credit (“TJC”) under Sections 38 and 51. The S corporation
reduced its deduction for wages by the amount of the TJC pursuant to Section 280C(a).
Although the S corporation’s shareholders were not subject to the AMT, they each had to
compute alternative minimum taxable income (“AMTI”) in order to determine the tentative
minimum tax ceiling on the amount of the TJC that could be applied against regular tax liability
under Section 38(c)(1)(A). Each shareholder determined its AMTI by deducting its
proportionate share of the S corporation’s full wage expense (i.e., the wage expense unreduced
by the TJC under Section 280C(a)).
The Commissioner argued that, despite the AMT disallowing the TJC, AMTI should be
calculated by taking into account the TJC wage expense limit because Section 280C(a) is not
specifically adjusted under the AMT regime. The shareholders argued that AMTI should not be
calculated by taking into account the TJC wage expense limit because a TJC cannot be taken for
AMT purposes. Both sides interpreted the separate, yet parallel, concept of the AMT to require
taxpayers to compute AMTI on a pure separate and parallel basis (i.e., by reapplying all the
provisions of the Code as they are modified by the AMT provisions rather than by starting from
regular taxable income and adjusting only for items specifically addressed by the AMT
- 89 provisions). Thus, the issue before the court was whether the calculation of an S corporation
shareholder’s AMTI included the shareholder’s allocable share of the S corporation’s full wage
expense, unreduced by the TJC wage expense limit.
Tax Court Opinion: The Tax Court found that Congress intended that the AMT parallel
the regular tax system only partially, rather than completely. The court ruled that, pursuant to
Section 55(b)(2), AMTI is calculated by first computing taxable income under the regular tax
system and then altering that amount to reflect the items in Sections 56 through 59. Because the
Section 280C(a) wage expense limit enters into the computation of taxable income and Sections
56 through 59 do not adjust the application of Section 280C(a), the court held that the
shareholders must take into account the Section 280C(a) wage expense limit created by the
regular tax TJC in determining AMTI. As a result, the court refined the separate, yet parallel,
concept of the AMT by rejecting the interpretation that AMTI is computed by reapplying all the
provisions of the Code as they are modified by the AMT provisions. See also Ventas, Inc. v.
United States, 57 Fed. Cl. 411 (2003) (same).
Comment: Although Allen rejects a pure interpretation of the separate, yet parallel,
concept of the AMT, Allen did not address whether a separate AMT stock basis should be
maintained. Prior to the Tax Court’s decision in Allen, the Service issued TAM 9722005, which
appears to have dealt with the facts of Allen. In reaching the same result as the court in Allen,
the Service concluded that stock basis in an S corporation may be different for AMT and regular
tax purposes because the basis of property may be different as the result of reflecting differences
in the timing at which items of income and deduction are taken into account under each system
(e.g., the different treatment of depreciation between the regular tax and AMT systems). The
Service also found that AMTI should be calculated by following the same steps as those
followed in computing regular taxable income, but applying the Code as though it had been
modified to be consistent with the rules contained in Sections 56 through 59. Because the Tax
Court in Allen rejected this approach to the determination of AMTI, the TAM’s support of a
separate AMT stock basis could also be questioned. However, the dispute litigated before the
court did not involve, and the court’s opinion did not address, the issue of a separate AMT stock
basis.
4.
Charitable Contributions of Appreciated Property
Several traps exist for a shareholder of an S corporation who wishes to make a charitable
contribution of appreciated property. Assume the following scenario. The sole shareholder
(“A”) of an S corporation (“X”) has an initial adjusted basis in its X stock equal to $100x, which
is attributable to A’s initial contribution to X of a parcel of real estate that had a fair market value
and adjusted basis equal to $100x (and still has such value and basis). A also has appreciated
property with a fair market value equal to $100x and an adjusted basis equal to $75x. A
contributes the appreciated property to X. In a transaction unrelated to the contribution of the
appreciated property, A causes X to donate that property to charity. Later, A sells its stock in X
to a third party for the stock’s fair market value.
The amount of X’s charitable contribution generally is equal to the property’s fair market
value (i.e., $100x). See Section 170; Treas. Reg. § 1.170A-1(c). Pursuant to Section
1366(a)(1)(A), A takes the $100x charitable contribution into account in determining its
- 90 deduction under Section 170. A also reduces its stock basis by its pro rata portion of the
charitable contribution under Section 1367(a)(2) (i.e., by $100x, from $175x to $75x). See PLR
9340043. When A later sells its X stock, A recognizes $25x of gain (i.e., $100x less $75x). As a
result, the portion of A’s charitable contribution deduction attributable to the appreciation in the
contributed property (i.e., $25x) effectively is recaptured when A sells its X stock. Note that, if
(i) A had contributed the appreciated property directly to the charity or (ii) A had contributed the
appreciated property indirectly to the charity through the use of a partnership, A would not have
had to recapture any portion of the $100x charitable contribution deduction. See Rev. Rul. 9611, 1996-1 C.B. 140.
The Pension Protection Act of 2006, P.L 109-280 (“Pension Act of 2006”) corrects the
previously described problem for shareholders of S corporations that desire to make
contributions of appreciated property. Section 1203 of the Pension Act of 2006 amends Section
1367 so that when an S corporation contributes an appreciated asset to charity, a shareholder’s
basis in the stock of the S corporation is reduced by the shareholder’s allocable share of the
corporation’s basis in the contributed asset. The correction made by the Pension Act of 2006
applies to charitable contributions made in taxable years beginning after December 31, 2005, and
taxable years beginning before January 1, 2008 (i.e., the correction does not apply to charitable
contributions made in taxable years beginning on or after January 1, 2008). In the Emergency
Economic Stabilization Act of 2008, P.L. 110-343, it was amended to include taxable years
beginning before January 1, 2010. The Tax Relief, Unemployment Insurance Act of 2010, P.L.
111-312, amended it to apply to taxable years beginning before January 1, 2012. The American
Taxpayer Relief Act of 2012 amended it to apply to taxable years beginning before January 1,
2014.
Another trap for the unwary is illustrated as follows. Assume the same facts as the
preceding example except that the parcel of real estate is not contributed to X, so that A’s
adjusted basis in the stock of X equals $75x prior to X’s charitable contribution. Pursuant to
Section 1366(a)(1)(A), A should take a $100x charitable contribution into account in
determining its deduction under Section 170. However, Section 1366(d) permits A to take into
account only $75x of the $100x charitable contribution because A’s stock basis equals $75x.
The remaining portion of the charitable contribution is carried forward under Section 1366(d)
and may be taken into account only when A generates an additional $25x of basis in its X stock.
However, because A sold its stock before it could generate additional stock basis, the suspended
$25x charitable contribution is permanently lost. See Treas. Reg. § 1.1366-2(a)(5). As a result,
the portion of the charitable contribution attributable to the appreciation in the contributed
property is first deferred and then permanently lost. Note that, similar to the previous issue, if (i)
A had contributed the appreciated property directly to the charity or (ii) A had contributed the
appreciated property indirectly to the charity through the use of a partnership,69 A would not
69
Unlike a shareholder in an S corporation, a partner in a partnership may take its full
distributive share of the partnership’s charitable contributions into account regardless of its basis
in its partnership interest. Compare Section 704(d) (basis limitation applying solely to loss
items) with Section 1366(d) (basis limitation applying to loss and deduction items).
- 91 have had to defer (or permanently lose) any portion of the $100x charitable contribution
deduction.
The Tax Technical Corrections Act of 2007, P.L. 110-172 (“Technical Corrections Act of
2007”) corrects the previously described problem. Section 3(b) of the Technical Corrections Act
of 2007 adds Section 1366(d)(4), which provides that, in the case of a charitable contribution of
property, the general loss limitation rule of Section 1366(d) does not apply to the extent of the
shareholder’s pro rata share of such contribution over the shareholder’s pro rata share of the
adjusted basis of such contributed property. This correction made by the Technical Corrections
Act of 2007 applies to charitable contributions made in taxable years beginning after December
31, 2005 and taxable years beginning before January 1, 2008 (i.e., the correction does not apply
to charitable contributions made in taxable years beginning on or after January 1, 2008). See
also Rev. Rul. 2008-16, 2008-11 I.R.B. 585 (applying Section 1366(d)(4)).
F.
Coordination with Subchapter C of the Code
Section 1371(a) states that “[e]xcept as otherwise provided in this title, and except to the
extent inconsistent with [subchapter S], subchapter C shall apply to an S corporation and its
shareholders.” The legislative history of one of the predecessors to Section 1371(a) (Former
Section 1371(a)(1)) provides that, as to transactions with respect to its own stock, an S
corporation is to be treated as a regular corporation, unless the result would be inconsistent with
the purposes of the rules of subchapter S of the Code which treat the corporation as a passthrough entity. S. Rep. No. 97-640, at 15.
A regulation promulgated under another predecessor to Section 1371(a) (Former Section
1372) set forth the following list of Sections in subchapter C of the Code that applied to S
corporations: (i) Section 301 was applicable as if no election had been made; (ii) Sections 302,
303, 304, and 331 were applicable in determining whether a distribution was in exchange for
stock; (iii) Section 305 applied to distributions of the S corporation’s own stock; (iv) Section 311
was applicable; and (v) Section 341 was applicable. See Former Treas. Reg. § 1.1372-1(c)
(withdrawn as a result of the complete restructuring of subchapter S of the Code in the Revision
Act of 1982). Although this regulation no longer exists, the Code Sections listed above should
continue to apply to S corporations in the manner indicated above, except that the S corporation
distribution rules in Section 1368 should modify the C corporation distribution rules in Section
301. Also note that, for taxable years beginning after December 31, 2002 and not beginning
after December 31, 2008, the Jobs and Growth Act of 2003 repealed Section 341. See sections
302 and 303 of the Jobs and Growth Act of 2003.
G.
Treatment of S Corporations as Shareholders of C Corporations
1.
General Tax Treatment of S Corporations as Shareholders
Prior to the Small Business Act of 1996: Prior to its repeal by the Small Business Act
of 1996 (discussed below), Former Section 1371(a)(2) provided that for purposes of subchapter
C of the Code, an S corporation in its capacity as a shareholder was to be treated as an
individual. The legislative history explicitly noted that this provision applied only where an S
- 92 corporation received a distribution from a C corporation. See S. Rep. No. 97-640, at 15; see also
Naprano v. United States, 834 F. Supp. 694 (D.N.J. 1993); TAM 9245004.
Originally, Section 1371(a)(2) presumably served to ensure that a distribution to an S
corporation was taxable under Section 301 of the Internal Revenue Code of 1954 (the “1954
Code”) in the same manner as a distribution to an individual (rather than as a distribution to a
corporation). (In 1982, when Section 1371(a)(2) was enacted, distributions to corporations and
individuals were treated differently, both in determining the amount of the distribution and the
distributee’s basis in distributed property. See generally TAM 9245004.) It appears that, read
literally, Section 1371(a)(2) itself did not serve to prevent an S corporation from taking a
dividends received deduction under Section 243. Section 1371(a)(2) applied solely for purposes
of Subchapter C of the Code. Section 243 was not (and still is not) located in Subchapter C of
the Code. See TAM 9245004.
However, a different Code Section prohibited (and still prohibits) an S corporation from
taking a dividends received deduction. See Section 1363(b). Section 1363(b) requires that an S
corporation compute its taxable income in the same manner as an individual. Since Section 243
provides for a dividends received deduction only for corporate shareholders, an S corporation
presumably is not eligible for such a deduction See TAM 9245004.
Beyond this context, the intended scope of Section 1371(a)(2) was unclear. It was
unclear whether this Section was intended to apply literally to reorganizations and divisive
transactions. For example, since a B reorganization requires an acquisition by a corporation of
control of another corporation, Section 1371(a)(2) literally would have prevented an S
corporation from acquiring stock of a target corporation under Section 368(a)(1)(B). Also, in a
divisive D reorganization, Section 355 contemplates the distribution by one corporation of
control of another corporation. If the distributing S corporation was treated as an individual
under Section 1371(a)(2), Section 355 would not have applied. A liquidation under Section 332
also would not have been available because that Section is premised on the existence of a
corporate shareholder.
However, in GCM 39768 (Dec. 1, 1988), the Service expressed the view that Section
1371(a)(2) should not prevent a transferor S corporation that momentarily holds the stock of a
controlled corporation from engaging in a divisive “D” reorganization. See e.g., PLR 9321006;
PLR 9320009; PLR 9319041; PLR 9319018; PLR 9319016; PLR 9319002; PLR 9318024; PLR
9312025. Similarly, Section 1371(a)(2) should not prevent a transferor S corporation that
momentarily holds the stock of an acquiring corporation from engaging in an “A”, “C”,
acquisitive “D,” or “F” reorganization.
Pursuant to the Small Business Act of 1996: The Small Business Act of 1996 repealed
Section 1371(a)(2) of the Code. Thus, the Small Business Act of 1996 clarified that the
liquidation of a C corporation into an S corporation will be governed by the generally applicable
rules of subchapter C of the Code, including the provisions of Sections 332 and 337 allowing a
tax-free liquidation of a corporation into its parent corporation. An acquiring S corporation also
will be able to make a Section 338 election (assuming all other applicable requirements are met),
- 93 resulting in immediate recognition of all the acquired C corporation’s gains and losses (and any
resulting tax liability).
However, the repeal of Code Section 1371(a)(2) was not intended to change the general
rule governing the computation of income of an S corporation. For example, it does not allow an
S corporation, or its shareholders, to claim a dividends received deduction with respect to
dividends received by the S corporation, or to treat any item of income or deduction in a manner
inconsistent with the treatment accorded to individual taxpayers.
2.
S Corporations as Owners of 80 Percent-Owned Subsidiaries
As discussed above (see Section II.A.2.), prior to its amendment by the Small Business
Act of 1996, Former Section 1361(b)(2) provided that a member of an affiliated group
(determined under Section 1504 without regard to the exceptions contained in subsection (b)
thereof) was an “ineligible corporation” for purposes of Section 1361 and thus could not be an S
corporation. See Section 1361(b)(2)(A). This provision effectively prevented an S corporation
from owning 80 percent or more of the stock of a C corporation. See Section 1504.
In the Small Business Act of 1996, Congress amended Former Section 1361 to allow an S
corporation to own up to 100 percent of the stock of a C corporation. See Sections 1361, 1362;
section 1308 of the Small Business Act of 1996. The S corporation is still unable, however, to
file a consolidated return with its C corporation subsidiaries, because an S corporation is not an
“includible corporation” under Section 1504(a) for purposes of determining affiliation. See
Section 1504(b)(8). However, if an S corporation parent owns an 80 percent interest or greater
in the stock of a C corporation that, in turn, holds an 80 percent interest or greater in the stock of
another C corporation and the two C corporations otherwise satisfy the affiliation requirements
of Section 1504, the two C corporations generally can elect to file a consolidated return. See
Sections 1501, 1504.
Issues raised by an S corporation’s ownership of a C corporation subsidiary are discussed
throughout this Outline. See, e.g., Sections IV.A., B. (discussing the application of the
corporate-level tax on built-in gains and the passive investment income rules).
H.
Qualified Subchapter S Subsidiaries
Also as a result of the Small Business Act of 1996, if an S corporation owns 100 percent
(but not less) of the stock of a C corporation, the S corporation may elect to treat its wholly
owned C corporation as a qualified subchapter S subsidiary (“QSub”). In virtually all
circumstances, such a QSub is treated for federal tax purposes as an unincorporated division of
the S corporation.
The QSub rules present several planning opportunities. For example, although an S
corporation cannot join in the filing of a consolidated return, it can achieve a similar effect by
treating its C corporation subsidiaries as QSubs. (An S corporation cannot elect to treat a wholly
owned C corporation as an S corporation because S corporations are not eligible shareholders of
other S corporations. See Section 1361(b)(1).)
- 94 1.
Introduction
If an S corporation (the “S parent”) owns 100 percent of the stock of a C corporation that
would qualify for S corporation status if its stock were held directly by the S parent’s
shareholders, the S parent may elect to treat such subsidiary as a QSub. See Section
1361(b)(3)(B).70 When an S corporation makes a valid QSub election with respect to a wholly
owned C corporation subsidiary, the separate existence of the QSub generally is ignored, and the
subsidiary generally is treated for federal tax purposes as a division of the S corporation.
Note, however, that the TRA of 1997 contained a technical correction to the QSub rules
in the Small Business Act of 1996. That technical correction authorizes the Service to issue
regulations providing instances under which a QSub may be treated as a separate corporation.
The legislative history to the technical correction specifically states the expectation that such
regulations would treat a bank that has elected QSub treatment as a separate legal entity for
purposes of those Code provisions that apply specifically to banks (e.g., Section 582). This
technical correction is effective for taxable years beginning after December 31, 1996.
Furthermore, the 2004 JOBS Act amended Section 1361(b)(3)(A) to authorize the
Service to provide guidance regarding information returns of QSubs required under Section 6031
through and including Section 6060. Section 239(a), P.L. 108-357. This amendment is effective
for taxable years beginning after December 31, 2004. Section 239(b), P.L. 108-357. The GOZone Act amended Section 1361(b)(3) to clarify that an S corporation and a QSub are recognized
as separate entities for information return purposes, except as otherwise provided by the Service.
Section 413(c), P.L. 109-135. The amendment is effective for taxable years beginning after
December 31, 2004. See Section 413(d), P.L. 109-135.
Upon making the QSub election, the subsidiary generally is considered to have liquidated
into the S parent. When the QSub election is terminated, the S parent generally is considered to
have contributed the QSub’s assets to a C corporation in exchange for its stock. The tax
treatment of such liquidation and such asset transfer are discussed below.
2.
Electing QSub Status
a.
IRS Notice 97-4 – Pre-October 10, 2000 Elections
IRS Notice 97-4, 1997-1 C.B. 351, provided a temporary QSub election procedure. The
preamble to the final QSub regulations71 provided that taxpayers should follow the election
70
A corporation that elects to be treated as an S corporation may also elect QSub status
for certain foreign subsidiaries if the S corporation made an election under Section 1504(d) to
treat the foreign subsidiaries as domestic corporations. See PLR 200120033.
71
On April 21, 1998, the Service issued proposed QSub regulations under Sections 1361
and 1362. These regulations were issued as final regulations on January 20, 2000. See T.D.
8869, 65 Fed. Reg. 3,843-3,856 (Jan. 25, 2000). The final QSub regulations generally apply to
taxable years that begin on or after January 20, 2000. However, taxpayers may elect to apply the
(Continued …)
- 95 procedure in IRS Notice 97-4, rather than the election procedure in the final QSub regulations,
until the QSub election form was published. T.D. 8869, 65 Fed. Reg. at 3,844. On October 10,
2000, the Service released the QSub election form, Form 8869. See IRS Ann. 2000-83, 2000-2
C.B. 348. Thus, the temporary QSub election procedures in IRS Notice 97-4 may not be used on
or after October 10, 2000.
Prior to October 10, 2000, the S parent made a QSub election by filing a Form 966 with
the service center where the corporation becoming a QSub had been required to file its federal
income tax returns. The S parent was required to follow the instructions for that form with
certain modifications. Under IRS Notice 97-4, a QSub election could not be made effective
more than 75 days before the date the Form 966 was filed with the Service. See also Presidio
Advisors, LLC v. United States, 2011-2 USTC ¶ 50,662 (Fed. Cl. 2011) (holding that a
corporation did not qualify as a QSub since the corporation was not wholly owned by an S
corporation for the entire 75-day retroactive period preceding the filing of the QSub election
pursuant to IRS Notice 97-4).
b.
Final QSub Regulations and Form 8869
The final QSub regulations provide that a QSub election is made by filing a completed
election form, Form 8869. The election form must be signed by a person authorized to sign the S
corporation’s tax return. Treas. Reg. § 1.1361-3(a)(2). Form 8869 should be filed at the Service
Center where the subsidiary filed its most recent return. Id.; Form 8869. However, if the S
parent forms a subsidiary, and makes a valid QSub election effective upon formation, Form 8869
should be filed at the Service Center where the S parent filed its most recent return. Treas. Reg.
§ 1.1361-3(a)(2); Form 8869.
Pursuant to the final QSub regulations, a QSub election can be made at any time of the
taxable year. Treas. Reg. § 1.1361-3(a)(3). The QSub election may be effective retroactively up
to two months and 15 days prior to the day the QSub election is made, or it may be effective on
any day not more than 12 months after the date of the filing of the election. Treas. Reg. §
1.1361-3(a)(4). Note that this time period is a change from the time period in IRS Notice 97-4.
The change to two months and 15 days in the regulations conforms the election time period to
that of the S election. Note, however, a major difference in timing between an S election and a
QSub election. An S election made more than two months and 15 days after the first of a
corporation’s tax year is effective on the first day of the next tax year. A QSub election made
more than two months and 15 days after the first day of the S parent’s tax year may be made
effective at any time during the period beginning on the date that is two months and 15 days
before the filing date and ending 12 months after the filing date.
regulations in whole, but not in part (aside from those sections with special dates of
applicability), for taxable years beginning on or after January 1, 2000, provided the corporation
and all affected taxpayers apply the regulations in a consistent manner.
- 96 c.
Extensions to Elect QSub Status
In certain circumstances, taxpayers can request relief for late QSub elections pursuant to
Rev. Proc. 2003-43, which superseded Rev. Proc. 98-55 effective June 9, 2003. Furthermore, an
extension to file a QSub election may be available under Treas. Reg. §§ 301.9100-1 and
301.9100-3, which provide that the Commissioner has the discretion to grant a reasonable
extension of time. Treas. Reg. § 1.1361-3(a)(6). To grant such an extension, the Service must
determine that the requirements of Treas. Reg. § 301.9100-3 have been met. This requires that
the Commissioner be satisfied that the taxpayer acted reasonably and in good faith, and that
granting relief will not prejudice the interests of the government. See PLR 200411029; PLR
200326007; PLR 200026014; PLR 200021023; PLR 199931025; PLR 9834101. Finally, the
Service has provided simplified but limited relief for late QSub elections in certain
circumstances discussed in Section III.H.5., below. See Rev. Proc. 2004-49, 2004-33 I.R.B. 210.
d.
Subsequent QSub Election Apparently Not Prohibited
Neither the five-year reelection prohibition of Section 1362(g) nor Section 1361(b)(3)(D)
prevents a former S corporation from being eligible to have a QSub election made with respect to
it within five years of such corporation’s termination of its S election. But see PLR 199952072
(ruling that, where Section 1362(g) prohibited a former S corporation from reelecting S
corporation status within the 5-year reelection period, it was also prohibited from becoming a
QSub during the same period). Informal discussions with an official from the Service suggest
that a former S corporation is eligible to have a QSub election made with respect to it within the
5-year reelection period of Section 1362(g).
3.
The Effect of a QSub Election
When an S corporation makes a valid QSub election, the subsidiary generally is deemed
to have liquidated into the S parent. Treas. Reg. § 1.1361-4(a)(2)(i). In general, the liquidation
into the S parent takes place at the close of the business day before the QSub election becomes
effective. Treas. Reg. § 1.1361-4(b)(1). Thus, if a C corporation parent with a wholly owned
subsidiary makes an S election (for itself) and a QSub election (for the subsidiary) effective on
the same date, the liquidation of the subsidiary occurs immediately before the S election
becomes effective (i.e., while the parent is a C corporation). See, e.g., TAM 200247002 (ruling
that when a parent of a consolidated group makes an S election for itself and QSub elections for
all of its wholly owned subsidiaries effective on the same date, deferred gain from intercompany
transactions between members of the consolidated group is not accelerated as a result of the
deemed liquidation of the subsidiaries but is accelerated immediately thereafter when the parent
converts to an S corporation pursuant to Treas. Reg. § 1.1502-13(d) and (j)).
If the S parent, however, does not own 100 percent of the stock of the subsidiary on the
day prior to the QSub election becoming effective, the liquidation occurs immediately after the
time at which the S parent first owns 100 percent of the stock. Treas. Reg. § 1.1361-4(b)(3)(i).
Furthermore, if the S parent acquires the stock of a target S corporation and makes a QSub
election for the target effective on the day the target stock is acquired, the target is deemed to
liquidate at the beginning of the day the termination of its S election is effective in order to avoid
the target being treated as a C corporation on the acquisition date. Treas. Reg. § 1.1361-
- 97 4(b)(3)(ii); see also PLR 200252085. This rule helps the S parent avoid any Section 1374 issues
with respect to the QSub’s assets. See Section IV.A., below. Finally, special liquidation timing
rules apply to an acquisition of a target corporation in a transaction to which Section 338 applies.
See Treas. Reg. § 1.1361-4(b). These rules confirm that (i) an S corporation that acquires a
target corporation may make a Section 338 election (with or without a Section 338(h)(10)
election) and a QSub election for the target corporation and (ii) the Section 338 election is taken
into account prior to the QSub election. See id.; see also Treas. Reg. § 1.1361-4(d) ex. 3.
Tiered Subsidiaries: If an S corporation makes QSub elections for a tiered group of
subsidiaries that are effective on the same date, the S corporation may specify the order of the
liquidations. If no order is specified, the liquidations are deemed to occur in order from the
lowest tier subsidiary to the highest tier subsidiary (i.e., a bottom-up liquidation order). Treas.
Reg. § 1.1361-4(b)(2). A bottom-up liquidation order effectively causes the S parent to acquire
all of the assets of the subsidiaries in the liquidating chain in a single transferred-basis
transaction subject to Section 1374(d)(8); a top-down liquidation order effectively causes the S
parent to acquire separately the assets of each subsidiary in the liquidating chain in multiple
transferred-basis transactions subject to Section 1374(d)(8), limiting the S parent’s ability to
utilize tax attributes of one liquidating subsidiary against tax attributes of another liquidating
subsidiary in a Section 1374 context. See Section IV.A., below. A bottom-up liquidation order
also helps avoid the triggering of income from an excess loss account held by an upper tier
subsidiary in respect of stock in a lower tier subsidiary, where such subsidiaries are members of
a consolidated group immediately before the QSub elections are effective. See Treas. Reg. §
1.1502-19.
Insolvent Subsidiary: Although a QSub election may be made for an insolvent
corporation, Sections 332 and 337 will not apply to the deemed liquidation. Thus, the QSub
election may trigger gain or loss recognition to the corporation for which the QSub election is
made and the S parent. See Treas. Reg. § 1.1361-4(d) ex. 5; see also Prop. Treas. Reg. § 1.3322, 46 Fed. Reg. 11,903 (Mar. 10, 2005).
General Principles of Tax Law Apply: The tax treatment of the deemed liquidation (or
of a larger transaction that includes the liquidation) is to be determined under general principles
of tax law, including the step transaction doctrine. Treas. Reg. § 1.1361-4(a)(2)(i). Thus, if an S
corporation forms a subsidiary and makes a valid QSub election for that subsidiary effective the
same day, the transfer of assets to the subsidiary and the deemed liquidation are disregarded and
the subsidiary is deemed to be a QSub from its inception. Id.; see also PLR 200252085.
Banks: Note that there are special rules for banks. If, in a valid QSub election, the S
parent or the subsidiary is a bank, any special rules in the Code that are applicable to banks
continue to apply separately to the bank parent or bank subsidiary as if the deemed liquidation
had not taken place. Treas. Reg. § 1.1361-4(a)(3); see, e.g., Vainisi v. Comm’r, 599 F.3d 567
(7th Cir.
2010), acq. in result, 2010-52 I.R.B. 897 (noting that, under Treas. Reg. § 1.1361-4(a)(3),
special financial institution rules apply separately to a bank that also constituted a QSub, but
concluding that special bank rule regarding the deductibility of interest on debt used to purchase
qualified tax-exempt obligations—section 291(a)(3)—was inapplicable to such bank under the
- 98 language of Section 1363(b)(4) since it had not been a C corporation for the prior 3 taxable
years). But see Former Prop. Treas. Reg. § 1.1363-1(b), 71 Fed. Reg. 50,007 (Aug. 24, 2006)
(withdrawn without explanation on October 25, 2011 via IRS Ann. 2011-75, 2011-48 I.R.B. 823)
(stating that special bank rule regarding the deductibility of interest on debt used to purchase
qualified tax-exempt obligations was applicable to a bank that also constituted a QSub,
regardless of whether such bank had been a C corporation for any of the prior 3 taxable years).
Certain Federal Tax Liabilities: In addition to the special rules for banks that respect
the separate legal existence of QSubs for certain federal tax purposes, a QSub is treated as a
separate corporation for purposes of: (i) federal tax liabilities of the QSub with respect to any
taxable period for which the QSub was treated as a separate corporation, (ii) federal tax liabilities
of any other entity for which the QSub is liable, and (iii) refunds or credits of federal tax. Treas.
Reg. § 1.1361-4(a)(6)(i).72 For example, assume a domestic corporation (“X”) has owned all of
the outstanding stock of another domestic corporation (“Y”) since 2001. X and Y do not report
their taxes on a consolidated basis. For 2003, X makes a timely S election and simultaneously
makes a QSub election for Y. In 2004, the Service determines that Y miscalculated and
underreported its income tax liability for 2001. Pursuant to Treas. Reg. § 1.1361-4(a)(6)(i), the
deficiency for Y’s 2001 taxable year may be assessed against Y, and, in the event that Y fails to
pay the liability after notice and demand, a general tax lien will arise against all of Y’s property
and rights to property. See Treas. Reg. § 1.1361-4(a)(6)(ii) ex. 2.
QSub Stock: The stock of a QSub will be disregarded for all federal tax purposes,
except for purposes of the special rules for banks and for purposes of determining that 100
percent of the stock of the subsidiary is held by the S parent under Treas. Reg. § 1.1361-2(a)(1).
Any outstanding instruments, obligations, or arrangements of the QSub that would not be
considered stock for purposes of the rules regarding the prohibition against a second class of
stock if the QSub were an S corporation are not treated as outstanding stock of the QSub. Treas.
Reg. § 1.1361-2(b)(2).
The QSub regulations provide that a QSub (“QSub 1”) that wholly owns the stock of
another QSub (“QSub 2”) and distributes the stock of QSub 2 to the S parent does not trigger
Section 311 because the stock of QSub 2 is disregarded for all federal tax purposes. See Treas.
Reg. § 1.1361-5(a)(4) ex. 3; PLR 200204011. It appears, however, Section 311 gain is not
triggered because the stock of QSub 1, rather than the stock of QSub 2, is disregarded for federal
tax purposes.
Recourse Loans to QSubs: Query whether a recourse loan to a QSub is treated for
federal tax purposes as a nonrecourse loan to the S parent because (i) the QSub is treated as a
division for federal tax purposes and (ii) the loan is secured only by the assets owned by the
QSub under state law rather than all the assets owned (and deemed to be owned) by the S parent
under federal tax law. Cf. Mark J. Silverman, Use of Limited Liability Companies in Corporate
Transactions, in Tax Planning for Domestic & Foreign Partnerships, LLCs, Joint Ventures &
Other Strategic Alliances 2011 (Practising Law Institute 2011).
72
These regulations apply on or after April 1, 2004. Treas. Reg. § 1.1361-4(a)(6)(iii).
- 99 -
Transition Rule: The final QSub regulations contain a special transition rule that
applies if (i) an S corporation acquires stock of an already related corporation (as defined by
Section 267(b)) and (ii) thereafter makes a QSub election for that corporation. See Treas. Reg. §
1.1361-4(a)(5). Under the special transition rule, the step transaction doctrine will not apply to
the stock acquisition and the subsequent QSub election if the QSub election is effective before
January 1, 2001. Id.
Consider the following example. Individual A owns 100 percent of the stock of X, an S
corporation. X owns 79 percent of the stock in Y, a solvent corporation. A owns the remaining
21 percent of Y stock. On May 4, 1998, A contributes its Y stock to X in exchange for X stock.
X makes a QSub election with respect to Y effective immediately following the transfer. The
liquidation is respected as an independent step separate from the stock acquisition, and the tax
consequences of the liquidation are determined under Sections 332 and 337. The contribution by
A of the Y stock qualifies under Section 351, and no gain or loss is recognized by A, X, or Y.
Treas. Reg. § 1.1361-4(a)(5)(ii) ex. 1. Without the transition rule, the above transaction could be
treated as a “D” reorganization, which could make Y susceptible to gain recognition under
Section 357(c). See Treas. Reg. § 1.1361-4(a)(2)(ii) ex. 3. But see section 357(c)(1)(B)
(amended by section 898, P.L. 108-357) (eliminating the application of Section 357(c) to
acquisitive “D” reorganizations for transfers of money or other property, or liabilities assumed,
in connection with a reorganization occurring on or after October 22, 2004).
Loss Carryover Rule: If an S corporation were to acquire the stock of another S
corporation in a transaction in which the acquiring S corporation's basis in the stock received was
determined by reference to the transferor's basis, and the acquiring S corporation made a QSub
election with respect to the acquired corporation effective on the day of acquisition, any losses
disallowed under Section 1366(d) with respect to a former shareholder of the QSub would be
available to that shareholder as a shareholder of the acquiring S corporation. See Treas. Reg. §§
1.1361-4(c), 1.1366-2(c)(1).
QSub Employment Taxes: In IRS Notice 99-6, 1999-1 C.B. 321, the Service addressed
whether a QSub or the owner of the QSub should pay the employment taxes of employees of the
QSub. IRS Notice 99-6 provides that the Service generally will accept reporting and payment of
employment taxes with respect to QSub employees if made in one of two ways:

Calculation, reporting, and payment of all employment tax obligations are
made by the owner of the QSub (as though the QSub employees are
employed directly by the owner) and under the owner’s name and
taxpayer identification number; or

Separate calculation, reporting, and payment of all employment tax
obligations by the QSub with respect to its employees are made under its
own name and its own taxpayer identification number.
IRS Notice 99-6 also provides that, even if the second method is chosen, the owner retains
ultimate responsibility for the employment tax obligations incurred with respect to the QSub
employees. Cf. CCA 199922053 (concluding that the sole owner of a single member limited
- 100 liability company is personally liable for the employment taxes incurred by the limited liability
company); Littriello v. United States, 484 F.3d 372 (6th Cir. 2007) (same).
An owner of multiple QSubs may choose the first method with respect to one QSub and
the second method with respect to its other QSubs. If the owner uses the first method with
respect to a given QSub for a return period that begins on or after April 20, 1999, the taxpayer
must continue to use the first method unless and until otherwise permitted by the Commissioner.
See T.D. 9356 (Aug. 16, 2007) (providing the Commissioner’s permission to switch to the
second method with respect to wages paid on or after August 16, 2007 and before January 1,
2009).
On August 16, 2007, the Treasury Department and the Service issued final regulations
that treat QSubs (and other types of disregarded entities) as separate entities for purposes of
employment taxes, certain excise taxes, and related reporting obligations. See Treas. Reg. §§
1.34-1, 1.1361-4(a), 1.1361-6, 301.7701-2(a)(c)(2)(iv), (v). The Treasury Department and the
Service stated that treating a QSub as the employer for purposes of employment taxes will
improve the administration of the tax laws and simplify compliance. See T.D. 9356. Under the
regulations, the employment tax provisions will apply to wages paid on or after January 1, 2009.
Treas. Reg. §§ 1.1361-4(a)(7)(ii), 301.7701-2(e)(5).73 With respect to wages paid prior to this
effective date, QSubs and their owners will be allowed to continue to use the procedures outlined
in IRS Notice 99-6.
4.
Termination of a QSub Election
A corporation's QSub status will continue until its QSub election is terminated. Upon
termination, the corporation will be treated as a new corporation acquiring all of its assets, and
assuming all of its liabilities, from the S corporation in exchange for stock of the new
corporation immediately before the termination. Treas. Reg. § 1.1361-5(b)(1)(i). The tax
treatment of a termination, or of any larger transaction in which it occurs, will be determined
under the Code and general principles of tax law, including the step transaction doctrine. Id.
Sale of 100% of QSub Stock: If the terminating event is a sale of 100 percent of the
stock of the QSub, the deemed contribution of assets to the “new corporation” is disregarded and
the transaction is treated as a taxable sale of QSub assets followed by a contribution of such
assets by the purchaser to a new C corporation. Treas. Reg. § 1.1361-5(b)(3) ex. 9.
Furthermore, if the purchaser of the stock of the QSub is an S corporation and it elects to treat
the former QSub as a new QSub effective as of the acquisition date, the deemed formation and
immediate liquidation of the new C corporation is disregarded. Id.
Sale of More Than 20% But Less Than 100% of QSub Stock: For sales occurring in
taxable years beginning on or before December 31, 2006, if the terminating event is a sale of
73
Note that the related excise tax provisions apply to liabilities imposed and actions first
required or permitted in periods beginning on or after January 1, 2008. Treas. Reg. § 301.77012(e)(6).
- 101 more than 20 percent but less than 100 percent of the stock of the QSub, the former S parent
must recognize any gain on all assets transferred, because the nonrecognition provision of
Section 351 will not apply. Treas. Reg. § 1.1361-5(b)(3) ex. 1. This results from the application
of the step transaction rule – the former S parent’s deemed contribution of assets to the “new
corporation” is stepped together with the sale of stock, so that the former S parent is not treated
as being in control of the “new corporation” immediately after the contribution. As a result, the
asset contribution does not satisfy the requirements of Section 351(a), and the entire deemed
asset contribution is taxable to the former S parent. Treas. Reg. § 1.1361-5(b)(1)(i).
The magnitude of the gain recognized in the above scenario may be reduced by merging
the QSub into a single member LLC owned by the S parent and then selling more than 20
percent (for example, 21 percent) of the interest in the LLC. In this structure, the former S
parent should be treated as selling an undivided 21 percent interest in all the assets of the LLC to
the buyer of the 21 percent interest in the LLC followed by a Section 721 partnership formation
transaction by the buyer and the former S parent. In this transaction, Section 1001 requires the S
parent to recognize gain or loss from the deemed sale of only 21 percent of each asset of the
LLC, as opposed to 100 percent of each asset in the prior scenario. Compare Treas. Reg. §
1.1361-5(b)(3) ex. 2 with Treas. Reg. § 1.1361-5(b)(3) ex. 1; see also Rev. Rul. 99-5, 1999-1
C.B. 434.
For a sale of stock of a QSub occurring in taxable years beginning after December 31,
2006, where such sale results in the termination of the QSub election, such sale is treated (for all
purposes of the Code) as a sale of an undivided interest in the assets of the QSub (based on the
percentage of stock sold) followed by an acquisition by a new corporation of all of the QSub
assets and liabilities in a transaction to which Section 351 applies. Section 1361(b)(3)(C)(ii);
Section 8234 of the Iraq Act of 2007. Thus, where an S corporation sells 21 percent of the stock
of a QSub to an unrelated party, the S corporation will be treated as selling a 21 percent interest
in all of the assets of the QSub, followed by an acquisition by a new corporation of all of the
QSub’s assets and liabilities in a transaction to which Section 351 applies. Accordingly, the S
corporation will recognize gain or loss associated with the sale of only 21 percent of each QSub
asset.
Sale of QSub Assets Rather Than QSub Stock: Unlike a sale of QSub stock, it does
not appear that the direct sale of some of the QSub assets by the QSub will terminate the QSub
election. See Section 1361(b)(3)(C); Treas. Reg. § 1.1361-5(a). Apparently, such a transaction
would be treated for federal tax purposes as a direct sale of the assets from the S parent to the
buyer. See Sections 1001, 1361(b)(3)(A).
Distribution of QSub Stock in Section 355/Section 368(a)(1)(D) Transactions: The
distribution by an S corporation parent of the stock of a QSub will terminate the QSub election.
Treas. Reg. § 1.1361-5(a)(1)(iii). The deemed contribution of the assets of the QSub to a newly
created controlled subsidiary in exchange for subsidiary stock pursuant to Treas. Reg. § 1.13615(b), and the immediate distribution of all of such stock by the parent to its shareholders, may be
treated as a reorganization described in Section 368(a)(1)(D) by reason of Section 355 if
otherwise applicable requirements of Section 355 are satisfied. See PLR 201128025; PLR
- 102 201115006; PLR 201045018; PLR 201010023; PLR 200915001; PLR 200845027; PLR
200845026; PLR 200306033.
Furthermore, if a QSub election terminates because the S parent distributes the QSub
stock to some or all of the S parent’s shareholders in a reorganization described in Section
368(a)(1)(D) by reason of Section 355, any loss or deduction disallowed under Section 1366(d)
with respect to a shareholder of the S parent immediately before the distribution is allocated
between the S parent and the former QSub with respect to the shareholder. Treas. Reg. §§
1.1361-5(b)(2), 1.1366-2(c)(2). Such allocation may be made according to any reasonable
method, including:

a method based on the relative fair market value of the shareholder’s stock
in the S parent and the former QSub immediately after the distribution;

a method based on the relative adjusted basis of the assets in the S parent
and the former QSub immediately after the distribution; or

in the case of losses and deductions clearly attributable to either the S
parent or the former QSub, any method that allocates such losses and
deductions accordingly.
Treas. Reg. § 1.1366-2(c)(2).
Effective Date of Termination: The termination of the QSub election is effective (i) on
the date included in the revocation statement (if the election is revoked under Treas. Reg. §
1.1361-3(b)), (ii) at the close of the last day of the S parent’s last taxable year as an S corporation
if the S parent’s S election terminates under Treas. Reg. § 1.1362-2, or (iii) at the close of the
day on which an event occurs that renders the subsidiary ineligible for QSub status under Section
1361(b)(3)(B). Treas. Reg. § 1.1361-5(a)(1).
Revocation under Treas. Reg. § 1.1361-3(b)(1) is accomplished by filing a statement with
the service center where the S parent’s most recent tax return was properly filed. The statement
must include the names, addresses, and taxpayer identification numbers of the S parent and the
subsidiary, and must be signed by a person authorized to sign the S parent’s tax return. The
revocation is effective on the date specified in the statement or, if no date is specified, on the date
the statement is filed. The effective date of the revocation may not be more than 2 months and
15 days prior to the date on which the statement is filed. Also, the effective date may not be
more than 12 months after the date on which the statement is filed. Treas. Reg. § 1.1361-3(b)(2).
Inadvertent Terminations: Prior to the enactment of the 2004 JOBS Act, no rules
analogous to Section 1362(f) existed to permit the Service to determine that a corporation is a
QSub during a period when the corporation did not satisfy the requirements of Section
1361(b)(3)(B). For example, if the S parent inadvertently transferred one share of QSub stock to
another person, the QSub election terminated. See Explanation of Provisions, 65 Fed. Reg., at
3,847. However, the 2004 JOBS Act amended Section 1362(f) to make it applicable to QSub
elections and terminations. Section 238(a), P.L. 108-357. This amendment is effective for
- 103 elections and terminations made after December 31, 2004. Section 238(b), P.L. 108-357; see
also Treas. Reg. § 1.1362-4 (incorporating the rules of amended Section 1362(f)).
Note that, even without the new amendment to Section 1362(f), if the QSub election
terminates because the S parent inadvertently terminated its own S election, Section 1362(f) may
provide relief to the QSub as a consequence of the S parent obtaining relief under that provision
with respect to its S election. See Explanation of Provisions, 65 Fed. Reg., at 3,847-3,848.
QSub and S Corporation Election Prohibition After Termination: A corporation
whose QSub election has terminated generally may not make an S election or have a QSub
election made with respect to it for five taxable years following termination unless the
Commissioner consents. Section 1361(b)(3)(D); Treas. Reg. § 1.1361-5(c)(1). In the case of
QSub elections effective after December 31, 1996, if a corporation’s QSub election terminates,
the corporation may, without requesting the Commissioner’s consent, make an S election or have
a QSub election made with respect to it before the expiration of the five-year period if (i)
immediately following the termination, the corporation (or its successor corporation) is otherwise
eligible to make an S election or have a QSub election made for it, and (ii) the relevant election
is made effective immediately following the termination of the QSub election. Treas. Reg. §
1.1361-5(c)(2); see, e.g., PLR 200306033.
A corporation whose QSub election has been revoked effective on the first day the QSub
election was to be effective will not be treated as having its QSub election terminated for
purposes of the 5 year reelection rule in Section 1361(b)(3)(D). Treas. Reg. § 1.1361-3(b)(4).
Presumably, such QSub election will be treated as never taking effect for all federal tax
purposes.
Employer Identification Number: If a corporation’s QSub election terminates, the new
corporation formed as a result of the termination must use its own EIN for federal tax purposes.
If the new corporation had an EIN before the effective date of its QSub election or during its
QSub status, it should use that EIN. Otherwise, the new corporation must apply for a new EIN.
Treas. Reg. § 301.6109-1(i)(3); see also Rev. Rul. 2008-18, 2008-13 I.R.B. 674.
QSub Bankruptcy Issues: QSubs have a property interest in their QSub status for
bankruptcy purposes. In re Majestic Star Casino, LLC, et al., 2012-1 USTC ¶ 50175 (Bankr. Del.
Jan 24, 2012) (a debtor company had a property interest in its status as a QSub, such that when
the non-debtor parent S corporation revoked its S corporation status, thereby terminating
debtor’s QSub status, such revocation and resulting termination constituted an unauthorized
transfer of estate property under section 549 of the Bankruptcy Code and a violation of the
automatic stay imposed by section 362 of the Bankruptcy Code).
5.
QSubs and Tax-Free Reorganizations
QSub Mergers: QSubs may engage in certain tax-free reorganizations to which Section
368(a)(1)(A) applies (i.e., mergers or consolidations). See Treas. Reg. § 1.368-2(b). The most
significant aspect of these regulations is that a target corporation may merge into a QSub in a
transaction to which Section 368(a)(1)(A) applies. See Treas. Reg. § 1.368-2(b)(1)(iv) ex. 2.
The regulations also confirm that, if a target S corporation that has a QSub merges into a
- 104 disregarded entity, the termination of the QSub election followed by the deemed contribution of
the former QSub’s assets to a new C corporation immediately prior to the merger does not
disqualify the merger under Section 368(a)(1)(A). See Treas. Reg. § 1.368-2(b)(1)(iv) ex. 3
(providing that the deemed formation by the target S corporation of a C corporation subsidiary as
a result of the termination of its subsidiary’s QSub status is disregarded for federal income tax
purposes, and instead the target S corporation is treated as transferring the assets of its subsidiary
to the acquirer followed by the acquirer contributing those assets to a new C corporation
subsidiary in exchange for stock); see also Treas. Reg. § 1.1361-5(b)(3) ex. 9. These regulations
apply to transactions occurring on or after January 23, 2006. Treas. Reg. § 1.368-2(b)(1)(v). For
transactions generally occurring in the three years preceding January 23, 2006, Temp. Treas.
Reg. § 1.368-2T(b) applied, which provided rules virtually identical to the rules summarized
above. A special transition rule permits certain taxpayers that initiate but fail to complete a
transaction prior to January 23, 2006, to elect to apply Temp. Treas. Reg. § 1.368-2T(b) to such
transaction rather than Treas. Reg. § 1.368-2(b). See Treas. Reg. § 1.368-2(b)(1)(v)(B).
Section 368(a)(1)(A), (C), (D), and (F) Transactions Involving S Parent: Rev. Rul.
2004-85, 2004-2 C.B. 189, provides that a corporation’s S election does not terminate when it
merges in a transaction described in Section 368(a)(1)(F) into a corporation (i) that is newly
formed and wholly owned by the shareholders of the merging S corporation and (ii) that also
qualifies to be an S corporation. See also Treas. Reg. § 1.381(b)-1(a)(2); Rev. Rul. 2008-18,
2008-13 I.R.B. 674 (providing that a corporation’s S election does not terminate in other
transactional variations that qualify as transactions described in Section 368(a)(1)(F)); Rev. Rul.
64-250, 1964-2 C.B. 333; PLR 201119017; PLR 201115016; PLR 201007043. Rev. Rul. 200485 also confirms that the newly formed corporation need not make a new S election to be treated
as an S corporation. See also Rev. Rul. 2008-18, 2008-13 I.R.B. 674. The ruling also provides
that, if the merging S corporation in the transaction described above owned a corporate
subsidiary with respect to which the S parent had made a QSub election, the transaction does not
terminate the QSub election. See also PLR 201007043.
In addition, Rev. Rul. 2004-85 addresses the effect of a transaction described in either
Section 368(a)(1)(A), (C), or (D) (but not also described in Section 368(a)(1)(F)) on a previous
QSub election made by a transferor S corporation with respect to a wholly owned corporate
subsidiary. For example, assume an S corporation (“Y”) owns 100 percent of the stock of
another corporation (“Sub2”) with respect to which Y has made a QSub election. Y transfers
Y’s assets, including 100 percent of stock of Sub2, to another S corporation (“M”) in a
transaction described in Section 368(a)(1)(A), (C), or (D) but not described in Section
368(a)(1)(F). The Service ruled that, since the transaction is not described in Section
368(a)(1)(F), M is not treated as Y would have been treated if there had been no such transaction
pursuant to Treas. Reg. § 1.381(b)-1(a)(2) and Rev. Rul. 64-250. The Service held that the QSub
election with respect to Sub2 would terminate at the close of the day on which Y transferred its
assets unless M makes a QSub election effective immediately following the termination pursuant
to Treas. Reg. § 1.1361-5(a)(1)(iii) and -5(c)(2).
An S parent may use a QSub to engage in a tax-free reorganization described in Sections
368(a)(1)(D) and 355. In PLR 201216027, parent S corporation (“P”) wholly owned subsidiary
(“C”) for which it previously made a QSub election. P distributed all of the shares of C’s stock
- 105 to P’s shareholders pro rata. The Service ruled that the distribution caused C to convert from a
disregarded entity (i.e., a QSub) to a regarded C corporation and caused P to be treated as
distributing all of the stock of C to its shareholders, and, therefore, (i) such conversion and
distribution constituted a valid “D” reorganization and (ii) C could make an S election effective
immediately after the distribution. See also PLR 201238018.
In Rev. Proc. 2004-49, 2004-33 I.R.B. 210, the Service provided a simplified procedure
to request relief for a late QSub election by a transferee corporation that engaged in the type of
transaction described immediately above (or that engaged in a similar transaction that was
treated as a taxable sale). This relief is in addition to the relief for a late QSub election provided
in Rev. Proc. 2003-43 and Treas. Reg. §§ 301.9100-1 through -3.
IV.
ADDITIONAL EFFECTS OF CONVERTING TO AN S CORPORATION
When considering (i) the conversion of a C corporation to an S corporation or (ii) the
acquisition by an existing S corporation of assets in a transaction in which Section 381 applies,
additional issues must be addressed. These issues deal with rules that effectively preserve the
application of subchapter C of the Code to certain assets and income of an S corporation. Note
that these issues are in addition to the issues raised with respect to the general effects of an S
election discussed in the previous Section of this Outline.
A.
Corporate Level Tax on Built-In Gains – Section 1374
1.
Purpose
In the years leading up to the TRA of 1986, Congress was concerned that, as a result of
the repeal of the General Utilities doctrine, C corporations would convert to S corporation status
in an effort to gain the same tax results previously offered under General Utilities (i.e., one level
of tax on the built-in gain in corporate assets upon liquidation). As a result, Section 1374 was
added by the TRA of 1986 (and significantly modified by the TAMRA of 1988) to prevent
circumvention of the repeal of the General Utilities doctrine. See H.R. Conf. Rep. No. 99-841, at
II-198 to II-203 (1986); Staff of the J. Comm. on Taxation, 99th Cong., General Explanation of
the Tax Reform Act of 1986, 344-45 (Comm. Print 1987). Section 1374 effectively extends the
double-tax regime of subchapter C of the Code to certain assets and income of an S corporation.
2.
General Rule
Section 1374(a) provides that if an S corporation has a “net recognized built-in gain”
(“NRBIG”) for any taxable year in the “recognition period,” then a corporate-level tax will be
imposed on the income of the S corporation. The term “recognition period” means the 10-year
- 106 period beginning with the first day of the first taxable year for which the corporation was an S
corporation. See Section 1374(d)(7).74 But see Section 1374(d)(9).
The American Recovery and Reinvestment Act of 2009, P.L. 111-5, added a special rule
that reduces the recognition period from 10 years to 7 years for taxable years beginning in 2009
and 2010. Section 1374(d)(7)(B) provides that, with respect to any taxable year of an S
corporation beginning in 2009 or 2010, no tax is imposed under section 1374 on the net
recognized built-in gain of an S corporation if the seventh taxable year in the S corporation’s
recognition period preceded such taxable year. Thus, with respect to gain that arose prior to the
conversion of a C corporation to an S corporation, no tax is imposed under section 1374 after the
seventh taxable year the S corporation election is in effect. In the case of built-in gain
attributable to an asset received by an S corporation from a C corporation in a carryover basis
transaction, no tax is imposed under section 1374 if such gain is recognized after the date that is
7 years following the date on which the asset was acquired. See Section 1374(d)(7)(B). The
Small Business Jobs Act of 2010, P.L. 111-240, added a similar provision that further reduces
the recognition period to 5 years, but only for taxable years beginning in 2011. See Section
1374(d)(7)(B)(ii). The American Taxpayer Relief Act of 2012 reduces the recognition period to
five years for tax years beginning in 2012 or 2013. See Section 1374(d)(7)(C). The American
Taxpayer Relief Act of 2012 also provides that when an S corporation sells property using the
installment sale method, the treatment of payments shall be determined by the year in which the
sale was made. See Section 1374(d)(7)(E). Finally, it amends the rule addressing carryover of
NRBIG, providing that it may only be carried over to years within the recognition period. See
Section 1374(d)(2)(B).
3.
Computation of Tax
The term “net recognized built-in gain” generally means the lesser of: (1) the amount
which would be taxable income for the S corporation’s taxable year if only “recognized built-in
gains” (described below) and “recognized built-in losses” (described below) were taken into
account,75 or (2) the corporation’s taxable income for such taxable year (as defined in Section
74
Section 1601(f) of the TRA of 1997 amended Former Section 1374(d)(7) to provide
special rules in the case of thrift institutions or former thrift institutions that become S
corporations.
75
Note that this provision does not permit the S corporation simply to offset the
recognized built-in losses against the recognized built-in gains in applying Section 1374. Rather,
the provision permits the S corporation to offset the recognized built-in losses against the
recognized built-in gains only to the extent that such losses are permitted to offset such gains
under the Code. For example, an S corporation that incurs a $100 long-term capital loss, which
qualifies as a recognized built-in loss, and $100 of ordinary income, which qualifies as a
recognized built-in gain, has a NRBIG of $100 because the capital loss cannot offset the ordinary
income. See Section 1211.
- 107 1375(b)(1)(B)).76 Section 1374(d)(2). If the net amount of the corporation’s recognized built-in
gains and losses exceeds its net taxable income for a taxable year, the excess is treated as
recognized built-in gain in the succeeding year. Section 1374(d)(2)(B). Although the untaxed
built-in gain is carried forward, it apparently will escape Section 1374 if such gain is carried to
years beyond the close of the recognition period. This carryforward provision applies only to S
corporations for which an election was made after March 31, 1988.
The effect of computing the Section 1374 tax on NRBIG is that recognized built-in gain
will be offset by post-conversion, recognized built-in losses. In other words, Section
1374(d)(2)(A) segregates recognized built-in gains and losses in each taxable year and subjects
the net amount to a tax at the corporate level.
The rate of tax used in the computation is the highest rate specified in Section 11(b).
Section 1374(b)(1). However, if the asset is a capital asset held by the S corporation for the
requisite holding period, then the rate of tax may be determined under Section 1201. See Section
1374(b)(4); H.R. Rep. No. 99-841, 99th Cong. 2d Sess. II-203 (1986).
4.
Recognized Built-In Gain
The term “recognized built-in gain” (“RBIG”) means any gain recognized during the
recognition period on the “disposition of any asset,” except to the extent that the S corporation
establishes that: (i) the asset disposed of was not held at the beginning of the recognition period,
or (ii) the recognized gain exceeds the gain inherent in such asset as of the beginning of the
recognition period. Section 1374(d)(3).77
Although Section 1363(d) provides that an S corporation’s taxable income shall be
computed in the same manner as an individual, Treas. Reg. § 1.1374-2(a)(2) provides that, for
purposes of the Section 1374 tax, rules applicable to C corporations as modified by Section
1375(b)(1)(B) shall apply. Section 1375(b)(1)(B) provides that taxable income is determined
under Section 63(a) without regard to (i) the deductions in part VIII of subchapter B of the Code
(except for the deduction allowed by Section 248) and (ii) the deduction under Section 172.
Note that this special determination of taxable income should permit an S corporation to reduce
its taxable income by passive activity losses that arise during the period in which the corporation
is a C corporation but are taken into account during a year in which the corporation is an S
corporation.
76
77
As an apparent example of the first exception, the regulations provide that Section
1374 does not apply to the sale of oil during the recognition period if the S corporation extracted
the oil after the date of its conversion to S corporation status; presumably this is because the S
corporation did not “hold” the oil on the date of conversion (i.e., it merely held a working
interest in an oil and gas property on the date of conversion). See Treas. Reg. § 1.1374-4(a)(3)
ex. 1; see also Rev. Rul. 2001-50, 2001-2 C.B. 343 (applying the same rule to the sale of timber,
coal, and domestic iron ore); Rev. Proc. 2001-51, 2001-2 C.B. 369 (removing from the “No
Rule” list of Rev. Proc. 2001-3, 2001-1 C.B. 111, the Section 1374 issues addressed in Rev. Rul.
2001-50); PLR 200205028 (ruling that Section 1374 did not apply to income derived from an S
(Continued …)
- 108 -
The regulations address the meaning of the statutory phrase “disposition of any asset.”
The regulations provide that Section 1374(d)(3) applies only to gains recognized “in a
transaction treated as a sale or exchange for federal income tax purposes.” Treas. Reg. § 1.13744(a). Thus, sales and distributions should constitute “dispositions.”
Furthermore, Section 1374(d)(5)(A) (as added by the TAMRA of 1988) provides that a
“disposition” occurs when an income item is recognized in the recognition period and such item
is attributable to periods before the first taxable year for which the corporation is an S
corporation. See also IRS Ann. 86-128, 1986-51 I.R.B. 22. The regulations generally provide
that an “item of income” shall be treated as RBIG if the item would have been included in gross
income before the beginning of the recognition period by a taxpayer using the accrual method of
accounting. Treas. Reg. § 1.1374-4(b)(1). Thus, the collection of accounts receivable by a cashbasis S corporation would constitute the “disposition” of an asset. See PLR 200329011.
Similarly, a disposition occurs on the completion of a long-term contract by an S corporation on
the completed contract method of accounting.
The Service has announced that the taxpayer’s method of accounting will be used to
identify whether inventory on hand at the time of conversion has been disposed of following the
conversion. IRS Ann. 86-128, supra. Thus, where LIFO is used, Section 1374 would not apply
until inventory is sold from layers existing as of beginning of the recognition period.78
5.
Recognized Built-In Loss
Section 1374(d)(4) defines “recognized built-in loss” (“RBIL”) as any loss recognized
during the recognition period on the disposition of any asset to the extent that the S corporation
establishes that: (i) such asset was held by the S corporation as of the beginning of the
corporation’s sale of minerals that had been mined and processed after the S corporation
converted).
See also Preamble to Prop. Treas. Reg. § 1.1363-2, 1993-2 C.B. 636 (“Whether goods
are disposed of following a conversion from C to S corporation status depends upon the
inventory method used by the taxpayer. Thus, a C corporation using the LIFO method of
accounting will not be taxed on the built-in gain attributable to LIFO inventory to the extent it
does not liquidate LIFO layers during the ten-year period following the conversion.”); Treas.
Reg. § 1.1374-7(b) (“[I]f a corporation changes its method of accounting for inventory (for
example, from the FIFO method to the LIFO method or from the LIFO method to the FIFO
method) with a principal purpose of avoiding the tax imposed under Section 1374, it must use its
former method to identify its dispositions of inventory.”). But see TCB 88 Gen. Expl. at 65
(stating that regulatory authority under Section 337(d) may apply where a corporation elects S
corporation status and adopts the LIFO method of accounting); Section 1363(d) (effectively
applying a tax to inventory analogous to the Section 1374 tax in situations where Section 1374
does not apply).
78
- 109 recognition period, and (ii) the recognized loss does not exceed the loss inherent as of the
beginning of the recognition period.
Pursuant to Section 1374(d)(5)(B) (as added by the TAMRA of 1988 and revised by the
Revenue Reconciliation Act of 1989, P.L. 101-239 (the “RRA of 1989”)), accrued deductions
arising before the recognition period and taken into account during the recognition period
(determined without regard to any carryover) will be treated as RBILs.79 Thus, Sections
1374(d)(5)(A) and (B) now provide parity under Section 1374 for items of accrued income and
expenses – both would give rise to RBIGs and RBILs, respectively. The regulations continue the
parity and clarify that, for purposes of Section 1374(d)(4), the limitations imposed by Section
461(h)(2)(C) do not apply. Treas. Reg. § 1.1374-4(b)(2).
6.
Limitation – Net Unrealized Built-In Gain
a.
In General
Importantly, Section 1374(c)(2) and the regulations limit the amount of taxable built-in
gains for any year to the total “net unrealized built-in gain” (“NUBIG”) of the S corporation, less
the NRBIGs for prior taxable years within the recognition period. The term “net unrealized
built-in gain” means the amount (if any) by which the fair market value of all of the assets of the
S corporation at the beginning of its first year as an S corporation exceeds the aggregate adjusted
basis of such assets at such time. Section 1374(d)(1).80 Pursuant to Section 1374(d)(5)(C),
appropriate adjustments to the NUBIG shall be made (at the time of conversion) where accrued
income and expense items would be treated as RBIGs or RBILs, respectively, if such items were
properly taken into account (or allowable as a deduction) during the recognition period.81
The regulations further define NUBIG as the total of the following items:

the amount that would be the amount realized if on the first day of the
recognition period the corporation remained a C corporation and sold all
79
See, e.g., PLR 200925005 (certain salary expenses and other costs relating to the
production of outstanding accounts receivable on the effective date of the S election that were
taken into account during the recognition period qualified as RBILs under Section
1374(d)(5)(B)). Note that Section 1374(d)(5)(B) should treat a suspended passive activity loss as
a RBIL if (i) such loss arose originally in a year in which the S corporation was a C corporation,
and (ii) such loss is taken into account by the S corporation during its recognition period.
80
See also the discussion below in Section IV.A.6.b. regarding the possibility of an S
corporation having a negative NUBIG.
81
Note that this provision should permit a suspended passive activity loss that originally
arose in a year in which an S corporation was a C corporation to reduce NUBIG at conversion.
Cf. St. Charles Investment Co. v. Comm’r, 232 F.3d 773.
- 110 its assets at fair market value to an unrelated party which assumed all its
liabilities; decreased by

a liability of the corporation that would be included in the amount realized
under the hypothetical sale above, but only if the corporation would be
allowed a deduction on payment of the liability; decreased by

the aggregate adjusted bases of the corporation’s assets on the first day of
the recognition period; increased or decreased by

the corporation’s Section 481 adjustments on the first day of the
recognition period; and increased by

any recognized built-in loss that would not be allowed under Sections 382,
383, or 384.
Treas. Reg. § 1.1374-3(a).
An appraisal will be required to determine fair market value.82 Query whether goodwill
must be valued. If so, the potential Section 1374 tax will be reduced to the extent that value is
assigned to goodwill. Valuing goodwill in this context does not affect the basis of tangible assets
held as of the beginning of the recognition period. Note that the regulations include an example
in which goodwill is valued. See Treas. Reg. § 1.1374-3(c) ex. 1.
b.
Subsequent Adjustments to NUBIG
A corporation that wholly owns a C corporation subsidiary and that converts to an S
corporation will include in its NUBIG the built-in gain or loss inherent in the subsidiary’s stock
unless the S corporation (i) liquidates the subsidiary prior to the date of conversion or (ii) makes
a QSub election for the subsidiary effective on the date of conversion. If the S corporation (i)
refrains from making a QSub election for the subsidiary and (ii) liquidates the subsidiary during
the recognition period in a transaction to which Section 332 applies, the built-in gain or loss
attributable to the subsidiary’s stock disappears. See Section 334(b). However, Section 1374
does not clearly provide whether the S corporation should adjust its NUBIG for the amount of
built-in gain or loss that disappeared pursuant to the liquidation (i.e., the built-in gain or loss
inherent in the subsidiary stock). It appears that the failure to adjust NUBIG in these situations
would not carry out the principles of Sections 332 and 381 because NUBIG would include the
built-in gain or loss in the liquidated subsidiary’s stock even though (i) such stock and all of its
attributes disappear in a Section 381 transaction, and (ii) the built-in gain or loss in the liquidated
subsidiary’s assets carry over to the S corporation and are separately subject to Section 1374
pursuant to Section 1374(d)(8) (discussed below). Moreover, if the S corporation cannot adjust
See, e.g., Ringgold Telephone Co. v. Comm’r, 99 T.C.M. (CCH) 1416 (2010)
(determining fair market value of partnership interest held by corporation for purposes of
calculating the corporation’s NUBIG and RBIG under section 1374).
82
- 111 its NUBIG for such amount, the S corporation could pay Section 1374 tax twice with respect to
built-in gain attributable to the subsidiary.
In an effort to avoid these problems, the Service issued regulations that permit
adjustments to NUBIG. See Treas. Reg. §§ 1.1374-3(b), (c), -10(a).83 Under the general rule of
the regulations, if (i) Section 1374(d)(8) applies to an S corporation’s acquisition of assets,84 (ii)
some or all of the stock of the corporation from which such assets were acquired was taken into
account in the computation of NUBIG for a pool of assets of the S corporation, and (iii) some or
all of such stock is redeemed or canceled in such transaction, then such NUBIG will be adjusted
to eliminate any effect any built-in gain or built-in loss in the redeemed or canceled stock (other
than stock with respect to which a loss under Section 165 is claimed) had on the initial
computation of NUBIG for that pool of assets.85 Treas. Reg. § 1.1374-3(b)(1). If such stock had
built-in gain, NUBIG would decrease. If such stock had built-in loss, NUBIG would increase.
83
The regulations were proposed on June 25, 2004 and made final on February 22, 2005.
See 69 Fed. Reg. 35,544 (June 25, 2004); T.D. 9180 (Feb. 22, 2005). The final regulations adopt
the proposed regulations without substantive change. The final regulations do, however, provide
additional language concerning their effective date, which is described below in more detail.
84
Section 1374(d)(8) is discussed below in Section IV.A.7.b. In general, Section
1374(d)(8) provides that, if an S corporation receives property from a C corporation or former C
corporation in a carryover-basis transaction, such property will be subject to Section 1374 even
though the assets were not held by the S corporation at the beginning of the recognition period.
Examples of transactions described in Section 1374(d)(8) include (i) a liquidation by an S
corporation of its wholly owned C corporation subsidiary in a transaction described in Sections
332 and 337(a) and (ii) a transfer by a C corporation of substantially all of its assets and
liabilities in exchange for voting stock of the S corporation immediately followed by the
liquidation of the C corporation in a transaction described in Section 368(a)(1)(C).
85
For purposes of this rule, stock acquired in a substituted-basis transaction (e.g., a
transaction to which Section 351 applies) would be treated as taken into account in the
computation of the NUBIG for a pool of assets of the S corporation. Treas. Reg. § 1.13743(b)(1); Section 1374(d)(6). This rule appears to address the following scenario. A corporation
owns on the date of its conversion to an S corporation (among other assets) a parcel of real estate
with a $100 built-in gain. Two years after conversion, the S corporation contributes the real
estate to a newly formed C corporation in exchange for all of its stock in a transaction to which
Section 351 applies. Since the contribution of the real estate to the C corporation constitutes a
substituted-basis transaction, the stock received in exchange for the real estate succeeds to the
real estate’s $100 built-in gain subject to Section 1374. See Sections 358(a), 1374(d)(6). In the
fifth year after conversion, the S corporation completely liquidates its C corporation subsidiary in
a transaction to which Sections 332 and 337(a) apply, thereby receiving back its previously
contributed real estate that still has a built-in gain of $100 (which will be subject to Section 1374
separately under Section 1374(d)(8)). Under the special “substituted-basis transaction” rule of
the regulations, the stock of the C corporation that is redeemed or canceled in the liquidation
would be considered to have been part of the original pool of assets that created the S
corporation’s NUBIG (despite the fact that such stock was not held by the S corporation on the
(Continued …)
- 112 -
There are two limits on the general rule. First, the NUBIG of the pool of assets that
includes the redeemed or canceled stock would be adjusted only by the amount of built-in gain or
built-in loss in the redeemed or canceled stock that has not already resulted in RBIG or RBIL
during the recognition period.86 Treas. Reg. § 1.1374-3(b)(2)(i). Second, such NUBIG shall not
be adjusted to duplicate a previous adjustment to such NUBIG pursuant to the general rule.
Treas. Reg. § 1.1374-3(b)(2)(ii).
Generally, an adjustment to NUBIG under these regulations affects computations of tax
under Section 1374 for taxable years that end on or after the date of the transaction to which the
regulations apply.87 Treas. Reg. § 1.1374-3(b)(3). Furthermore, the regulations apply to taxable
years beginning after February 23, 2005, the date the regulations were published as final
regulations. Treas. Reg. § 1.1374-10(a). Additionally, the regulations permit an S corporation to
elect to apply the regulations to Section 1374(d)(8) transactions that occurred in taxable years
that began on or before February 23, 2005. Id. An S corporation (and its predecessors or
successors) and all affected shareholders may elect such treatment by filing original or amended
returns that are consistent with the regulations for those taxable years of the S corporation during
the relevant recognition period that are not closed as of the first date after February 23, 2005 on
which the S corporation files an original or amended return. Id.
date of its conversion). Therefore, the regulations would require a reduction of $100 to the S
corporation’s NUBIG. If the special “substituted-basis transaction” rule of the regulations did
not exist, the S corporation would not be permitted to reduce its NUBIG by reason of the
liquidation of its C corporation subsidiary, thereby duplicating the $100 of built-in gain subject
to Section 1374 in the real estate.
86
The preamble to the proposed regulations illustrates this limitation with the following
example. Assume that X, a C corporation, wholly owns another C corporation, Y. X makes an S
election. On the date X’s S election becomes effective, the Y stock has a basis of $0 and a fair
market value of $100. The built-in gain inherent in the Y stock contributes $100 to X’s NUBIG.
During the recognition period and prior to the liquidation of Y, Y distributes $20 to X in a
distribution to which Section 301(c)(3) applies. That amount constitutes RBIG under Section
1374(d)(3). If Y later distributes its assets to X in a distribution to which Sections 332 and
337(a) apply, the proposed (and final) regulations would require X to reduce its NUBIG by $80
(i.e., originally determined built-in gain in the Y stock of $100 less the previous RBIG with
respect to such Y stock of $20). Preamble, 69 Fed. Reg. at 35,545-46; see also Treas. Reg. §
1.1374-3(c) ex. 4.
87
This rule seems to be aimed at preventing an S corporation from seeking a refund of
tax paid under Section 1374 with respect to a taxable year prior to the taxable year in which the
relevant carryover-basis transaction occurs by claiming that the adjustment to NUBIG should be
applied in the prior year to limit the amount of NRBIG with respect to which the tax under
Section 1374 had been paid.
- 113 Take special note that the regulations contain a concept that previously did not appear to
exist under Section 1374 – a negative NUBIG. See Treas. Reg. § 1.1374-3(c) ex. 3. Prior to the
regulations, an S corporation whose aggregate basis in its assets exceeded the fair market value
of such assets on the date of conversion apparently did not have a NUBIG (i.e., it had a NUBIG
of $0). See Section 1374(d)(1) (defining NUBIG as the “amount (if any) by which the fair
market value of the assets of [the] S corporation, exceeds the aggregate adjusted bases of such
assets”) (emphasis added).88 In an apparent effort to ameliorate the effect on an S corporation
from increasing NUBIG for the elimination of built-in loss stock, the regulations appear to
permit an S corporation in such a situation to offset the increase in NUBIG required by the
general rule of the regulations with the excess (at the time of conversion) of the S corporation’s
aggregate basis in its assets over the fair market value of such assets (i.e., the S corporation’s
negative NUBIG).89 This taxpayer-friendly rule has not been stated expressly in the proposed
regulations. Rather, the rule is demonstrated by example. See id.
The regulations do not apply to transactions described in Section 355. However, the
Service had requested comments regarding whether the rules in the proposed regulations should
be expanded to apply to such transactions. See Preamble to Prop. Treas. Reg. § 1.1374-3, 69
Fed. Reg. at 35,546. For example, an S corporation that owns all of the stock of a C corporation
on the date of its conversion to an S corporation may later distribute the stock of the C
corporation in a distribution to which Section 355 applies. In such a distribution, the S
corporation’s basis in the stock of the C corporation is eliminated. See id. Thus, similar to the
liquidation and reorganization scenarios addressed by the regulations, a transaction to which
Section 355 applies may raise similar concerns to those addressed in the regulations.
Apparently, the Service did not receive any comments regarding the application of the
88
In contrast to the relevant statutory language, it appears that the definition of NUBIG in
the Treasury regulations seems to permit the possibility of a negative NUBIG. Treas. Reg. §
1.1374-3(a) provides, in general, that NUBIG is equal to the amount realized from a hypothetical
sale of all of an S corporation’s assets at fair market value “decreased by” the S corporation’s
aggregate adjusted bases of such assets. It appears that, if aggregate basis exceeds aggregate fair
market value, an S corporation could have a negative NUBIG under this rule -- although under
the current regulations such negative NUBIG would have the same tax consequences as a $0
NUBIG.
89
This rule should give additional incentive to a corporation planning to make an S
election (or planning to engage in a carryover-basis transaction subject to Section 1374(d)(8)) to
conduct an appraisal of its assets as of the time of conversion (or an appraisal of the assets it
plans to acquire in a carryover basis transaction subject to Section 1374(d)(8) as of the time of
the transaction), regardless of whether it may believe that it has zero aggregate built-in gain in
such assets. If a corporation fails to appraise its assets due its belief that it has, at most, zero
aggregate built-in gain in such assets, the corporation may not be able to determine at a later time
the amount of negative NUBIG it had in such assets at conversion in order to use such amount to
offset an increase to NUBIG required by the regulations upon a post-conversion liquidation or
reorganization involving a C corporation subsidiary. Such S corporations might be forced to
increase their NUBIG from $0 (rather than from a negative amount).
- 114 regulations to transactions described in Section 355. See T.D. 9180. However, the authors
understand that the Service has a current guidance project addressing this issue.
7.
Scope of Provision
a.
S Corporations Covered
Section 1374 applies generally to S corporations that formerly were C corporations, S
corporations that acquire assets of another C corporation in certain transactions, and S
corporations that acquire assets of another S corporation in certain transactions. A corporation
that always was an S corporation generally will not be covered. Section 1374(c)(1), (d)(8).
For this purpose, a corporation and its predecessors are treated as one corporation. Section
1374(c)(1); Treas. Reg. § 1.1374-1(e). This rule may subject an S corporation to Section 1374
where it otherwise would be exempt.
To illustrate, assume that a newly formed S corporation acquires a C corporation target in
a Section 381 transaction (e.g., a merger or C reorganization). Although the S corporation itself
has always been an S corporation, under Section 1374(c)(1) the S corporation and the C
corporation would be treated as one corporation. The result is that the newly formed S
corporation would be treated as a former C corporation and would be subject to Section 1374 –
as to the assets acquired from the C corporation. See also Section 1374(d)(8).
b.
Assets Covered
In General: The assets covered by Section 1374 generally are those held at the
beginning of the recognition period (assuming the taxpayer can overcome the presumption in
Section 1374(d)(3)). However, special rules apply where an S corporation acquires property in a
carryover-basis transaction or a substituted-basis transaction. See Section 1374(d)(6), (8); see
also IRS Ann. 86-128.
Carryover-Basis Transactions: If an S corporation receives property from a C
corporation or former C corporation in a carryover-basis transaction, such property will be
subject to Section 1374 even though the S corporation was never a C corporation and even
though the assets were not held by the S corporation at the beginning of the recognition period.
See Section 1374(d)(8); see e.g., PLR 9011042; PLR 9005021. The NUBIG with respect to the
property will be measured at the time of conveyance. The recognition period will begin on the
date the property is received. It appears that the S corporation’s pre-acquisition assets will not
become subject to Section 1374 as a result of the acquisition, nor will they be used to compute
NUBIG. See Section 1374(d)(8); see also IRS Ann. 86-128.
Offsetting NRBIG from One Asset Batch Against Loss from Another Asset Batch
Prohibited: The regulations provide that any Section 1374 tax attributable to assets acquired in
a carryover-basis transaction described in Section 1374(d)(8) must be determined separately
from (i) any Section 1374 tax attributable to assets acquired in other carryover-basis transactions
described in Section 1374(d)(8) and (ii) the assets the corporation held on the first day of the
recognition period. Thus, any loss carryforward acquired in one carryover-basis transaction
described in Section 1374(d)(8) can offset only the NRBIG attributable to assets acquired in the
- 115 same transaction. Treas. Reg. § 1.1374-8(b). For this purpose, the S corporation’s taxable
income limitation is allocated among each of the separate determinations based on the relative
amounts of gain. Treas. Reg. § 1.1374-8(c), (d) ex. 2.
Effect of QSub Elections: Special rules apply when a parent corporation acquires assets
from a subsidiary for which the corporation intends to make a QSub election. If the corporation
makes an S election for itself and a QSub election with respect to its subsidiary effective on the
same date, the subsidiary’s assets do not become subject to Section 1374 as a result of the
deemed liquidation of the subsidiary because the liquidation is deemed to occur immediately
before the S election becomes effective. See Treas. Reg. § 1.1361-4(b)(1); see also TAM
200247002. However, the subsidiary’s assets become subject to Section 1374 when the parent
converts to an S corporation immediately after the deemed liquidation. See Treas. Reg. §
1.1361-4(b)(1); see also TAM 200247002. Thus, Section 1374(d)(8) does not apply to the
subsidiary’s assets.
If the parent corporation makes an S election for itself and a QSub election with respect
to its subsidiary but the effective date of the S election precedes the effective date of the QSub
election, the assets of the subsidiary become subject to Section 1374 as a result of the parent
acquiring the subsidiary’s assets in a carryover-basis transaction described in Section 1374(d)(8)
(rather than as a result of the parent’s conversion to an S corporation). This treatment is
significant because, as mentioned above, the Section 1374 attributes attributable to the
subsidiary’s assets (e.g., a capital loss carryforward) cannot be used in determining Section 1374
tax with respect to the parent’s other assets. See Treas. Reg. §§ 1.1374-1(c), -8(b). If an S
corporation has tiered subsidiaries for which it will make QSub elections effective on the same
date, the general rule is that the subsidiaries liquidate in a bottom-up fashion in order to avoid
multiple groups of Section 1374(d)(8) assets that cannot be netted for purposes of the Section
1374 tax. See Treas. Reg. §§ 1.1361-4(b)(2), 1.1374-8(b).
Substituted-Basis Transactions: Where property subject to Section 1374 is transferred
in a substituted-basis transaction (e.g., a transaction to which Sections 351, 721, or 1031 applies),
the built-in gain or loss of the transferred assets will carry over to the property received. The
recognition period will be the same as that of the transferred property. See Section 1374(d)(6);
see also IRS Ann. 86-128.
In PLR 200909001, taxpayer, an S corporation, owned common units in a partnership.
Taxpayer subsequently made separate acquisitions of unrelated C corporations, causing these
corporations to be liquidated under Section 332 and subjecting those assets to their own 10-year
recognition period under Section 1374. After each of these acquisitions, the taxpayer contributed
assets to the partnership in exchange for additional partnership common units. Under Section
1374(d)(6), the taxpayer’s block of partnership common units had the same 10-year recognition
period as the assets did under the above Section 1374(d)(8) acquisitions. Taxpayer wanted to
sell certain lots of its partnership common units, representing that it had kept track of the specific
assets acquired in each of the Section 1374(d)(8) acquisitions and identified the specific lot of
partnership common units associated with each transaction. The ruling held that the taxpayer’s
sale of separately identified lots of partnership common units after the units had been held for
more than the applicable 10-year recognition period would not be subject to Section 1374.
- 116 Accordingly, for purposes of determining whether sold partnership units were held beyond the
recognition period, the ruling allowed the taxpayer to separate its older partnership units from the
partnership units it acquired more recently in connection with the Section 1374(d)(8)
acquisitions.
Query how Section 1374(d)(6) should apply in the following circumstances. Assume an
S corporation owns, among other assets subject to Section 1374, an ordinary income asset with a
built-in gain subject to Section 1374 and a capital asset with a built-in loss subject to Section
1374.90 The amount of built-in gain in the ordinary income asset equals the amount of built-in
loss in the capital asset. The S corporation contributes both assets to a wholly owned C
corporation in exchange for stock in a transaction described in Section 351. Alternatively, the S
corporation contributes both assets to a partnership in exchange for a partnership interest in a
transaction described in Section 721. Should the C corporation stock or partnership interest be
treated as having built-in gain or built-in loss subject to Section 1374? Should the stock or
partnership interest be treated as having a blended character that effectively removes any Section
1374 taint since the amount of the built-in gain exactly offsets the amount of built-in loss in the
contributed assets? Should the stock or partnership interest be treated as having a split character
– part built-in gain and part built-in loss?
Assets Acquired from Another S Corporation: Where the S corporation acquires
property in a carryover-basis transaction from another S corporation (e.g., in a reorganization),
Section 1374 should not apply if the acquired assets are not already subject to Section 1374. See
PLR 9340006; PLR 9319016; PLR 9318024; PLR 9310038; PLR 9306017. If an S corporation
acquires assets that already are subject to Section 1374, such assets will continue to be subject to
Section 1374 in the hands of the transferee. This can occur when an S corporation with assets
subject to Section 1374 (i) transfers some of those assets to a wholly owned C corporation
subsidiary, (ii) immediately thereafter distributes all of the subsidiary’s stock in a transaction to
which Sections 355 and 368(a)(1)(D) apply, and (iii) causes the subsidiary to convert to an S
corporation on the date of the distribution of its stock. See PLR 201117009; PLR 200916017;
PLR 200906028; PLR 200903075; PLR 200852025; PLR 200409027; PLR 9722017; PLR
9722015. The recognition period attributable to the assets acquired from the distributing S
corporation does not begin anew. See IRS Ann. 86-128; PLR 200916017; PLR 200906028; PLR
200903075; PLR 200852025; PLR 200409027; PLR 200320013; PLR 9722017; PLR 9722015;
PLR 9414016. Query whether the distributing S corporation’s NUBIG should be allocated
between itself and its distributed subsidiary, as its AAA and C corporation earnings and profits
are allocated. See Treas. Reg. §§ 1.312-10(a), 1.1368-2(d)(3).
Query what result obtains where a C corporation acquires untainted assets from an
existing S corporation and, pursuant to the same plan, makes an S election itself. Have the
former S corporation assets become subject to Section 1374?
90
Note that, upon the sale of both assets by the S corporation, the capital loss cannot
offset the ordinary income. See Sections 1211, 1374(d)(2).
- 117 8.
NOL Carryovers , Capital Loss Carryovers, and other Loss and
Deduction Carryovers
Section 1374(b)(2) provides that a net operating loss carryover and a capital loss
carryover arising in a taxable year for which the S corporation was a C corporation can be used
to offset NRBIG. Query whether other loss and deduction carryovers may be used to offset
NRBIG. The legislative history of Section 1374(b)(2) suggests that other loss and deduction
carryovers could offset NRBIG. See H.R. Conf. Rep. No. 99-841, at II-203 (1986); Staff of the
J. Comm. on Taxation, 99th Cong., General Explanation of the Tax Reform Act of 1986 344,
344 n.91 (Comm. Print 1987). However, Treas. Reg. § 1.1374-5(a) clearly states that other loss
and deduction carryovers, such as charitable contribution carryforwards under Section 170(d)(2),
cannot offset NRBIG. But see Prop. Treas. Reg. § 1.1374-5(a), 67 Fed. Reg. 64,331-02 (Oct. 18,
2002) (providing that a loss attributable to the basis of redeemed stock that is taken into account
pursuant to Prop. Treas. Reg. § 1.302-5 is allowed as a deduction against NRBIG under Section
1374(b)(2), provided that the loss arose in a year in which the corporation was a C corporation).
Passive Activity Losses: It appears that a suspended passive activity loss that arises in a
year in which an S corporation was a C corporation may be used to reduce NRBIG in light of the
previously mentioned legislative history and the provisions of Section 469. Section 469(f)(2)
presumably requires Section 469 to continue to apply to a closely held C corporation that
converts to an S corporation. See St. Charles Investment Co. v. Comm’r, 232 F.3d at 778. If
such an S corporation remained a closely held C corporation, Section 469(g) would permit it
upon the disposition of a passive activity to reduce its taxable income by a related passive
activity loss for purposes of Section 11 tax. Thus, an S corporation should be permitted to use a
passive activity loss to reduce its taxable income for purposes of Section 1374 just as a closely
held C corporation would be permitted to use its passive activity loss to reduce its taxable
income for purposes of Section 11, since the Section 1374 tax generally serves as a substitute for
the Section 11 tax.
Application of Sections 382-384: In cases where the S corporation undergoes an
ownership change under Section 382(g)(1), it is unclear whether Section 1374(b)(2) overrides
Section 382. In general, Section 382 allows pre-change losses to offset recognized built-in gains,
in full, provided certain threshold tests are satisfied. See Section 382(h)(3)(B). If this threshold
test is not met, pre-change losses may offset recognized built-in gains only to the extent of the
Section 382 limitation.
In contrast, Section 1374(b)(2) does not contain any threshold limitations. Section
1371(a) states that subchapter C of the Code applies only to the extent that it is not inconsistent
with the rules of subchapter S of the Code. Query whether the application of the Section
382(h)(3)(B) threshold limit would be inconsistent with Section 1374(b)(2)?
To illustrate, assume that a loss corporation (“L”) is a C corporation with net operating
loss carryovers of $1,000,000. L is owned by individual A. A sells all of the L stock to
individual B for cash. Assume that L’s Section 382 limitation, as computed under Section
382(b), is $100,000. B makes an S election for L. L subsequently sells assets which generate
recognized built-in gain of $200,000. Section 1374(b)(2) apparently would allow L to use NOL
carryovers to offset the recognized built-in gain in full, regardless of whether L met the threshold
- 118 test under Section 382(h)(3)(B). Thus, no Section 1374 tax would be imposed. If Section
1374(b)(2) operates in conjunction with Section 382, and if the threshold test is not met,
recognized built-in gains could be offset by NOL carryovers only to the extent of the Section 382
limitation. In this case, L could offset its recognized built-in gain with NOL carryovers to the
extent of $100,000. Section 1374 tax would be imposed on the remaining $100,000.
The regulations make clear that any limitations imposed by Sections 382, 383(b), and 384
on the use of a C corporation’s net operating loss and capital loss carryforwards on the first day
of the recognition period also limit their use as deductions against the S corporation’s NRBIG.
Treas. Reg. § 1.1374-5. The regulations include the following example: X is a C corporation
which has an ownership change under Section 382(g)(1) on January 1, 1994. On that date, X has
a fair market value of $500,000, net operating loss carryforwards of $400,000, and a NUBIG
under Section 382(h)(3)(A) of $0. Assume X’s Section 382 limitation under Section 382(b)(1) is
$40,000. X elects to become an S corporation on January 1, 1998. On that date, X has net
operating loss carryforwards of $240,000 (having used $160,000 of its pre-change net operating
losses in its 4 preceding taxable years) and a Section 1374 NUBIG of $250,000. In 1998, X has
NRBIG of $75,000. X may use $40,000 of its net operating loss carryforwards as a deduction
against its $75,000 NRBIG, because X’s Section 382 limitation is $40,000.
9.
Installment Sales
The Service concluded that the purposes underlying the General Utilities repeal and the
related amendments to Section 1374 in the TRA of 1986 could be circumvented if an S
corporation disposes of an asset either prior to or during the recognition period in an installment
sale reported under the installment method. Accordingly, the Service stated that it would issue
regulations governing the treatment of installment sales under Section 1374. IRS Notice 90-27,
1990-1 C.B. 336. Indeed, the regulations provide that if a corporation sells an asset either before
or during the recognition period and reports income from the sale under the installment method
(either during or after the recognition period), the income, when recognized, will be taxed under
Section 1374 to the extent it would have been included in NRBIG during the recognition period
if the entire amount of income to be reported from the sale was reported in the year of the sale
and all provisions of Section 1374 and the regulations applied. If the corporation sells the asset
before the recognition period, the entire amount of income to be reported from the sale that was
not reported before the recognition period is treated as having been reported in the first year of
the recognition period. Treas. Reg. § 1.1374-4(h)(1).91
The regulations include the following example. X is a C corporation that elects to
become an S corporation effective January 1, 1996. On that date, X sells Blackacre with a basis
of $0 and a value of $100,000 in exchange for a $100,000 note bearing a market rate of interest
payable on January 1, 2001. X does not make the election under Section 453(d) and, therefore,
The Installment Tax Correction Act of 2000, P.L. 106-573, (the “Installment Act of
2000”) retroactively repealed the repeal of the installment sale method for accrual method
taxpayers. As a result, the installment sale method applies to accrual method taxpayers as if it
was never repealed.
91
- 119 reports the $100,000 gain using the installment method under Section 453. In the year 2001, X
has income of $100,000 on collecting the note, unexpired C year attributes of $0, RBIL of $0,
current losses of $100,000, and taxable income of $0. If X had reported the $100,000 gain in
1996, X’s aggregate net recognized built-in gain from 1996 through 2001 would have been
$75,000 greater than otherwise. Under the regulations, X has $75,000 NRBIG subject to tax
under Section 1374. X also must treat the $25,000 excess of the amount reported ($100,000 over
the amount subject to tax, $75,000) as income reported under the installment method in the
succeeding taxable year(s) in the recognition period, except to the extent X establishes that the
$25,000 was not subject to tax under Section 1374 in the year 2001 because X had an excess of
RBIL over RBIG in the taxable year of the sale and succeeding taxable year(s) in the recognition
period. Treas. Reg. § 1.1374-4(h)(5) ex. 1.
For assets sold for installment notes prior to March 26, 1990, gain recognized beyond the
recognition period due to Section 453 should not be subject to Section 1374. See Rev. Rul. 65292, 1965-2 C.B. 319; PLR 8704042 (only installment payments actually received are taken into
account for “old” Section 1374 purposes).
10.
Partnership Interests
a.
Overview
An S corporation that owns an interest in a partnership on the first day of the recognition
period or contributes assets to a partnership that it held on the first day of the recognition period
must treat its distributive share of partnership items as RBIG or RBIL to the extent the S
corporation’s distributive share would have been treated as RBIG or RBIL if the items originated
in, and were taken into account directly by, the S corporation (the “look-through rules”).
The look-through rules generally apply only to the extent the S corporation had built-in
gain (“BIG”) or built-in loss (“BIL”) in its partnership interest on the first day of the recognition
period. If an S corporation disposes of its interest in the partnership during the recognition
period, the amount treated as RBIG or RBIL on the disposition is adjusted to take into account
the amounts treated as RBIG or RBIL under the look-through rules. Furthermore, there are
special rules regarding Section 704(c) property and property that is distributed from a partnership
and subsequently disposed of by the S corporation partner.
These rules appear to prevent a corporation from employing the following techniques
(among others) to circumvent Section 1374. Under the first technique, the corporation (i)
contributes built-in gain assets to a partnership prior to an S corporation conversion, (ii) converts
to an S corporation, (iii) causes the partnership to sell such assets, (iv) causes the partnership to
distribute the cash proceeds to the S corporation, and (v) takes the position that the gain
attributable to such assets is not subject to Section 1374 because the S corporation did not “hold”
the built-in gain assets at the time of conversion. Under the second technique, the corporation (i)
converts to S corporation status, (ii) contributes built-in gain assets to a partnership, (iii) causes
the partnership to sell such assets, (iv) causes the partnership to distribute the cash proceeds to
the corporation, and (v) takes the position that the gain attributable to such assets is not subject to
Section 1374 because it was not incurred by the corporation (rather, it was incurred by a separate
entity – the partnership).
- 120 -
b.
Look-Through Rules: (Treas. Reg. § 1.1374-4(i)(1))
If an S corporation either (i) owns a partnership interest at the start of the recognition
period or (ii) transfers property to a partnership in a substituted-basis transaction described in
Section 1374(d)(6) (e.g., a Section 721 transaction) during the recognition period, the S
corporation determines the effect on its NRBIG from its distributive share of partnership items as
follows:

Step One: Apply the normal rules of Section 1374 to the S corporation’s
distributive share of partnership items to determine the extent to which
such items would have been treated as RBIG or RBIL if such items had
originated in and been taken into account directly by the S corporation.
These items are known as “partnership 1374 items.”

Step Two: Determine the S corporation’s NRBIG without the partnership
1374 items.

Step Three: Determine the S corporation’s NRBIG with the partnership
1374 items.

Step Four

Partnership RBIG: If the amount in Step Three is greater
than the amount in Step Two, then the excess amount is known
as the S corporation’s “partnership RBIG” to the extent it is not
limited by the overall limit (described below). The S
corporation’s total NRBIG is the sum of the amount in Step
Two and its partnership RBIG.

Partnership RBIL: If the amount in Step Two is greater than
the amount in Step Three, then the excess amount is known as
the S corporation’s “partnership RBIL” to the extent it is not
limited by the overall limit (described below). The S
corporation’s total NRBIG is the difference between the
amount in Step Two and its partnership RBIL.
Overall Limit on Partnership RBIG: An S corporation’s partnership RBIG for any tax
year may not exceed the excess (if any) of the S corporation’s RBIG limitation (defined below)
over its partnership RBIG for prior tax years. Treas. Reg. § 1.1374-4(i)(2). However, this limit
shall not apply if a corporation forms or avails itself of a partnership with a principal purpose of
avoiding the tax imposed under Section 1374. Id.
Overall Limit on Partnership RBIL: An S corporation’s partnership RBIL for any tax
year may not exceed the excess (if any) of the S corporation’s RBIL limitation (defined below)
over its partnership RBIL for prior tax years. Id.
- 121 RBIG and RBIL Limitation: Pursuant to Treas. Reg. § 1.1374-4(i)(4), the RBIG or
RBIL limitation is the total of the following:

the amount that would be realized if, at the start of the recognition period,
the corporation had remained a C corporation and had sold its partnership
interest (and any assets the corporation contributed to the partnership
during the recognition period) at fair market value to an unrelated party,
decreased by

the corporation’s adjusted basis in the partnership interest (and any assets
the corporation contributed to the partnership during the recognition
period) at the time of the above sale, increased or decreased by

the corporation’s allocable share of the partnership’s Section 481(a)
adjustments at the time of the above sale.
If the amount calculated above is positive, the RBIG limitation is that positive amount and the
RBIL limitation is zero. If the amount calculated above is negative, the RBIL limitation is that
negative amount and the RBIG limitation is zero.
Small Interest Exception: The look-through rules do not apply to a tax year in the
recognition period if (i) the S corporation’s partnership interest represents less than 10 percent of
the partnership’s capital and profits at all times during the tax year and prior tax years in the
recognition period and (ii) the fair market value of the S corporation’s partnership interest at the
start of the recognition period is less than $100,000. Treas. Reg. § 1.1374-4(i)(5). This relief
provision also contains two anti-abuse rules. See Treas. Reg. § 1.1374-4(i)(5)(ii), (iii).
c.
Disposition of a Partnership Interest: (Treas. Reg. § 1.13744(i)(3))
Gain on Disposition: If an S corporation disposes of its partnership interest and
recognizes gain on the disposition, the amount of such gain that may be treated as RBIG may not
exceed the excess (if any) of the S corporation’s RBIG limitation over its partnership RBIG
during the recognition period. See, e.g., Treas. Reg. § 1.1374-4(i)(8) ex. 7. Unlike the antiabuse rule applicable to the determination of partnership RBIG, it appears that an anti-abuse rule
does not exist with respect to the disposition of a partnership interest.
Loss on Disposition: If an S corporation disposes of its partnership interest and
recognizes loss on the disposition, the amount of such loss that may be treated as RBIL may not
exceed the excess (if any) of the S corporation’s RBIL limitation over its partnership RBIL
during the recognition period.
- 122 d.
Special Rules
(i)
Section 704(c) Gain or Loss
Solely for purposes of Section 1374, an S corporation’s Section 704(c) gain or loss
amount with respect to any asset is not reduced during the recognition period, except for amounts
treated as RBIG or RBIL with respect to that asset. Treas. Reg. § 1.1374-4(i)(6). This rule is
designed to prevent an S corporation that contributes appreciated property to a partnership from
deferring RBIG by using the special allocation rules of Section 704 to reallocate a portion of any
gain recognized by the partnership to other partners. See, e.g., Treas. Reg. § 1.1374-4(i)(8) ex. 8.
(ii)
Disposition of Distributed Property (Treas. Reg. §
1.1374-4(i)(7))
In General: If (i) on the first day of the recognition period, an S corporation holds an
interest in a partnership that holds an asset, (ii) the partnership distributes the asset to the S
corporation during the recognition period, and (iii) the S corporation thereafter disposes of the
asset, the asset is treated as (a) having been held by the S corporation on the first day of the
recognition period and (b) having the fair market value and adjusted basis in the hands of the S
corporation that it had in the hands of the partnership on that day. Treas. Reg. § 1.1374-4(i)(7).
The amount of RBIG or RBIL that could be triggered upon a subsequent disposition of the
distributed asset is apparently not limited by any of the limits placed in Treas. Reg. § 1.1374-4(i).
See, e.g., Treas. Reg. § 1.1374-4(i)(8) ex. 9 (disregarding, apparently, the S corporation partner’s
RBIG limitation).
Purpose: The preambles to the proposed and final regulations merely state that this is a
“special rule.” See T.D. 8579, 1995-1 C.B. 170; 57 Fed. Reg. 57,971 (Dec. 8, 1992). Congress
expected that the Treasury Department would draft regulations that would prevent S corporations
from circumventing the Section 1374 tax. See Staff of Joint Comm. on Taxation, 99th Cong.,
General Explanation of the Tax Reform Act of 1986 345 (Comm. Print 1987); H.R. Conf. Rep.
No. 99-841, at II-204 (1986); S. Rep. No. 100-445, at 67 (1988). The rule in Treas. Reg. §
1.1374-4(i)(7) may have been promulgated to prevent a corporation that was expecting to make
an S election from reducing (or eliminating) its Section 1374 tax by contributing a BIG asset to a
loss partnership before the conversion. But for the regulation, the S corporation thereafter could
reacquire the asset through an in-kind distribution after conversion. The S corporation could
thus dispose of the BIG asset for a gain that would not qualify as RBIG because Section
1374(d)(3)(A) exempts assets not held directly by the S corporation on the first day of the
recognition period from the Section 1374 tax. Treas. Reg. § 1.1374-4(i)(7) may have been
needed to prevent such an avoidance of Section 1374. It appears that no other rule would apply
to such transactions. See Treas. Reg. § 1.1374-4(i)(2) to (5); Treas. Reg. § 1.1374-9 (the antistuffing rule); Treas. Reg. § 1.1374-10(b)(1) (applying to certain transfers of property to a
partnership that occur prior to the effective date of the final regulations).
Potential Problem: It may be inequitable to apply the RBIG limitation to a sale of an
interest in a partnership that holds a contributed BIG asset, yet not to apply the same limit when
the partnership distributes the BIG asset to an S corporation partner and the S corporation
subsequently disposes of the asset. Compare Treas. Reg. § 1.1374-4(i)(8) ex. 7 (sale of
- 123 partnership interest) with Treas. Reg. § 1.1374-4(i)(8) ex. 9 (disposition of distributed
partnership asset).
Potential Justifications For The Rule: Under the rule in Treas. Reg. § 1.1374-4(i)(7),
the S corporation is forced to recognize the same amount of RBIG or RBIL that it would have
recognized had it directly held the asset, instead of contributing it to a partnership prior to its
conversion to S corporation status. Furthermore, under the aggregate theory of partnerships, the
difference in treatment between a sale of a partnership interest and the sale of an asset distributed
by a partnership does not appear inequitable. Under the aggregate theory of partnerships, when a
partner sells his partnership interest, he is considered as selling his proportionate interest in each
partnership asset. Thus, a proportionate amount of the basis of any loss asset is used to reduce
any gain on the sale that would otherwise arise. Under the aggregate theory of partnerships,
when a partner receives an in-kind distribution of a gain asset and sells it subsequently, the
selling partner can use no part of the basis of any loss asset to reduce gain because the partner is
not treated as selling a proportionate interest in each partnership asset. It appears that the
Treasury Department applied, at least in a modified form, the aggregate theory of partnerships in
Treas. Reg. § 1.1374-4(i). Compare Treas. Reg. § 1.1374-4(i)(1) (providing generally that an S
corporation should look through its partnership interest to apply Section 1374) with Treas. Reg. §
1.1374-4(i)(2) (limiting generally the amount of partnership RBIG to the amount of built-in gain
in the S corporation’s partnership interest).
Potential Solution: Instead of the S corporation directly selling a distributed partnership
asset, the partnership could dispose of the asset and then distribute the cash proceeds to the S
corporation partner. The RBIG limitation would limit the amount of partnership RBIG taken
into account by the S corporation partner. However, the following risks exist: (i) if the antiabuse rule in Treas. Reg. § 1.1374-4(i)(2) applies, the RBIG limitation would not limit
partnership RBIG; (ii) a cash distribution will trigger additional gain to the S corporation partner
under Section 731(a) if the S corporation partner’s basis in its partnership interest is not equal to
or greater than the amount of the cash distribution; and (iii) a minority interest partner may have
difficulty causing the partnership to dispose of assets.
11.
Effective Date of Section 1374
Section 1374 applies to taxable years beginning after December 31, 1986, but only if the
corporation’s S election is filed after 1986. Section 1374 will not apply if the S election was
made before January 1, 1987. See P.L. 99-514, § 633(b); see also P.L. 100-647, § 1006(g)(1)
(clarifying the effective date rule).
In addition, if a corporation makes a valid S election on or after January 1, 1987 and
before January 1, 1989, it may nevertheless qualify for partial relief from Section 1374 if such
corporation qualifies for transitional relief under the TRA of 1986 and the TAMRA of 1988 (i.e.,
certain small, closely held corporations). See P.L. 99-514, § 633(d)(8); P.L. 100-647, §
1006(g)(7); IRS Notice 88-134, 1988-2 C.B. 559; see also Colorado Gas Compression, Inc. v.
Comm’r, 366 F.3d 863 (10th Cir. 2004) (ruling that an S corporation need not maintain its status
as an S corporation continuously to enjoy the benefit of the old capital gains tax under the
transition rules contained in the TRA of 1986 and the TAMRA of 1988; despite revocation of its
1988 S election in 1989 and reelection of S corporation status in 1994, gains from sales of pre-
- 124 1988 built-in gain assets in 1994 through 1996 were subject to the old capital gains tax rather
than Section 1374). Relief from Section 1374 in this case would extend only to long-term capital
gains – not ordinary income or short-term capital gain – and only to the extent of the applicable
percentage. See P.L. 99-514, § 633(d); Rev. Rul. 86-141, 1986-2 C.B. 151; PLR 8809063.
On December 21, 2004, the Treasury Department and the Service issued temporary
regulations effectively overruling Colorado Gas Compression. See Former Temp. Treas. Reg. §§
1.1374-8T(a)(2), -10T(c). The temporary regulations provided that a corporation’s most recent S
election (rather than an earlier but later revoked or terminated election) determines whether and
how the corporation is subject to Section 1374. Temp. Treas. Reg. § 1.1374-10T(c). The
temporary regulations also applied to any transactions described in Section 1374(d)(8) that occur
on or after December 27, 1994, regardless of the date of the S corporation’s S election. Former
Temp. Treas. Reg. § 1.1374-8T(a)(2). On December 21, 2005, the Treasury Department and the
Service removed the temporary regulations and replaced them with final regulations containing
the same rules. See Treas. Reg. §§ 1.1374-8, -10; T.D. 9236, 70 Fed. Reg. 75730-75731.
The old capital gains tax will apply to S corporations failing to meet the effective date
provisions of Section 1374. See Section IV.A.15. below for a brief discussion of the old capital
gains tax.
12.
Regulations Cover Additional Issues
In addition to the issues already addressed, the regulations include detailed rules with
respect to the following items:

Section 267(a)(2) and Section 404(a)(5) deductions - Treas. Reg.
§ 1.1374-4(c);

Section 481 adjustments taken into account during the recognition period Treas. Reg. § 1.1374-4(d);92

a deemed distribution of income from a DISC taken into account during
the recognition period under Section 995(b)(2) - Treas. Reg. § 1.13744(e);

discharge of indebtedness income or bad debt deductions taken into
account during the first year of the recognition period - Treas. Reg. §
1.1374-4(f); and

income taken into account during the recognition period under the
completed contract method. Treas. Reg. § 1.1374-4(g).
92
See, e.g., MMC Corp v. Comm’r, 551 F.3d 1218 (10th Cir. 2009).
- 125 The Service issued these final regulations on December 23, 1994. They apply for tax years
ending on or after December 27, 1994, but only for a return filed under an S election made on or
after that date. Treas. Reg. § 1.1374-10.
13.
Recordkeeping Issues
Section 1374 seeks to maximize corporate-level tax because it presumes that gains
recognized within the recognition period are RBIGs and that losses recognized within the
recognition period are not RBILs. See Section 1374(d)(3), (4). An S corporation may rebut
these presumptions only by proving the fair market value and adjusted basis of each of its assets
at the time of conversion. Thus, an S corporation must keep detailed records and proof as to
asset bases and fair market values as of the beginning of the recognition period.
In order to avoid future controversy over (i) the proper amount of NUBIG and (ii)
whether a gain (or loss) recognized at a future date constitutes a RBIG (or a RBIL), an S
corporation could execute a pre-filing agreement (a “PFA”) with the Service that fixes the
amount of NUBIG and the amount of built-in gain or built-in loss in each of its assets. See Rev.
Proc. 2001-22, 2001-1 C.B. 745; IRS Ann. 2003-43, 2003-1 C.B. 1139. The PFA process is
designed to permit certain taxpayers to resolve, before the filing of a return, the treatment of an
issue that otherwise likely would be disputed in a post-filing examination (such as whether a
recognized gain constitutes a RBIG). The PFA process is intended to produce agreement on
factual issues (e.g., the fair market value and adjusted basis of an asset) and apply settled legal
principles (e.g., Section 1374 and the definition of fair market value) to those facts. A PFA is a
“specific matter closing agreement” under Section 7121 and resolves the subject of the PFA for a
specified taxable period (e.g., for the extent of the recognition period). See Rev. Proc. 2001-22;
IRS Ann. 2003-43.
14.
Additional Planning Issues
In addition to the techniques already discussed, there are several ways to reduce an S
corporation’s exposure to Section 1374.

In anticipation of converting to an S corporation, a corporation might
consider having built-in loss assets contributed to it (or assets that are
expected to decline in value) in order to reduce its NUBIG. However,
under certain circumstances, these assets may be disregarded for purposes
of Section 1374. See Treas. Reg. § 1.1374-9.

Built-in loss assets (or assets that are expected to decline in value) could
be contributed to an S corporation during the recognition period in order to
offset any expected RBIGs through operation of the taxable income
limitation. However, under certain circumstances, these assets also may
be disregarded for purposes of Section 1374. See id. However, any
amount of NRBIG limited by the taxable income limitation will carry
forward and become a RBIG in the next taxable year (unless the next
taxable year falls outside the recognition period).
- 126 
An S corporation should time its dispositions of built-in gain assets so that
they occur in the same taxable years as its dispositions of built-in loss
assets. This will reduce the amount of NRBIG taken into account each
year.

An S corporation planning to dispose of a built-in gain asset should time
the disposition so that it occurs in a loss year (or in a year where taxable
income is limited by an increase in compensation expenses or other
business expenses). However, any amount of NRBIG limited by the
taxable income limitation will carry forward and become a RBIG in the
next taxable year (unless the next taxable year falls outside the recognition
period).

Rather than selling a built-in gain asset, an S corporation could lease the
asset or use it as financing collateral in order to avoid a RBIG. But see
Anschutz Co. v. Comm’r, Nos. 11–9001, 11–9002 (10th Cir. Dec. 27,
2011) (ruling that variable prepaid forward contracts and share lending
agreements with respect to built-in-gain assets constituted sales rather than
financings with respect to such built-in gain assets, thereby triggering
Section 1374 tax for the relevant S corporation).

An S corporation wishing to replace a built-in gain asset with another asset
could use a like-kind exchange to avoid a RBIG. However, the like-kind
asset received succeeds to the surrendered asset’s status as a built-in gain
asset. See Section 1374(d)(6).
15.
Old Capital Gains Tax
Prior to the TRA of 1986, Former Section 1374 (and prior to the Revision Act of 1982,
Former Section 1378) imposed a corporate-level tax on certain capital gains of an S corporation.
See Former Section 1374 (1982 to 1986); Former Section 1378 (1966 to 1982). The purpose of
these provisions was to dissuade a corporation with accumulated earnings and profits from doing
the following: (i ) convert to S corporation status, (ii) sell capital gain property, (iii) distribute
the sales proceeds tax-free to shareholders, and (iv) revoke the S election in the next year in
order to prevent the shareholders from taking into account future corporate earnings. See S. Rep.
No. 89-1007 (1966). These steps would avoid a capital gains tax at the corporate level and
would avoid a dividend taint for the distribution of the sales proceeds. Id.
This tax on capital gains still may apply today to a corporation that has been an S
corporation since before the effective dates of Section 1374. For example, a corporation (“X”)
becomes an S corporation in 1985. In 2003, X acquires a capital asset with a fair market value of
$1 million and an adjusted basis of $0 in a tax-free reorganization described in Section
368(a)(1)(A). In 2005, when the fair market value of the capital asset is $10 million, X sells the
asset and recognizes $10 million of long-term capital gain. Under Former Section 1374(c)(3)
and assuming the taxable income requirements under Former Section 1374 are met, the entire
$10 million would be subject to tax under Former Section 1374. See Treas. Reg. §§ 1.13741A(c), (c)(vi) ex. 1, -10(a); T.D. 8579 (1994) (redesignating - not removing - the regulations
- 127 under Former Section 1374). Note that, if Section 1374 applied, only $1 million of such longterm capital gain would be subject to tax under Section 1374 because the remaining $9 million of
gain accrued while the asset was held by the S corporation.
B.
Corporate Level Tax on Passive Investment Income - Section 1375
1.
In General
Purpose: Prior to the Revision Act of 1982, a corporate-level tax on an S corporation’s
passive investment income did not exist. However, a corporation’s S election generally would
terminate retroactively for any taxable year in which it derived more than 20 percent of its gross
receipts from passive income (regardless of the existence of earnings and profits). See Former
Section 1372(e)(5). Congress enacted this rule to dissuade self-employed individuals from
incorporating passive investment assets in an S corporation in order to use favorable fringe
benefit provisions applicable only to corporations and their employees (including shareholderemployees) while also avoiding a corporate-level tax on the income from such assets. See S.
Rep. No. 91-1535, at 1-2 (1970).
As a result of amendments to employee-benefit rules in the Tax Reform Act of 1969 and
the Revision Act of 1982, Congress significantly reduced the applicability of such favorable
fringe benefit provisions to S corporations and shareholder-employees of S corporations. See
Section 1372 (treating, for purposes of the employee fringe benefit provisions in Subtitle A of
the Code, an S corporation as a partnership and any “2-percent shareholder” of an S corporation
as a partner rather than a shareholder-employee); Former Section 1379 (treating certain
contributions by an S corporation to a pension plan on behalf of certain shareholder-employees
as currently includible in such shareholder-employees’ gross income). However, Congress
continued to be concerned that C corporations (i) would invest their accumulated earnings and
profits in passive investment assets instead of making a taxable distribution of such earnings so
that the shareholders could invest in the same assets directly, and (ii) then would elect S
corporation status to distribute the income from such investment assets without triggering a
shareholder-level tax (i.e., a distribution out of the AAA) and to avoid the corporate-level
personal holding company tax. See Sections 541, 1363(a); S. Rep. No. 97-640, at 6 (1982).
Thus, Congress also enacted Section 1375 (and Section 1362(d)(3), discussed below in Section
V.A.2.) in the Revision Act of 1982 to dissuade C corporations from doing this.
General Rules: Under Section 1375, a tax is imposed on an S corporation if it has both
accumulated earnings and profits at the close of any taxable year and more than 25 percent of the
S corporation’s gross receipts consist of “passive investment income.” The tax is imposed on
“excess net passive income” (“ENPI”). Section 1375(a). The rate of tax is the highest rate
specified in Section 11(b) (i.e., 35 percent).93 Section 1375(a). Unlike Section 1374, it does not
93
Note that, although the Jobs and Growth Act of 2003 reduced the tax rate applicable to
personal holding companies from 35 percent to 15 percent, the Jobs and Growth Act of 2003 did
not reduce the 35-percent tax rate applicable to S corporations that have similar income under
Section 1375. See section 302(e) of the Jobs and Growth Act of 2003. As a result, an S
(Continued …)
- 128 appear that the capital gains tax rates apply to income generated from otherwise-qualifying
property. Also, most credits are disallowed. Section 1375(c).
ENPI is determined by multiplying the corporation’s “net passive income” for the taxable
year by the following quotient: “passive investment income” in excess of 25 percent of gross
receipts divided by the total passive investment income for the taxable year. Section
1375(b)(1)(A). ENPI for a taxable year cannot exceed the corporation’s taxable income for the
year as determined under Section 63(a) without regard to Sections 172, 241-247, and 249-250
(special deductions for corporations). Section 1375(b)(1)(B). However, unlike Section 1374,
Section 1375 does not carry forward excess ENPI when the taxable income limitation applies.
2.
Definitions
The term “net passive income” means “passive investment income” reduced by
deductions that are directly connected with the production of such income. Section 1375(b)(2).
The terms “passive investment income” and “gross receipts” have the same meanings as under
Section 1362(d)(3). See Section V.A.2., below. Furthermore, the definition of accumulated
earnings and profits (i.e., “subchapter C earnings and profits”) has the same meaning as under
the regulations under Section 1362(d)(3). See Treas. Reg. § 1.1375-1(b)(4); see Section
V.A.2.c., below.
Section 1375(b)(4) clarifies that passive investment income does not include “recognized
built-in gain or loss of the S corporation for any taxable year in the recognition period.” Query
whether this rule could be interpreted to mean that the recognized built-in gain or loss need not
be taxed under Section 1374 to be excluded from Section 1375 (i.e., such gain or loss only needs
to meet the definition of “recognized built-in gain” or “recognized built-in loss” in Section
1374(d), but does not need to be taxed under Section 1374(b)). For example, assume an S
corporation with a net operating loss carryover of $100x sells an asset that generates a
recognized built-in gain of $100x (which would also qualify as passive investment income under
Section 1375). Section 1374 tax is not imposed on the S corporation because the net operating
loss carryover reduces the S corporation’s net recognized built-in gain to zero. Should the $100x
recognized built-in gain be excluded from Section 1375 under these circumstances?
3.
Rules Relating to C Corporation Subsidiaries
Section 1362(d)(3) and the regulations thereunder provide that dividends received by an
S corporation from a C corporation in which the S corporation has an 80 percent or greater
interest are not treated as passive investment income for purposes of Sections 1362 and 1375 to
the extent the dividends are attributable to the earnings and profits of the C corporation derived
from the active conduct of a trade or business. Treas. Reg. § 1.1362-8(a). See Section
V.A.2.b.(iii) below for a detailed review of Section 1362(d)(3) and the regulations thereunder.
corporation pays tax on certain passive income at a higher rate than the rate paid by a C
corporation with similar income.
- 129 4.
Special Rules Relating to QSubs
If an S corporation has a QSub, the calculations required by Section 1375 will be made
only once, at the S parent’s level, taking into account the tax items of all of the S parent’s direct
and indirect QSubs. Note, however, that the TRA of 1997 (amending Former Section 1361(b)(3)
of the Code) authorizes the Service to issue regulations pursuant to which QSubs may be treated
as separate corporations.
5.
Waiver of Section 1375 Tax
The Secretary (or Commissioner) may waive the Section 1375 tax if the S corporation
establishes that (i) it determined in good faith that it had no subchapter C earnings and profits at
the close of a taxable year, and (ii) during a reasonable period of time after it was determined
that it did have subchapter C earnings and profits at the close of such taxable year, such earnings
and profits were distributed. The S corporation has the burden of establishing that the Section
1375 tax should be waived. Treas. Reg. § 1.1375-1(d). A request for waiver must be made in
writing. Id.
6.
Planning To Avoid Section 1375 Tax
The following techniques may be used to reduce an S corporation’s exposure to the
Section 1375 tax.

An S corporation could ensure that its accumulated earnings and profits
were distributed in full by the end of the relevant taxable year.

Alternatively, an S corporation could elect, with consent of all
affected shareholders, to distribute accumulated earnings and
profits before distributing AAA. See Section 1368(e)(3).

An S corporation could increase its gross receipts without increasing its
passive investment income by selling ordinary income assets or by selling
stock or securities.

An S corporation could decrease its taxable income by increasing
compensation expenses or other ordinary business expenses.
C.
LIFO Recapture
Purpose: After the enactment of Section 1374 in the TRA of 1986, a C corporation still
could avoid the repeal of the General Utilities doctrine with respect to built-in gain in its
inventory assets through the following steps: (i) convert to the LIFO inventory identification
system (if not otherwise using such system already), (ii) then convert to S corporation status, (iii)
then sell inventory assets, and (iv) take the position that Section 1374 did not apply to the gain
from the sale of the inventory assets because such assets had not been held by the S corporation
at conversion. In the Omnibus Budget Reconciliation Act of 1987, P.L. 100-203, (“OBRA
1987”), Congress enacted Section 1363(d) to ensure that the repeal of the General Utilities
- 130 doctrine would apply in situations like the one described above. See H.R. Conf. Rep. No. 100495 (1987); H.R. Rep. No. 100-391 (1987). Thus, Section 1363(d) effectively acts as a backstop
to Section 1374 and prevents a potential distortion between C corporations that use the FIFO
inventory identification system and C corporations that use the LIFO inventory identification
system.
In General: Under Section 1363(d), a C corporation using the LIFO inventory
identification method that elects S corporation status will be required to recapture the benefits of
the LIFO election by increasing gross income for its final C year.94 See Section 1363(d).
Regulations under Section 1363(d), adopted in 1994, extend the LIFO recapture rules to apply to
a C corporation if it used the LIFO inventory identification method during its last taxable year
before the transfer of its assets to an S corporation in a transaction where the S corporation’s
basis in the assets are determined in whole or in part by reference to the basis of the assets in the
hands of the C corporation. Treas. Reg. § 1.1363-2(a)(2);95 see also FSA 199922011 (applying
the rule in Treas. Reg. § 1.1363-2(a)(2) to years prior to 1994).
In general, the LIFO benefit is the excess of the corporation’s inventory valued at FIFO
over its value under LIFO. See Section 1363(d)(3). Any increase in tax resulting from the
recapture of this LIFO benefit will be payable in four annual installments. The first installment
is due on the date of the C corporation’s last return (without extensions). The three succeeding
installments must be paid by the due date of the S corporation’s return (without extensions) for
such years. See Section 1363(d)(2); Treas. Reg. § 1.1363-2(b); see also IRS Ann. 88-60, 198815 I.R.B. 47. A failure to pay, or late payment of, a LIFO recapture installment payment does
not cause any remaining unpaid installments to become due immediately. See IRS Notice 20034, 2003-1 C.B. 294. If, however, an S corporation files a final return before it has paid the three
succeeding Section 1363(d) installments, all remaining installments are payable with the final
return. See Rev. Proc. 94-61, 1994-2 C.B. 775.
The GO-Zone Act added Section 1363(d)(5), which provides that any corporate tax
imposed by reason of Section 1363(d) is disregarded for purposes of rules relating to: (i) the
prohibition on adjustments of earnings and profits of an S corporation (see Section 1371(c)(1));
and (ii) the reduction in the basis of S corporation stock by reason of nondeductible expenses that
are not properly chargeable to capital accounts (see Section 1367(a)(2)(D)). The provision is
generally effective for corporations that elected S corporation status after December 17, 1987.
Section 411(b), P.L. 109-135.
94
Section 1363(d) does not apply when a sole proprietorship using the LIFO inventory
identification method transfers its assets to a newly formed corporation in a Section 351
transaction, and, in its first year of existence, the new corporation timely makes an S election.
See PLR 201010026.
95
2(d)(2).
This rule applies to transfers made after August 18, 1993. Treas. Reg. § 1.1363-
- 131 Basis Adjustment: The basis of the inventory assets will be increased to reflect the
LIFO recapture amount. See Section 1363(d)(1); Rev. Proc. 94-61, 1994-2 C.B. 775. Thus,
such increase in basis apparently will render Section 1374 inapplicable to future sales of such
assets unless the LIFO recapture amount does not increase basis to the fair market value of such
assets at conversion. See Section 1363(d)(1); Treas. Reg. § 1.1363-2(c). Also note that, if the
converting C corporation uses a net operating loss carryover to avoid any increase in tax from
LIFO recapture, the basis of the inventory assets still must be increased by the full LIFO
recapture amount. See Rev. Proc. 94-61, 1994-2 C.B. 775.
Consolidated Return Issue: A corporation subject to LIFO recapture is not treated as a
member of an affiliated group with respect to the LIFO recapture amount. See Section
1363(d)(4)(D). Thus, where a corporation is acquired from a consolidated group, the LIFO
recapture amount is imposed on the acquired corporation and is not included in the consolidated
group’s return (i.e., the acquired corporation’s gross income from the LIFO recapture amount
cannot be offset with losses from other members of the consolidated group).
Partnership Interests: Prior to August 13, 2004, a C corporation using the LIFO
inventory identification method arguably could have avoided Section 1363(d) if it transferred its
inventory assets to a partnership immediately before converting to S corporation status. The S
corporation then could have reacquired such assets through an in-kind partnership distribution.
Although such assets then might have been subject to Section 1374, the S corporation arguably
would have deferred corporate-level tax on such assets until the time of actual disposition (rather
than triggering such tax at conversion).
Query whether this type of transaction should be prevented, presumably by applying a
look-through rule for partnership interests under Section 1363(d). Note that Sections 1374 and
1375 have look-through rules. See Treas. Reg. §§ 1.1362-2(c)(4)(ii)(B)(4), 1.1362-8, 1.13744(i), 1.1375-1(b)(4). The Tax Court and the Service have taken the position that such a rule
should apply for Section 1363(d) purposes. See Coggin Automotive Corp. v. Comm’r, 292 F.3d
1326 (11th Cir. 2002), rev’g 115 T.C. 349 (2000); TAM 9716003; Treas. Reg. § 1.1363-2(b)-(g).
In Coggin, Petitioner was a holding company that held over 80 percent of the stock of
five C corporations. The subsidiaries maintained their inventory under the dollar-value LIFO
method. As a result of a series of transactions intended to convert the subsidiaries into
partnerships, Petitioner acquired limited partnership interests in five partnerships that held the
inventory formerly held by the subsidiaries. Then, Petitioner elected S corporation status. As a
result of the above, the Commissioner determined that Petitioner’s conversion to S corporation
status triggered the inclusion of the partnerships’ LIFO reserves into Petitioner’s gross income.
The Tax Court agreed with the Commissioner by holding that the aggregate approach (as
opposed to the entity approach) to partnerships better serves the underlying purpose and scope of
Section 1363(d). Accordingly, Petitioner was deemed to own a pro rata share of the
partnerships’ inventories. Consequently, upon Petitioner’s S election, it was required to include
its ratable share of the LIFO recapture amount in gross income.
- 132 However, applying the plain meaning of Section 1363(d), the Eleventh Circuit held that
the Commissioner should have applied the entity approach to partnerships. Accordingly,
Petitioner did not own any inventory at the time of its S corporation election. The court stated:
“It is worrisome to think that a taxpayer may not know in advance whether this would be the day
that the fictional aggregate theory or the fictional entity theory of partnerships will be applied on
an ad hoc basis. Relying upon the plain meaning of the statute, in a legitimate business
transaction, a taxpayer deserves the right to be able to predict in advance what the tax
consequences of such transaction will be with reasonable certainty. Here the statute just does not
do what the litigation position of the Commissioner would have it do.... Any potential windfall
to holding companies must be cured by Congress, not the judiciary. See Gitlitz, 121 S.Ct. at
710.” Id. at 1333-34.
Query: Does the Eleventh Circuit’s opinion preclude a regulatory fix under Section
1363? Note that Treas. Reg. § 1.701-2(e)(1) permits the Commissioner to apply the aggregate
theory of partnerships to carry out the purpose of any provision of the Code or the regulations
promulgated thereunder. See Treas. Reg. § 1.701-2(e)(1) (applicable to transactions occurring
on or after December 29, 1994). The Eleventh Circuit referred to this regulation in a footnote,
but noted that the regulation (i) had not been issued when Coggin undertook the transaction at
issue and (ii) was prospective in nature. See Coggin, 292 F.3d at 1333 n.18.
In 2004, the Treasury Department and the Service issued proposed regulations that
effectively adopted the Tax Court’s holding in Coggin. See Prop. Treas. Reg. § 1.1363-2(b)-(g),
69 Fed. Reg. 50,109-50,112 (Aug. 13, 2004). These proposed regulations were made final on
July 11, 2005. See T.D. 9210. The regulations provide that a C corporation that holds an
interest in a partnership that owns LIFO inventory (directly or indirectly through one or more
partnerships) must include an amount in gross income equal to the “lookthrough LIFO recapture
amount” when the corporation (i) makes an S election or (ii) transfers its interest in the
partnership to an S corporation in a nonrecognition transaction (within the meaning of Section
7701(a)(45)) in which the transferred interest constitutes transferred basis property (within the
meaning of Section 7701(a)(43)). Treas. Reg. § 1.1363-2(b). The “lookthrough LIFO recapture
amount” is generally defined as the amount of income that would be allocated to the corporation
taking into account Section 704(c) and Treas. Reg. § 1.704-3, if the partnership sold all of its
LIFO inventory for the inventory’s FIFO value. Treas. Reg. § 1.1363-2(c)(4).
Furthermore, a corporation required to include in gross income a “lookthrough LIFO
recapture amount” must increase its basis in its partnership interest by the amount of the
“lookthrough LIFO recapture amount.” Treas. Reg. § 1.1363-2(e)(2)(i). Also, the relevant
partnership that directly owns the LIFO inventory that created the “lookthrough LIFO recapture
amount” may elect to adjust the basis of such inventory by such recapture amount. Treas. Reg. §
1.1363-2(e)(2)(ii). An analogous elective rule would apply to basis adjustments to interests in
partnerships that indirectly owned LIFO inventory through another partnership. Id. However,
such adjustments may be made only with respect to the relevant S corporation partner (similar to
basis adjustments to partnership property pursuant to Section 743(b)). Id. The regulations apply
to S elections and transfers made on or after August 13, 2004. Treas. Reg. § 1.1363-2(g)(3).
- 133 D.
Investment Credit Recapture
An S corporation continues to be liable for recapture taxes under Section 47 with respect
to credits claimed during C corporation years. Section 1371(d)(2).
E.
Estimated Taxes
As a result of the RRA of 1989, for taxable years beginning after 1989, S corporations are
required to make estimated tax payments at the corporate level for income tax resulting from
built-in gains, passive investment income, capital gains, and investment tax credit recapture. See
Section 6655(g)(4)(A).
V.
CEASING TO BE AN S CORPORATION
A.
Terminating the S Election
A valid S election is effective for the year made and all subsequent years until it is
terminated. Section 1362(c). A termination may be accomplished only by (i) revocation, (ii)
generating passive investment income under certain circumstances, or (iii) ceasing to be a small
business corporation. See Mourad v. Comm’r, 121 T.C. 1 (2003) (“An S corporation election
terminates in one of three ways: (1) Revocation by the shareholder(s); (2) the entity ceases to be
a ‘small business corporation’; or (3) the entity’s passive income exceeds 25 percent of its gross
receipts for the previous 3 consecutive years. The Code provides only these three ways by which
the S corporation election may be terminated.”); Aaron v. Comm’r, 87 T.C.M. (CCH) 1087
(2004); In re Stadler Associates, Inc., 186 B.R. 762 (Bankr. S.D. Fla. 1995). Accordingly, the
following actions of an S corporation do not constitute events of termination: (i) merging into
another corporation, (ii) liquidating, (iii) failing to maintain a permitted year under Section 1378,
(iv) filing a petition for liquidation pursuant to chapter 7 of the U.S. Bankruptcy Code, and (v)
filing a petition for reorganization pursuant to chapter 11 of the U.S. Bankruptcy Code.
1.
Revocation
An S election may be revoked if (and only if) shareholders holding more than one-half of
the shares of stock of the corporation – determined at the time such revocation is made – consent
to the revocation. Section 1362(d)(1)(B); Treas. Reg. § 1.1362-2(a)(1). A revocation made
during the first two and one-half months of the taxable year will be effective retroactively to the
first day of such taxable year. Section 1362(d)(1)(C)(i). A revocation made after the close of the
two and one-half month period will be effective on the first day of the following taxable year.
Section 1362(d)(1)(C)(ii); Treas. Reg. § 1.1362-2(a)(2)(i).96 However, Section 1362(d)(1)(D)
96
Note that the Service has stated that it will not authorize retroactive relief for an
untimely revocation. See IRS Info. Ltr. 20020104; E.C.C. 200848050 (Jul. 22, 2008), 2008 TNT
232-19 (Nov. 28, 2008). The Tax Court agreed with the Service’s position on this issue. See
Aaron v. Comm’r, 87 T.C.M. (CCH) 1087 (2004) (“Petitioner argues that although there is no
reasonable cause exception that directly excuses the petitioners’ failure to timely revoke the
Subchapter S election of BP Concessions, there is no specific provision that directly indicates
(Continued …)
- 134 provides that a revocation may be effective on or after the date on which the revocation is made
if the revocation specifies such a date. See Treas. Reg. § 1.1362-2(a)(2)(ii). A revocation also
may be rescinded at any time prior to its effective date. See Treas. Reg. § 1.1362-2(a)(4), 6(a)(4).
Note, however, that a debtor corporation’s right to make or revoke an S election may
constitute “property” of the debtor corporation, so that a prepetition revocation of a corporation’s
S election can constitute a transfer of property that is voidable by the trustee under applicable
bankruptcy laws. See Parker v. Saunders (In re Bakersfield Westar, Inc.), 226 B.R. 227, 234 (9th
Cir. BAP 1998); see also In re Majestic Star Casino, LLC, 2012-1 USTC ¶ 50175 (Bankr. Del.
Jan. 24, 2012) (a debtor company had a property interest in its status as a QSub, such that when
the non-debtor parent S corporation revoked its S corporation status, thereby terminating
debtor’s QSub status, such revocation and resulting termination constituted an unauthorized
transfer of estate property under section 549 of the Bankruptcy Code and a violation of the
automatic stay imposed by section 362 of the Bankruptcy Code).
2.
Generating Passive Investment Income
Under Section 1362(d)(3), an S election will be terminated if two conditions exist: (i) the
S corporation has “accumulated earnings and profits” at the close of each of three consecutive
taxable years, and (ii) more than 25 percent of the “gross receipts” of the S corporation for each
of such taxable years consists of “passive investment income.” Section 1362(d)(3)(A)(i); Treas.
Reg. § 1.1362-2(c)(1). For purposes of determining the three-year period, only taxable years
beginning after December 31, 1981 in which the corporation was an S corporation are included.
Section 1362(d)(3)(A)(iii). In general, this provision was enacted to dissuade a C corporation
from investing its accumulated earnings and profits in passive investment assets and then
electing S corporation status in order to (i) distribute income from such assets without triggering
a shareholder-level tax and (ii) avoid the corporate-level personal holding company tax. See
Section IV.B.1., above.
a.
Gross Receipts
The term “gross receipts” includes the total amount received or accrued by the S
corporation under its method of accounting without reduction for cost of goods sold (i.e., basis),
returns and allowances, or other deductions. See Treas. Reg. § 1.1362-2(c)(4)(i). If (i) an S
corporation operates a business through a partnership with another corporation and (ii) the
partnership’s expenses exceed its gross receipts, the S corporation should take into account its
distributive share of the partnership’s gross receipts and not its distributive share of the
that a reasonable cause exception does not apply. . . . While we are sympathetic to petitioner’s
medical condition during 1997 and 1998, there is no provision under Section 1362(a) for a
reasonable cause exception for revocation of the S corporation election. We must apply the law
as written; it is up to Congress to address questions of fairness and to make improvements to the
law.”). Thus, a revocation made during a year but after the first two and one-half months of such
year cannot be made effective on the first day of such year.
- 135 partnership’s loss for purposes of Section 1362(d)(3). See Rev. Rul. 71-455, 1971-2 C.B. 318
(applying to Section 1375 as well); see also PLR 200309021 (same). Thus, gross receipts is not
synonymous with gross income.
(i)
Sale or Exchange of Capital Assets
General Rules: Gross receipts from the sale or exchange of capital assets (other than
“stock or securities”) are taken into account only to the extent of net capital gain income (i.e.,
basis reduces gross receipts and losses offset gains). Section 1362(d)(3)(B)(i); Treas. Reg. §
1.1362-2(c)(4)(ii)(A). Gross receipts from the sale or exchange of “stock or securities” are taken
into account only to the extent of gains (i.e., basis reduces gross receipts but losses do not offset
gains). Section 1362(d)(3)(B)(ii); Treas. Reg. § 1.1362-2(c)(4)(ii)(B).
Exception: For taxable years beginning on or before May 25, 2007, gross receipts does
not include amounts received by an S corporation that are treated under Section 331 as payments
in exchange for stock where the S corporation owns more than 50 percent of each class of stock
of the liquidating corporation. Former Section 1362(d)(3)(C)(iv). For purposes of this rule,
stock held by shareholders of the S corporation is not treated as owned by the S corporation.
Treas. Reg. § 1.1362-2(c)(4)(ii)(B)(2). This exception was removed by the Iraq Act of 2007 for
taxable years beginning after May 25, 2007. See Section 8231 of the Iraq Act of 2007.
“Stock or Securities”: “Stock or securities” includes stock, stock rights, stock warrants,
an interest in any corporation, an interest as a limited partner in a partnership, an interest in any
profit-sharing agreement, an interest in any oil, gas, or other mineral property, an interest in any
lease, collateral trust certificates, certificates of indebtedness, notes, car trust certificates, bills of
exchange, and obligations issued by or on behalf of a State, Territory, or political subdivision
thereof. Treas. Reg. § 1.1362-2(c)(4)(ii)(B)(3).
General Partner Interests: The regulations under Section 1362(d)(3) apply the
aggregate theory of partnerships to the ownership of a general partner interest in order to avoid
any inequity under Section 1362(d)(3) between owning “stock or securities” directly and owning
“stock or securities” through a partnership. If an S corporation disposes of a general partner
interest, the gain on the disposition is treated as gain from the sale of “stock or securities” to the
extent of the amount the S corporation would have received as a distributive share of gain from
the sale of “stock or securities” if all of the “stock or securities” held by the partnership had been
sold by the partnership at fair market value at the time the S corporation disposes of the general
partner interest. Treas. Reg. § 1.1362-2(c)(4)(ii)(B)(4)(i).
For this purpose, loss that would be recognized from the sale of “stock or securities” held
by the partnership is disregarded. Id. A look-through rule also applies to tiered partnerships. Id.
Finally, an S corporation may treat the disposition of a general partnership interest as the
disposition of a limited partnership interest. Treas. Reg. § 1.1362-2(c)(4)(ii)(B)(4)(ii). This rule
presumably offers relief to an S corporation from the administrative burden of calculating its
deemed distributive share of partnership gain under the general rule mentioned above.
- 136 (ii)
Exclusions and Deferrals
Gross receipts do not include amounts received in nontaxable sales or exchanges except
to the extent that gain is recognized by the S corporation. Treas. Reg. § 1.1362-2(c)(4)(iii).
Gross receipts also do not include amounts received (i) as a loan, (ii) as a repayment of a loan,
(iii) as a contribution to capital, or (iv) on the issuance by the corporation of its own stock. Id.
Since the taxpayer’s method of accounting controls when the gross receipts are included
in the Section 1362(d)(3) test, the installment method can apply to defer recognition of gross
receipts on asset sales. Treas. Reg. § 1.1362-2(c)(4)(i); see also PLR 8243169; PLR 7827009.
b.
Passive Investment Income
In general, the term “passive investment income” means “gross receipts” derived from
royalties, rents, dividends, interest, annuities, and, only for taxable years beginning on or before
May 25, 2007, sales or exchanges of “stock or securities.” Section 1362(d)(3)(C); Treas. Reg. §
1.1362-2(c)(5); Former Section 1362(d)(3)(C); Section 8231 of the Iraq Act of 2007. However,
the regulations to Section 1362(d)(3) generally exempt from the definition of passive investment
income gross receipts derived in the ordinary course of business. See Treas. Reg. §§ 1.13622(c)(5)(ii)(A)(2), (ii)(B)(2), (ii)(D)(2), (iii), 1.1362-8; see also Treas. Reg. § 1.13622(c)(5)(ii)(G). The Service has stated that determining whether income is passive investment
income is entirely independent from determining whether such income is from a passive activity
under Section 469. See PLR 200326014. The Service also has stated that amounts included in
an S corporation’s income under Section 951(a) (i.e., “subpart F income”) do not constitute
passive investment income. See CCA 201030024.
(i)
Royalties
“Royalties” means all royalties, including mineral, oil, and gas royalties, and amounts
received for the privilege of using patents, copyrights, secret processes and formulas, goodwill,
trademarks, tradebrands, franchises, and other like property. Treas. Reg. § 1.13622(c)(5)(ii)(A)(1). The gross amount of royalties is not reduced for the cost of the rights under
which the royalties spring or any amount allowable as a deduction in computing taxable income.
Id.
However, “royalties” does not include royalties derived in the ordinary course of a trade
or business of licensing property. Treas. Reg. § 1.1362-2(c)(5)(ii)(A)(2). Furthermore,
“royalties” does not include (i) copyright royalties, (ii) mineral, oil, or gas royalties if the income
from those royalties would not be treated as personal holding company income under Section
543(a)(3) and (a)(4) if the corporation were a C corporation, (iii) amounts received upon disposal
of timber, coal, or domestic iron ore with respect to which Section 631(b) and (c) apply, and (iv)
active business computer software royalties, as defined in Section 543(d) without regard to
Section 543(d)(5). Treas. Reg. § 1.1362-2(c)(5)(ii)(A)(3).
- 137 (ii)
Rents
“Rents” mean any amount received for the use of, or right to use, property (real or
personal) of the S corporation. Treas. Reg. § 1.1362-2(c)(5)(ii)(B)(1); see PLR 200326007
(ruling that an S corporation terminated its S election under Section 1362(d)(3)(A)(i) when lease
payments from its wholly owned subsidiary were not disregarded as a result of the S corporation
inadvertently failing to make a QSub election for the subsidiary). However, “rents” does not
include rents derived in the active trade or business of renting property. Treas. Reg. § 1.13622(c)(5)(ii)(B)(2). Rents are received in the active trade or business of renting property only if,
based on all the facts and circumstances, the corporation provides significant services or incurs
substantial costs in the rental business. Id.; see PLR 201125012; PLR 201119014; PLR
201118011; PLR 201025040; PLR 201005025; PLR 200326018; PLR 200025042; PLR
200024044; PLR 200020013; PLR 200018042; PLR 200016011; PLR 200014011; PLR
200014031; 200007022; PLR 9420014; PLR 9419029; 9418005; PLR 9417021; PLR 9411034
(S corporation’s distributive share of gross receipts attributable to a partnership’s activities will
not constitute passive investment income where the partnership provides significant services).
“Rents” does not include produced film rents, as defined in Section 543(a)(5). Treas.
Reg. § 1.1362-2(c)(5)(ii)(B)(3). Furthermore, “rents” does not include compensation for the use
of, or right to use, any real or tangible personal property developed, manufactured, or produced
by the taxpayer if, during the taxable year, the taxpayer is engaged in substantial development,
manufacturing, or production of real or tangible personal property of the same type. Treas. Reg.
§ 1.1362-2(c)(5)(ii)(B)(4).
(iii)
Dividends
(a)
In General
Dividends constitute passive investment income if (i) they meet the definition of
dividends under Section 316, (ii) they are amounts to be included in gross income under Section
551 (i.e., foreign personal holding company income), or (iii) they constitute consent dividends
under Section 565. Treas. Reg. § 1.1362-2(c)(5)(ii)(C).
(b)
Dividends from Affiliated Subsidiaries
In General: Pursuant to the Small Business Act of 1996, if an S corporation holds stock
in a C corporation meeting the requirements of Section 1504(a)(2) (generally, 80 percent of the
value and voting power of the C corporation stock), passive investment income will not include
dividends from the C corporation to the extent such dividends are attributable to the earnings and
profits of the C corporation derived from the active conduct of a trade or business. Section
1362(d)(3)(C).97 The Small Business Act of 1996 did not expressly require that such trade or
97
See CCA 201030024 (concluding that foreign corporations -- such as controlled
foreign corporations owned by an S corporation -- may constitute “C corporations” for purposes
of the rules under Section 1362(d)(3)(C)).
- 138 business be conducted by the C corporation and did not provide guidance on determining the
attribution of dividends to an active trade or business.
However, the Service addressed these issues in regulations. Treas. Reg. § 1.1362-8(a).98
Active earnings and profits of a C corporation subsidiary are the earnings and profits of the
corporation derived from activities that would not produce passive investment income under
Section 1362(d)(3) if the C Corporation were an S corporation. Id. The S corporation may use
any reasonable method to determine the amount of dividends that are not treated as passive
investment income under Section 1362(d)(3). Treas. Reg. § 1.1362-8(b)(1).
Safe Harbors: Regulations also provide safe harbors for determining the amount of
active earnings and profits. First, a corporation may treat its earnings and profits for a year as
active earnings and profits in the same proportion as the corporation’s gross receipts derived
from activities that would not produce passive investment income (if the C corporation were an S
corporation) bear to the corporation’s total gross receipts for the year in which the earnings and
profits are produced. Treas. Reg. § 1.1362-8(b)(1), (5). Second, if less than 10 percent of the C
corporation’s earnings and profits for a taxable year are derived from activities that would
produce passive investment income, all earnings and profits produced by that C corporation
during the taxable year are considered active earnings and profits. Treas. Reg. § 1.1362-8(b)(3).
Nonconsolidated Lower Tier Subsidiaries: If a C corporation subsidiary (“upper tier
corporation”) holds stock in another C corporation (“lower tier subsidiary”) meeting the Section
1504(a)(2) control test, the upper tier corporation’s gross receipts attributable to a dividend from
the lower tier subsidiary are considered to be derived from the active conduct of a trade or
business to the extent the lower tier subsidiary’s earnings and profits are attributable to the active
conduct of a trade or business by the subsidiary. Treas. Reg. § 1.1362-8(b)(2). See CCA
201030024 (concluding that a deemed dividend under Section 1248 from a controlled foreign
corporation due to a Section 1248 income inclusion and a deemed dividend under Section 78
from deemed foreign tax credits being claimed under Section 902 with respect to such Section
1248 deemed dividend constitute dividends from a lower-tier subsidiary for purposes of Treas.
Reg. § 1.1362-8(b)(2)). However, this rule does not apply to any member of a consolidated
group. Treas. Reg. § 1.1362-8(b)(2).
Consolidated Subsidiaries: For purposes of applying Section 1362(d)(3) to dividends
received by an S corporation from the common parent of a consolidated group, (i) the current
earnings and profits, accumulated earnings and profits, and active earnings and profits of the
common parent are determined under the principles of Treas. Reg. § 1.1502-33 (tiering up
earnings and profits within consolidated groups), and (ii) the gross receipts of the common
98
Treas. Reg. § 1.1362-8 applies to dividends received in taxable years beginning on or
after January 20, 2000. Treas. Reg. § 1.1362-8(e). However, taxpayers may elect to apply the
regulations in whole, but not in part, for taxable years beginning on or after January 1, 2000,
provided all “affected taxpayers” apply the regulations in a consistent manner. Id. “Affected
taxpayers” means all taxpayers whose returns are affected by the election to apply the
regulations. Id.
- 139 parent is the sum of the gross receipts of each member of the consolidated group (including the
common parent), adjusted to eliminate gross receipts from intercompany transactions, described
in Treas. Reg. § 1.1502-13. Treas. Reg. § 1.1362-8(c)(4).
Thus, it appears that dividends from a parent of a consolidated group could be excluded
from the definition of passive investment income if the parent had earnings and profits due to the
earnings and profits of a subsidiary member that were derived from the subsidiary’s active
conduct of a trade or business. See Treas. Reg. § 1.1362-8(c)(4)(i); Treas. Reg. § 1.1502-33(b).
Allocating Distributions to Active or Passive Earnings and Profits: Dividends from
current earnings and profits are attributable to active earnings and profits in the same proportion
as current active earnings and profits bear to total current earnings and profits. Treas. Reg. §
1.1362-8(c)(1). Dividends from accumulated earnings and profits for a taxable year are
attributable to active earnings and profits in the same proportion as accumulated active earnings
and profits for that taxable year bear to total accumulated earnings and profits for that taxable
year immediately prior to the distribution. Treas. Reg. § 1.1362-8(c)(2).
(iv)
Interest
“Interest” means any amount received for the use of money (including tax-exempt
interest and amounts treated as interest under Sections 483, 1272, 1274, or 7872). Treas. Reg. §
1.1362-2(c)(5)(ii)(D). However, “interest” does not include interest on any obligation acquired
from the sale of dealer property or the performance of services in the ordinary course of a trade
or business of selling such property or performing such services. Id.
(v)
Annuities
“Annuities” means the entire amount received as an annuity under an annuity,
endowment, or life insurance contract, but only if any part of the amount would be includible in
gross income under Section 72. Treas. Reg. § 1.1362-2(c)(5)(ii)(E).
(vi)
Sale of “Stock or Securities”
Only with respect to taxable years beginning on or before May 25, 2007, gross receipts
from the sale or exchange of “stock or securities” (as determined in Treas. Reg. § 1.13622(c)(4)(ii)(B)) are passive investment income to the extent of gains therefrom. Treas. Reg. §
1.1362-2(c)(5)(ii)(F); see Section 8231 of the Iraq Act of 2007.
(vii)
Special Rules for Dealers and Patrons
Notwithstanding the above rules regarding the definition of passive investment income,
passive investment income does not include gross receipts directly derived in the ordinary course
of a trade or business of (i) lending or financing, (ii) dealing in property, (iii) purchasing or
discounting accounts receivable, notes, or installment obligations, or (iv) servicing mortgages.
Treas. Reg. § 1.1362-2(c)(5)(iii). The regulations under Section 1362(d)(3) provide special rules
for options dealers, commodities dealers, and patrons of cooperatives as well. Id. However, note
that, for taxable years beginning after May 25, 2007, the Iraq Act of 2007 eliminated the special
- 140 statutory rules for options dealers and commodities dealers in former Section 1362(d)(3)(D). See
Section 8231 of the Iraq Act of 2007.
(viii) Special Rules for Certain Banks
The 2004 JOBS Act added Section 1362(d)(3)(F) to provide that passive investment
income does not include interest income earned by, and certain dividends derived from, assets
required to be held by (i) a bank described in Section 581, (ii) a bank holding company within
the meaning of section 2(a) of the Bank Holding Company Act of 1956 (12 U.S.C. § 1841(a)), or
(iii) a financial holding company within the meaning of section 2(p) of such Act. Section 237(a),
P.L. 108-357. This provision is effective for taxable years beginning after December 31, 2004.
Section 237(b), P.L. 108-357.
The GO-Zone Act later broadened Section 1362(d)(3)(F) so that it would apply to: (i) a
bank described in Section 581, or (ii) a depository institution holding company within the
meaning of Section 3(w)(1) of the Federal Deposit Insurance Act, which includes a bank holding
company and a savings and loan holding company. Section 413(b), P.L. 109-135. The GO-Zone
Act amendment applies as if it were included originally in the enactment of Section
1362(d)(3)(F) in the 2004 JOBS Act. Section 413(d), P.L. 109-135.
The Iraq Act of 2007 merely redesignated these rules to Section 1362(d)(3)(C)(v). See
Section 8231 of the Iraq Act of 2007.
c.
Accumulated Earnings and Profits
An S corporation will not generate earnings and profits while it is an S corporation.
Section 1371(c)(1). However, an S corporation may have accumulated earnings and profits (i.e.,
“subchapter C earnings and profits”) for the following reasons. See Treas. Reg. § 1.13622(c)(3).

An S corporation may have earnings and profits due to its prior status as a
C corporation.

Prior to the Small Business Act of 1996, an S corporation may have had
earnings and profits from pre-1983 subchapter S years. The Small
Business Act of 1996 provided, however, that if a corporation is an S
corporation for its first taxable year beginning after December 31, 1995,
the accumulated earnings and profits as of the beginning of that year are
reduced by the accumulated earnings and profits (if any) accumulated in
any taxable year beginning before January 1, 1983, for which the
corporation was an electing small business corporation under subchapter S
of the Code.

An S corporation may inherit earnings and profits of a C corporation or a
former C corporation as a result of an acquisition described in Section
381.
- 141 
The S corporation may have had earnings and profits allocated to it under
Section 312(h) (i.e., a Section 355 transaction).
Also, the subchapter C earnings and profits are modified under Section 1371(c) (e.g., for
dividend distributions and Section 355 divisions). Treas. Reg. § 1.1362-2(c)(3).
d.
Effective Date of Termination for Passive Income
A termination due to prolonged passive investment income is effective on the first day of
the first taxable year beginning after the close of the consecutive three-year period. Section
1362(d)(3)(A)(ii); Treas. Reg. § 1.1362-2(c)(2).
e.
Planning To Avoid Termination for Passive Income
Most of the techniques discussed in Section IV.B.6. above in connection with the
application of Section 1375, which imposes a corporate-level tax on excess net passive income,
also may be used to prevent an S corporation from terminating its S election due to excess
passive investment income. However, Section 1362(d)(3) does not contain a taxable income
limit like the limit contained in Section 1375 for excess net passive income. Thus, increasing
compensation expenses does not appear to be a viable technique to prevent termination under
Section 1362(d)(3).
Unlike the Section 1375 tax, Section 1362(d)(3) will apply only if an S corporation has
excess passive income and earnings and profits in three consecutive years. Thus, an S
corporation need only fail the 25 percent of gross receipts test once or fail the earnings and
profits test once in each three-year period to avoid termination under Section 1362(d)(3).
3.
By Ceasing To Be a Small Business Corporation
An S election will also terminate if the corporation ceases to be a small business
corporation at any time on or after the first day of the first taxable year in which the S election
took effect. Section 1362(d)(2)(A); Treas. Reg. § 1.1362-2(b)(1). Termination of S corporation
status for this reason is effective as of the date on which the event occurs. Section
1362(d)(2)(B); Treas. Reg. § 1.1362-2(b)(2). In contrast, a revocation may be effective
retroactively to the beginning of the year (if made within the first two and one-half months) or
prospectively if the shareholders specify a future date. Section 1362(d)(1)(C), (D).
The Service has taken the position that where a transfer of stock of an S corporation
terminated the S election but a court subsequently determined that the stock transfer was void ab
initio, the S election did not terminate. PLR 9409023. Similarly, the Service has taken the
position that a corporation’s S election is not terminated for violating the second class of stock or
ineligible shareholder requirements where: (i) the relevant parties execute a rescission
agreement that disregards the issuance of convertible preferred stock to several partnerships, and
(ii) such agreement is executed in the same year as the issuance of the stock. PLR 200533002;
see also Rev. Rul. 80-58, 1988-1 C.B. 181.
- 142 B.
What Is Not a Termination
Mergers and Combinations: A termination under Section 1362(d) should not occur
where the S election terminates simultaneously with the corporation’s existence. In Rev. Rul.
64-94, 1964-1 C.B. 317, the Service ruled that a merger of an S corporation into another
corporation did not terminate the S corporation’s election for its final year. See also Rev. Rul.
70-232, 1970-1 C.B. 178 (involving a combination of S corporations). The Service’s apparent
reasoning is that, under Section 381(b)(1), the target S corporation’s year ends with the date of
the merger. As to this final year, no termination occurred; during each day of such year, the
corporation was an S corporation.
The favorable result is that S corporations may be acquired in statutory mergers (or
combinations) without hindering the acquiring corporation’s (or new corporation’s) ability to
make an S election. That is, the Section 1362(g) five-year prohibition on making an S election
after a termination would not apply since a termination has not occurred. Also, in such cases, the
final taxable year of the S corporation would not constitute an S termination year. Thus, the
usual allocation rules of Section 1377(a) should apply.
Liquidations: The principles of Rev. Rul. 64-94 and Rev. Rul. 70-232 should also apply
to the liquidation of an S corporation to which Sections 331 and 336 apply, because the
liquidating S corporation’s taxable year apparently ends when its corporate existence ceases on
liquidation. See Sections 441(b)(3), 443(a)(2). Thus, a liquidation of an S corporation to which
Sections 331 and 336 apply should not terminate the S corporation’s S election, although its
corporate existence will cease.
Note that Section 1362(d)(2) effectively prohibits an S corporation and its shareholders
from qualifying for tax-free treatment in a liquidation to which Sections 332 and 337 apply
because such tax-free treatment can apply only if the S corporation has a corporate shareholder
that meets the control requirement described in Section 1504(a)(2). The existence of a corporate
shareholder would terminate the S corporation’s S election because the corporation would cease
to meet the definition of a “small business corporation.” See Section 1362(d)(2).
Failure To Use Permitted Year: As mentioned above in Section II.A.6.d.(ii), the failure
to report taxable income pursuant to a permitted year is not one of the specific circumstances for
S election termination under Section 1362(d). Thus, it appears that the failure of an S
corporation to report taxable income pursuant to a permitted year will not constitute a
termination event.
Filing for Bankruptcy: Section 1399 provides that, except for individual debtors, no
separate taxable entity shall result from the commencement of a bankruptcy case under title 11 of
the United States Code (which includes chapters 7 and 11 of the U.S. Bankruptcy Code). Thus,
if an S corporation debtor files a petition (i) for liquidation pursuant to chapter 7 of the U.S.
Bankruptcy Code or (ii) for reorganization pursuant to chapter 11 of the U.S. Bankruptcy Code,
the S corporation debtor does not cease being described as a small business corporation under
Section 1361(b). Furthermore, the filing of either of such petitions does not (i) constitute a
revocation of the S election or (ii) trigger the termination provision for excess passive investment
income. Thus, the filing of either of such petitions does not terminate the S corporation debtor’s
- 143 S election. See Mourad v. Comm’r, 121 T.C. 1 (2003) (holding that the filing by an S
corporation debtor of a petition for reorganization pursuant to chapter 11 of the U.S. Bankruptcy
Code does not cause the S corporation debtor to cease being a small business corporation or
otherwise to terminate its S election); In re Stadler Associates, Inc., 186 B.R. 762 (Bankr. S.D.
Fla. 1995) (same for chapter 7 petitions). Accordingly, the shareholders of the S corporation
debtor continue to take their pro rata share of the S corporation debtor’s items into account
during bankruptcy. See Mourad v. Comm’r, 121 T.C. 1 (“The tax treatment of the S corporation
is the same whether or not the entity filed for bankruptcy.”).99
C.
Inadvertent Terminations
If certain conditions are met, a corporation may continue as an S corporation despite the
occurrence of a terminating event. Section 1362(f) provides that a corporation will continue as
an S corporation “during the period specified by the Secretary” if:

the election was not terminated by revocation;

the Secretary determines that the termination was inadvertent;

no later than a “reasonable period of time” after discovery of the
terminating event, steps were taken to requalify the corporation as a small
business corporation; and

the corporation and each shareholder during the non-S-status period agree
to make the adjustments specified by the Secretary.
See Treas. Reg. § 1.1362-4; Rev. Proc. 2003-43; PLR 9301016; PLR 9253016.
For recent examples of situations where the Service granted relief under the inadvertent
termination provision, see PLR 201201005, PLR 201211005, PLR 200326007, PLR 200028026,
PLR 200027032, PLR 200026017, PLR 200024020, PLR 199913025, PLR 9821013, PLR
9818062, PLR 9723020, PLR 9634023, PLR 9634018, PLR 9420005, PLR 9419013, PLR
9417025, PLR 9417022, PLR 9417017, PLR 9416014, PLR 9416010, and PLR 9413037. In
addition, the Service has ruled that where an S corporation became aware that its state corporate
charter was revoked, and it reincorporated in the state in the following month, the corporation’s
status as a small business corporation was not terminated by reason of the revocation of the
charter provided that the corporation qualified as a small business corporation prior to the
revocation of the charter. See PLR 200123058; PLR 9411040; PLR 9231050.
99
Note that the filing of a bankruptcy petition (pursuant to either chapter 7 or chapter 11
of the U.S. Bankruptcy Code) by an individual who is a shareholder of an S corporation does not
terminate the S corporation’s S election because a bankruptcy estate of an individual is an
eligible shareholder of an S corporation under Section 1361(b)(1)(B). See also Treas. Reg. §
1.1361-1(b)(2).
- 144 Note that the failure to file timely QSST or ESBT elections may terminate a corporation’s
S election for having an ineligible trust shareholder under Section 1362(d)(2). See, e.g., PLR
200326028; PLR 200323042. Section 1362(f) or Rev. Proc. 2003-43 could provide relief in
these circumstances if the corporation and the trust can demonstrate that the failure to file a
timely QSST or ESBT election was inadvertent.
Section 1362(f) may become important upon subsequent audit or later discovery of facts
which jeopardize the S election, but should not be affirmatively relied upon as a planning tool.
2004 JOBS Act Amendments: The 2004 JOBS Act expanded the scope of Section
1362(f) to include QSub elections and terminations. Sections 231(b), 238(a), P.L. 108-357. The
amendments provide the Service with authority to provide relief for inadvertent invalid elections
and inadvertent terminations. Section 1362(f). These amendments are effective for taxable
years beginning after December 31, 2004. Sections 231(b), 238(a), P.L. 108-357; see also Treas.
Reg. § 1.1362-4 (incorporating the rules of amended Section 1362(f)).
D.
Treatment of S Termination Years
1.
Definition
An “S termination year” means any taxable year in which a termination first takes effect
(other than where it takes effect on the first day of the year). Section 1362(e)(4). A revocation
should not result in an S termination year, unless a prospective effective date (other than the first
day of a future year) is selected by the shareholders. Terminations resulting from excess passive
investment income under Section 1362(d)(3) also should not give rise to an S termination year
because such terminations are effective on the first day of the first year following the close of the
relevant three-year period. Section 1362(d)(3)(A)(ii). Thus, it appears that S termination years
will arise primarily when an S corporation ceases to be a “small business corporation” under
Section 1362(d)(2).
2.
Effect
In General: Under Section 1362(e)(1), an S termination year is broken into two separate
taxable years. The portion of the year ending before the first day on which the termination is
effective is treated as a short taxable year in which the corporation is an S corporation (i.e., an S
short year). The portion of the year beginning on the day on which the termination is effective is
treated as a short taxable year in which the corporation is a C corporation (i.e., a C short year).
However, for carryover purposes, the S short year and the C short year are treated as one taxable
year. See Section 1362(e)(6)(A).
For example, an individual (“A”) owns all of the stock of an S corporation. The S
corporation uses a calendar year. On July 1, 1999, A sells 10 shares of his stock to his wholly
owned corporation, thus terminating the S election. Under Section 1362(e)(1), the period from
January 1, 1999 through June 30, 1999 is treated as an S short year. The period from July 1,
1999 through December 31, 1999 is treated as a C short year.
- 145 Allocation Methods: Under Section 1362(e), income (loss) items of an S corporation
arising in the short taxable years mentioned above may be allocated in a pro rata fashion or in a
closing of the books fashion. For a detailed discussion of these allocation rules, see Section
III.A.4.c. above.
Timing of the Allocations: Regardless of the allocation method used, it is unclear
whether the income (loss) items of the S corporation pass through to the shareholders under
Section 1366(a) at the close of the S termination year (e.g., for stock basis adjustment purposes).
Although the statute is silent on this specific point, it would seem that income (loss) items pass
through at the end of the S termination year since the income (loss) items for the entire S
termination year must be allocated to the S short year and the C short year. See Section
1362(e)(2)(A). Such an allocation is not possible until the close of the S termination year.
Even where the shareholders elect to close the books, the S short year return is not due
until the C short year return must be filed. See Section 1362(e)(6)(B). However, one can also
argue that income (loss) items should pass through at the close of the S short year on the theory
that the S corporation should be treated the same as a partnership. Cf. Section 706(c).
The regulations provide that a shareholder must include in taxable income the
shareholder’s pro rata share of items for the S short year for the taxable year with or within
which the S termination year ends. See Treas. Reg. § 1.1362-3(c)(6).
E.
Post-Termination Distributions
Section 1371(e)(1) accords special treatment to certain distributions made by a
corporation after it ceases to be an S corporation. Section 1371(e)(1) states that distributions of
money by a corporation during the post-termination transition period (“PTTP”) are to be applied
against and reduce the basis of the recipient shareholder’s stock to the extent of the allocable
AAA. In effect, the shareholder may receive cash in a tax-free distribution to the extent of his
adjusted stock basis, or the allocable AAA, whichever is less. See FSA 200207015.
Section 1371(e)(1) only applies to distributions of money, not property. Furthermore, the
distribution must be made during the PTTP. Section 1371(e)(1). The PTTP generally is either:

the period beginning on the day after the last day of the corporation’s last
taxable year as an S corporation and ending on the later of (1) the day
which is one year after the beginning date or (2) the due date for filing the
last S corporation return (including extensions);

the 120-day period beginning on the date of a “determination” that the
corporation’s S election had terminated for a previous taxable year; or

the 120-day period beginning on the date of any “determination” pursuant
to an audit of the taxpayer which follows the termination of the
corporation’s S election and which adjusts a subchapter S item arising
during the corporation’s most recent existence as an S corporation.
- 146 Section 1377(b). “Determination” means any determination in Section 1313(a) or an agreement
between the corporation and the Secretary that the corporation failed to qualify as an S
corporation. Id.100
Section 1371(e) applies to distributions “[w]ith respect to the stock” of a corporation.
Accordingly, distributions under both Sections 301 and 302 may be covered.
Section 1371(e) applies only to the extent of AAA. Section 1371(e)(1) does not specify
what happens if the distribution exceeds the shareholder’s basis, but does not exceed the AAA.
Presumably capital gain treatment would be available. If the distribution exceeds the AAA,
presumably the usual rules of subchapter C of the Code would apply to the excess distribution.
An election may be made to forego Section 1371(e)(1) treatment for all distributions
made during the PTTP. Section 1371(e)(2). In such a case, the usual rules of subchapter C of
the Code would apply.
Comment: It appears that this special distribution rule will apply only when the
succeeding corporation (i.e., the same corporation but without an S election or a different
corporation that acquires the S corporation’s assets) inherits the S corporation’s AAA (i.e.,
Section 1371(e) should not apply when an S corporation merges into a C corporation in a taxable
transaction because Section 381 will not cause the carryover of the AAA). Cf. Treas. Reg. §
1.1377-2(b) (providing also that a tax-free transfer of assets from one S corporation to another S
corporation will not trigger Section 1371(e)(1) either).
Note: Unlike the definition of an S termination year in Section 1362(e), the definition of
the PTTP is not keyed to the occurrence of a termination of the S election. The definition is
keyed to the day after the last day of the last taxable year as an S corporation.
VI.
SUMMARY OF OTHER RELEVANT PROVISIONS
This Section contains a brief description of some of the various Code provisions (in
addition to the provisions mentioned above) that could apply to an S corporation or its
shareholders.
100
Prior to the Small Business Act of 1996, the definitions for the PTTP and a
“determination” were not as broad as under current law. See section 1307 of the Small Business
Act of 1996. The expansion of these definitions to their current law forms is effective for tax
years beginning after December 31, 1996. Section 1601(d) of the TRA of 1997 clarifies that the
effective date for the expansion of these definitions is for determinations after December 31,
1996, not for determinations with respect to taxable years beginning after that date. The TRA of
1997 further specifies that in no event will the expanded PTTP period end before the end of the
120-day period beginning after August 5, 1997.
- 147 A.
Investment Interest Deduction Limitation – Section 163(d)
General Rule: Noncorporate taxpayers may not deduct investment interest paid or
accrued during the taxable year in excess of net investment income for the taxable year. Section
163(d)(1). Any excess carries over to the succeeding taxable year. Section 163(d)(2).
Definitions: Investment interest is any interest otherwise allowable as a deduction for
the taxable year which is paid or accrued on indebtedness “properly allocable to” property held
for investment (other than qualified residence interest and interest taken into account for purpose
of the passive loss limitation). See Section 163(d)(3); see also Treas. Reg. § 1.163-8T(b)(3), (6).
Net investment income is the excess of investment income over investment expenses. Section
163(d)(4)(A). Investment income does not include net capital gain attributable to the disposition
of the investment property, except to the extent the taxpayer elects to have such gain taxed as
ordinary income. See Section 163(d)(4)(B)(iii).101 Investment expenses means deductions, other
than for interest, that are directly connected with the production of investment income. Section
163(d)(4)(C). However, investment income and investment expenses do not include any income
or expenses taken into account under Section 469 in computing income or loss from a passive
activity. Section 163(d)(4)(D).
B.
Acquisitions to Avoid Tax – Section 269
General Rules: If a “person,” including a trust, estate, company, partnership, or
corporation, acquires 50 percent or more of the stock (by voting power or value) of a
corporation, and the principal purpose for such acquisition was to evade or avoid federal income
tax by securing the benefit of an allowance not otherwise available, then the Secretary may
disallow or reallocate, wholly or partially, such allowance. Furthermore, if any corporation
acquires property of another corporation, not controlled immediately before such acquisition by
such acquiring corporation or its stockholders, in a carryover basis transaction, and the principle
purpose for such acquisition was to evade or avoid federal income tax by securing the benefit of
an allowance not otherwise available, then the Secretary may disallow or reallocate, wholly or
partially, such allowance. Section 269 will apply to a transaction where giving effect to the form
of the transaction would distort the tax liability of the taxpayer in light of Congress’s original
purpose for the particular allowance. Treas. Reg. § 1.269-2(b).
Section 269 does not apply to disallow any deduction, credit, or other allowance resulting
from a corporation making an S election, because enjoyment of these allowances by shareholders
of S corporations is consistent with the intent of Congress to allow shareholders of S
corporations to be taxed directly on the corporation’s earnings and to report corporate income as
their own for tax purposes. Rev. Rul. 76-363, 1976-2 C.B. 90.
101
Any dividend income that otherwise qualifies as net capital gain income under Section
1(h)(11) nonetheless will not qualify if it is taken into account as investment income under
Section 163(d)(4)(B). See Section 1(h)(11)(D) (added by the Jobs and Growth Act of 2003).
- 148 Definitions: An “allowance” is anything in the federal tax law which has the effect of
diminishing tax liability. Treas. Reg. § 1.269-1(a). A purpose is “the principal purpose” if it
exceeds in importance any other purpose. Treas. Reg. § 1.269-3(a).
C.
Limitation on the Use of the Cash Method of Accounting – Section 448
C corporations, partnerships with C corporation partners, and “tax shelters” (as defined in
Section 461(i)(3)) may not use the cash method of accounting. Exceptions are made for:
(i) small businesses (i.e., businesses which meet a $5 million gross receipts test), (ii) certain
personal service corporations, and (iii) certain farming businesses. S corporations do not fall
within the purview of Section 448 unless they meet the definition of a “tax shelter.” See Section
448(d)(3).
D.
Reduction of Paperwork Burden on Certain S Corporations
Beginning with the 2002 tax year, the Service will not require S corporations with less
than $250,000 of gross receipts and less than $250,000 in assets to complete Schedules L and M1 of Form 1120S, U.S. Income Tax Return for an S Corporation. See IRS News Release IR2002-48. This reporting exemption will permit a small S corporation to prepare its income tax
return by using its cash receipts and disbursements journal instead of additional accounting
methods maintained solely for tax reporting. See id.
VII.
COMPARISON OF S CORPORATIONS WITH OTHER ENTITIES AS
ACQUISITION VEHICLES
S corporations have advantages and disadvantages that may encourage or discourage
their use as an acquisition vehicle. In many cases, the choice of entity will depend on the
individual preferences of each taxpayer and his advisor. Some, but not all, of these advantages
are outlined below.
A.
Factors That Encourage the Use of S Corporations
1.
Repeal of the “General Utilities” Doctrine
Perhaps the most significant change to arise from the TRA of 1986 was the complete
repeal of the General Utilities doctrine. As a result, the appreciation in C corporation assets
generally is subject to two levels of tax upon distribution – a corporate-level tax on the built-in
gain in the assets and then a shareholder-level tax on the distribution. In contrast, the
appreciation in S corporation assets generally is subject to one level of tax upon distribution (i.e.,
built-in gain is recognized at the corporate level but taken into account at the shareholder level).
Thus, the repeal of the General Utilities doctrine encourages the use of S corporations over C
corporations.
The Jobs and Growth Act of 2003 reduces the shareholder-level tax applicable to C
corporation earnings that are distributed in the form of dividends. However, the Jobs and
Growth Act of 2003 does not affect the current system of taxing the appreciation in C
- 149 corporation assets twice on a nondividend distribution (i.e., once at the corporate level and once
at the shareholder level).
2.
Noncorporate Rate Compared to the Corporate Rate
Generally, the earnings (ordinary income and capital gains income) of an S corporation
are taxed at the rates applicable to individuals. In contrast, the earnings of a C corporation
(ordinary income and capital gains income) are taxed at the rates applicable to corporations.
Thus, the decision to elect S corporation status, in part, should depend on the present (and
projected future) differences between the noncorporate tax rates and the corporate tax rates.
a.
Ordinary Income Rates
The Jobs and Growth Act of 2003 eliminates the spread between the top noncorporate
rate (38.6 percent in 2002) applicable to ordinary income and the corporate rate (35 percent)
applicable to ordinary income starting in 2003. See Section 1(i)(2) (as amended by the Jobs and
Growth Act of 2003). The elimination of this spread should encourage the use of S corporations
over C corporations.
b.
Capital Gains Rates
The net capital gain of a corporation is taxed at the same rate as ordinary income of a
corporation, and is subject to tax at graduated rates up to 35 percent. Section 1201(a). In
contrast, the maximum capital gains tax rate applicable to individual investors generally is 15
percent for investments held for one year or longer. Section 1(h) (as amended by the Jobs and
Growth Act of 2003 and the Tax Increase Prevention and Reconciliation Act of 2005). Gain
from the sale of collectibles and certain small business stocks is taxed at a 28 percent rate, and a
certain portion of gain from the sale of real estate attributable to straight-line depreciation is
taxed at a 25 percent rate. Id.102 Thus, the spread between the corporate and noncorporate
capital gains rates also should encourage the use of S corporations over C corporations.
c.
Reduction of the Double Tax on C Corporation Earnings
The Jobs and Growth Act of 2003 reduces the shareholder-level tax applicable to
distributions of C corporation earnings that are treated as dividends. In general, dividend
distributions are treated as net capital gain to the recipient shareholder, which results in taxing
the dividend income at a 15 percent rate rather than the top ordinary income tax rate of 35
percent. See Section 1(h)(11) (added by the Jobs and Growth Act of 2003 and extended by the
Tax Increase Prevention and Reconciliation Act of 2005). As a result, this reduces one of the
traditional differences between the taxation of C corporation earnings and S corporation earnings
102
Special rules and tax rates may apply to the portion of the capital gain recognized on
the sale or exchange of stock in an S corporation allocable to certain collectibles owned by the S
corporation or deemed owned by the S corporation under a special tiered-entity rule. See Treas.
Reg. § 1.1(h)-1(a), -1(f) ex. 4.
- 150 (i.e., two levels of tax versus one level of tax) and should reduce (but not eliminate) the benefits
of using an S corporation rather than a C corporation.
3.
Former C Corporations Taxed on Built-In Gain
To protect the revenue expected from the repeal of the General Utilities doctrine, the
TRA of 1986 limited the ability of C corporations to elect S corporation status for the purpose of
avoiding the corporate-level tax on the disposition of their appreciated property. See Section
1374; Section IV.A., above. However, this limitation generally does not apply to corporations
that have always been S corporations. Thus, newly-formed corporations may pay a price under
Section 1374 if they operate as C corporations, even if only for a short period of time.
4.
The Alternative Minimum Tax
In General: While the reach of the AMT has been significantly expanded with respect
to both individuals and C corporations, C corporations are saddled with a greater portion of the
increased burden. For example, the adjusted current earnings (“ACE”) adjustment is imposed
only on C corporations, not on partnerships or S corporations. Furthermore, similar to the
regular tax, C corporation earnings potentially are subject to the AMT at the corporate level and
at the shareholder level. In contrast, S corporation earnings are subject to the AMT only at the
shareholder level. See Section 1363(a). Thus, these factors encourage the use of S corporations
over C corporations.
Unanswered Issues: Although S corporations are not subject to the corporate AMT, S
corporation shareholders are subject to the individual AMT. Several issues remain unanswered
regarding the proper calculation of an S corporation shareholder’s individual AMT liability. For
example, should an S corporation shareholder maintain separate AMT stock and debt bases, and
should an S corporation maintain a separate AMT accumulated adjustments account and a
separate AMT accumulated earning and profits account?
Current authority appears to support the conclusion that shareholders and S corporations
should maintain separate bases and accounts, respectively. See Staff of J. Comm. on Taxation,
General Explanation of the Tax Reform Act of 1986 438 (Comm. Print 1987) (explaining that
Congress intended that the AMT operate separate from, yet parallel to, the regular tax system);
see also Section 59(h); Treas. Reg. § 1.55-1; T.D. 8569, 1994-2 C.B. 13; cf. Prop. Treas. Reg. §
1.1502-55(g) (Dec. 30, 1992) (requiring each member of an affiliated group of corporations
filing a consolidated return to maintain separate AMT bases in the stock of other group
members); Explanation of Provisions, 57 Fed. Reg. 62,251, 62,251, 62,253 (Dec. 30, 1992)
(“The Service believes that Congress generally intended the AMT...to be separate from, and
parallel to, the regular tax system.”); TAM 9722005 (Feb. 5, 1997) (alternative minimum taxable
income should be determined by following the same steps as those followed in computing
regular taxable income, but applying the Code as though it had been modified to be consistent
with the rules contained in Section 56 through Section 59). But cf. Allen v. Comm’r, 118 T.C. 1
(2002) (interpreting the separate, yet parallel, concept of the AMT to require an individual to
calculate alternative minimum taxable income by computing taxable income under the regular
tax system and then altering that amount to reflect items in Section 56 through Section 59). See
generally Mark J. Silverman et al., Solutions for Issues Regarding S Corporations and Their
- 151 Shareholders Include Congressional Action, Revised Guidance From Treasury, 145 Daily Tax
Report J-1 (July 29, 2002).
B.
Types of Pass-Through Entities
In addition to S corporations and partnerships (including multiple-member LLCs), the
Code explicitly recognizes other types of pass-through entities.
Actual Pass-Through Entities: These pass-through entities include such special
purpose pass-through entities as trusts, estates, regulated investment companies (“RICs”), real
estate investment trusts (“REITs”), real estate mortgage investment conduits (“REMICs”),
financial asset securitization investment trusts (“FASITs”),103 and cooperatives.
Special purpose pass-through entities are designed to serve specific investment functions.
Most of these entities are allowed to deduct distributions (or deemed distributions) of income.
Such deductions help ensure that only one level of tax is paid on income generated within such
entities. Losses generally do not pass-through. Because of certain restrictions placed upon such
entities, these special purpose pass-through entities generally appear ill-suited to the conduct of
many active trades or businesses and, therefore, for use as acquisition vehicles.
Practical Pass-Through Entities: The Code also provides – though not expressly – for
the existence of what may be thought of as “practical” pass-through entities. These entities are C
corporations that shelter essentially all of their income (i.e., sheltered C corporations).
One example of a sheltered C corporation would be a personal service C corporation that
pays most of its income to its owner-employees as reasonable compensation. Since such
compensation is deductible, this type of corporation would pay little or no corporate level tax.
Instead, all the corporation’s income is taxed to its shareholder-employees.
A second example is a C corporation that has substituted a large portion of debt for equity
in its capital structure. Leveraging as a means of integrating the corporate and shareholder levels
of tax (i.e., the “practical” pass-through effect) may offer the greatest flexibility for many C
corporations.104 Leveraging can arise from actual cash borrowings. For example, a corporation
can engage in a leveraged buy-out: the borrowed money is used to acquire a target business, the
interest due on the debt shelters income used to pay the debt. Alternatively, the corporation can
engage in a leveraged recapitalization: the borrowed money is used to cash-out shareholders.
Furthermore, leveraging effects can also be created without cash borrowing. For example, a
corporation can distribute its own debt obligations to its shareholders.
103
Except with respect to certain FASITs existing on October 22, 2004, Congress
repealed the FASIT rules in the 2004 JOBS Act. See section 835, P.L. 108-357.
104
Note, however, that the deductibility of interest generated from leveraging may be
limited in certain circumstances. See, e.g., Section 163(j).
- 152 While sheltering corporate income from double tax has long been the goal of the owners
of closely held C corporations, the benefits of such shelter for larger corporations are now
sufficiently great to warrant rethinking the role of the sheltered C corporation.
C.
Advantages of S Corporations
S corporations offer many of the advantages of partnerships, but within a corporate
framework.
1.
Compared with C Corporations

S corporations pass-through to shareholders (i) separately-stated items of
income, loss, deduction, or credit and (ii) nonseparately stated income or
loss. Thus, in general, only a single tax is imposed on S corporation
income and the single tax is determined under noncorporate tax rates.

S corporation shareholders may withdraw earnings with greater ease.

S corporations are not subject to the accumulated earnings tax or the
personal holding company tax.

S corporations are not subject to the corporate alternative minimum tax.

S corporations may use the cash method of accounting (unless the entity is
viewed as a “tax shelter”).

S corporations may generate passive income, which can be used by
shareholders to offset their passive losses under Section 469.

Former C corporations, now S corporations, that incurred a passive
activity loss carryover in a C year may dispose of their entire interest in
the passive activity during an S year and, thus, trigger a flow-through
passive activity loss deductible against passive and ordinary income of the
shareholder. See St. Charles Investment Co. v. Comm’r, 232 F.3d 773
(10th Cir. 2000).

Unlike certain closely held C corporations, the at-risk rules of Section 465
do not apply at the entity level.

S corporations generally can avoid reasonable compensation issues as to
shareholder salaries, and can generally avoid the golden parachute rules
under Section 280G.

Like C corporations, S corporations generally may issue incentive stock
options and non-qualified stock options as long as they are not “deep in
the money.”
- 153 2.

Unlike partnerships, S corporations may take advantage of the
reorganization provisions of the Code as well as Sections 332, 338, and
355.


Compared with Partnerships
For example, an S corporation may acquire another corporation
in a tax-free transaction described in Section 368(a)(1)(B). S
corporations also may engage in divisive transactions described
in Section 355. Furthermore, an S corporation may liquidate a
subsidiary in a transaction to which Sections 332 and 337
apply.
Like partnerships, S corporations offer pass-through treatment for most
income items. They also offer:

limited liability to all of their shareholders, although similar
limited liability may be provided to partners (or members) of
partnerships that are organized as limited liability partnerships
or LLCs (and similar limited liability is provided to limited
partners of limited partnerships);105

continuity of life; and

ease of disposition (stock may be easier to sell than a
partnership interest).

S corporation shareholders do not receive deemed distributions upon
reduction in corporate liabilities, as is the case with partners under Section
752(b).

An S corporation is not constructively terminated if 50 percent or more of
the stock of an S corporation is sold, distributed, or exchanged within a
12-month period. A partnership, by contrast, is constructively terminated
if 50 percent or more of the total interest in partnership capital and profits
is sold or exchanged within a 12-month period. See Section 708(b)(1)(B).
105
However, under some statutes, a limited partner can lose its liability protection by
becoming too active in the management of the entity. By contrast, shareholders of an S
corporation generally are free to participate as vigorously in the management of the company as
desired without risking their limited liability protection. Of course, none of these statutes
protects any person from liability for their own negligence, recklessness, or intentionally tortious
behavior.
- 154 
Distributions of property by S corporations result in fair market value
basis (although gain is recognized at the corporate level and passed
through to shareholders). Distributions of property by partnerships, by
contrast, usually result in carryover basis with no gain recognized at the
partnership level. See Sections 731, 732.

Unlike partnerships, capital gain from the sale or exchange of S
corporation stock and from the distribution of property or money to a
shareholder is not partially recharacterized as ordinary income when the S
corporation owns unrealized receivables and inventory items. Cf. Sections
735, 751.

Unlike partnerships, the determination of whether COD income may be
excluded from gross income is made at the entity level under Section 108.
Unlike partners in a partnership, the tax attributes of an S corporation
shareholder are not relevant for purposes of applying Section 108 to an S
corporation’s COD income. Cf. Section 108(d)(6).

A shareholder/employee of an S corporation generally enjoys an
employment tax advantage over a service partner in a partnership. A
shareholder/employee’s pro rata share of S corporation income is not
subject to self-employment taxes, while a service partner’s distributive
share of partnership income generally is subject to self-employment taxes.
See Section 1402(a); Rev. Rul. 59-221, 1959-1 C.B. 225.
D.
Disadvantages of S Corporations

S corporations are subject to strict eligibility requirements that can hinder
financing ability and structural flexibility. For example, S corporations
are limited both in the number and type of permissible shareholders, and
may not have more than one class of stock. These restrictions may limit
the S corporation’s ability to raise capital.

In contrast to partnerships, special allocations of income or loss generally
are not permitted for S corporations.

S corporations cannot create outside stock basis by incurring inside debt.
A partner may increase the basis in its partnership interest when the
partnership borrows from third parties. See Sections 722, 752(a).
However, an S corporation shareholder generally cannot increase its stock
basis when the S corporation borrows from third parties.

Gain on appreciated S corporation assets is locked inside the corporation.
Gain will be recognized when assets are distributed or sold. In addition, S
corporations may be subject to a corporate-level tax on such gain under
Section 1374.
- 155 
Excessive net passive investment income may trigger a corporate-level tax
under Section 1375 and may terminate a corporation’s S election.

A corporation using the LIFO inventory identification method may be
required under Section 1363(d) to recapture LIFO benefits upon
conversion to S corporation status.

S corporations may be subject to state income and franchise taxes.

Most S corporations are required to use a calendar year unless an election
under Section 444 is made.

In contrast to C corporations, debt held by S corporations does not
automatically qualify for business debt classification for purposes of the
bad debt deduction under Section 166. Thus, the S corporation’s bad debt
deductions might only generate short-term capital losses rather than
ordinary losses. Furthermore, S corporations may not be able to claim a
bad debt deduction when the underlying debt is only partially worthless.
VIII. ACQUIRING AND CONVERTING C CORPORATIONS TO S CORPORATION
STATUS
A.
Making a C Corporation Eligible
If an existing C corporation already satisfies the small business corporation definition, it
can convert to S corporation status by filing Form 2553. An existing C corporation that is not
currently a small business corporation may be structured to qualify as a small business
corporation. Importantly, the size of the corporation is not a factor. Compare Section 1244.
1.
Purchase of Stock
Where the C corporation does not currently qualify as a small business corporation, it
may become qualified as a result of stock purchases by other shareholders. Ineligible
shareholders may be bought out directly or squeezed out through a merger. This may occur
where management or an investor group (comprised of qualifying shareholders) takes the target
C corporation private in a leveraged buy-out. However, caution must be exercised so that
acquisition indebtedness is not treated as a second class of stock.
2.
Recapitalization
If the corporation has more than one class of stock outstanding, a recapitalization may be
necessary so that the corporation’s capital structure satisfies the Section 1361 test. In addition, if
existing debt does not meet the straight debt safe harbor rules under Section 1361(c)(5), the old
debt may be exchanged for new debt pursuant to Section 368(a)(1)(E).
- 156 3.
Divisive D Reorganization
In a divisive D reorganization, the transferor corporation transfers some of its assets to a
newly-formed corporation in exchange for stock representing control of the new corporation.
The stock is then distributed in a transaction fulfilling the requirements of Section 355. See
Section 368(a)(1)(D).
The spun-off corporation may make an S election, unless (i) the transferor corporation
ceased being an S corporation during the previous five years and thus was barred from making
an S election under Section 1362(g) and (ii) the spun-off corporation is treated as a successor
corporation. See, e.g., PLR 200236044 (spin-off); PLR 200236038 (split-off). Theoretically, the
spun-off corporation may be forced to wait one year before it can elect S corporation status. This
is because it will have had a corporate shareholder during its first taxable year. In this case, Rev.
Rul. 72-320, 1972-1 C.B. 270 (momentary ownership by transferor ignored) may not apply to the
spun-off transferee. However, the Service has ruled privately on numerous occasions that
transitory ownership of S corporation stock by a corporation will not prevent an immediate
election by the spun-off corporation. See PLR 201102046 (same regarding a split-off); PLR
201026007 (same regarding a split-off); PLR 201002025; PLR 200943019 (same regarding a
split-up); PLR 200926024 (same regarding a split-off); PLR 200915026 (same regarding a splitoff); PLR 200850014 (same regarding a split-up); PLR 200843021 (same regarding a split-off);
PLR 200604016; PLR 200414023 (same regarding a split-off); PLR 9414016; PLR 9405014;
PLR 9404014; PLR 9402029 (same regarding a split-off); PLR 9403031; PLR 9350039; PLR
9344034; PLR 9344022; PLR 9338038; PLR 9321006; PLR 9319018 (same regarding a splitoff).
If the transferor corporation is a member of a consolidated group, the subsidiary will have
a new taxable year. Treas. Reg. § 1.1502-75(d)(2)(ii). In this setting, an S election may be made
even though the period for making an S election based upon the transferor’s consolidated return
year has expired. See PLR 8424042.
Importantly, if the distribution of subsidiary stock is to qualify as a transaction to which
Section 355 applies, it must satisfy the business purpose test. Eligibility for an S election alone
will not qualify as a sufficient business purpose. See Treas. Reg. § 1.355-2(b)(2) (reducing
federal taxes is not a valid business purpose). If the S election is respected for state tax purposes,
the state and local tax savings will not provide a business purpose for the transaction if the
reduction in federal taxes is “greater than or substantially coextensive with the reduction of non
Federal taxes.” Treas. Reg. § 1.355-2(b)(2), (5) ex. 7. A distribution solely to make an S election
at the state level may be valid. See PLR 8825085. Also, a subsequent S election may be made if
the transaction is supported by another business purpose. See, e.g., PLR 200236044 (spin-off);
PLR 200236038 (split-off). However, the presence of federal tax savings will invite scrutiny by
the Service. See Treas. Reg. § 1.355-2(b)(1); Rev. Proc. 96-30, 1996-1 C.B. 696 app. C.106
106
Note that appendix C to Rev. Proc. 96-30 is removed by Rev. Proc. 2003-48, 2003-2
C.B. 86, generally for all ruling requests postmarked after August 8, 2003.
- 157 B.
Changing Taxable Years To Obtain Maximum Benefit
As indicated above at Section II.B., an S election for a taxable year generally may only
be made during the preceding year or the first two and one-half months of the current year.
Where this time period has expired for the current taxable year (and the expiration was not
inadvertent), a taxpayer might consider changing its taxable year in order to obtain the benefits
of an S election without waiting until the beginning of the following year.
1.
New Corporations
A new corporation that fails to elect within the first two and one-half months may
terminate its first taxable year early. The corporation may then make an S election for its next
taxable year. See Brown v. United States, 68-2 USTC ¶ 9657 (M.D. Fla. 1968). For example,
individual B forms corporation (“X”) on January 1, 1994, and begins business on that date. In
April 1994, B decides that an S election is appropriate. B can close the books on January 31,
1994, and make an S election for X by April 15, 1994 for the year beginning February 1, 1994.
2.
Existing Corporations
For existing corporations, it may be more difficult to accelerate the benefits of an S
election where the election period for the current year has expired. Presumably, a corporation
may not change its taxable year in order to elect S corporation status for a taxable year that
immediately follows the short C year needed to effect the change in annual accounting period.
Prior to 2002, regulations under Section 442 explicitly prohibited such a change in a
corporation’s taxable year. See Treas. Reg. § 1.442-1(c)(2)(v) (as in effect in 2001). The new
regulations under Section 442 issued in 2002 do not address this situation. See Treas. Reg. §
1.442-1, T.D. 8996, 2002-1 C.B. 1127. However, Rev. Proc. 2002-37 provides that the
automatic change in accounting period procedures are not available to a corporation that attempts
to make an S election for the taxable year immediately following the short period unless the
change is to a permitted taxable year. Thus, the new regulations and Rev. Proc. 2002-37 do not
appear to signal a change in the policy established by the former regulations under Section 442.
3.
Acquisition of Existing C Corporation
Where an existing C corporation is to be acquired and converted into an S corporation,
the benefits of an S election may be accelerated as follows. The investors form a holding
company (“HC”) on April 1, 1994. HC purchases from unrelated parties the stock of the target C
corporation, a calendar year taxpayer, on April 15, 1994. HC then merges the target C
corporation into itself. Since HC is a newly-formed corporation, it may terminate its year
prematurely by closing its books as of April 30, 1994 (the end of the acquisition month). See
Sections 332(b), 381(b)(1); Treas. Reg. §§ 1.338-3(d), 1.441-1(c); Rev. Rul. 2001-46, 2001-2
C.B. 321; Rev. Rul. 90-95, 1990-2 C.B. 67 (Sit. 2). An election may be made for the next short
taxable period beginning May 1 and ending December 31, 1994.
- 158 C.
Effect of Conversion on the Corporation
Change To a Calendar Year: The C corporation currently may be a fiscal-year
taxpayer. Unless the corporation can establish a business purpose for the fiscal year (other than
deferral of income) or an election under Section 444 is made, the S election generally will force
the corporation to adopt a calendar year. Converting to a calendar year may cause a “bunching”
of income.
LIFO Recapture: Where a C corporation using the LIFO inventory identification
system converts to S corporation status, the C corporation must include in income for its last
taxable year the “LIFO recapture amount.” See Section 1363(d)(1). See Section IV.C. above for
more details.
Built-In Gains: If the S election is filed after December 31, 1986, the S corporation will
be subject to Section 1374. See Section IV.A.11., above. Transitional relief for certain small,
closely held corporations is available. See P.L. 99-514, § 633(d); Rev. Rul. 86-141, 1986-2 C.B.
151. If the S election was filed before January 1, 1987, the S corporation will be subject to
Former Section 1374. See Section IV.A.15., above.
Effect of Accumulated Earnings and Profits: The S corporation may have inherited
accumulated earnings and profits. As a result, the S corporation may be subject to tax under
Section 1375 on its “excess net passive income.” See Section IV.B., above. Further, the S
election is subject to termination if excess passive investment income exceeds 25 percent of
gross receipts for a consecutive three-year period. See Section 1362(d)(3); see also Section
V.A.2., above. In addition, under Section 1368(c) and Section 301(c) distributions in excess of
the AAA will be taxable to the shareholders as dividends. See Section III.C.2.b., above.
Investment Tax Credit Recapture: The S election itself or termination thereof will not
cause recapture of investment tax credits claimed during C corporation years. See Section
1371(d)(1). However, the S corporation will be liable for recapture taxes on subsequent
dispositions of assets upon which the credit was claimed in prior C corporation years. See
Section 1371(d)(2).
Foreign Losses: For purposes of Section 904(f), an S election is treated as a disposition
of a foreign business. See Section 1373(b).
IX.
S CORPORATION AS AN ACQUISITION VEHICLE
A.
Special Concerns with S Corporations
Where S corporations are involved in an acquisition, special planning concerns and issues
must be addressed.
1.
Newly-Formed S Corporation
If a newly-formed S corporation is to be used as the acquisition vehicle, the incorporators
must determine when they should file an S election.
- 159 -
In General: Where a newly-formed corporation is created to complete the acquisition,
the S election should be filed (i) after the corporation comes into existence and (ii) within two
and one-half months of the first day of its first taxable year. Determining when these two points
in time occur may be difficult. See Treas. Reg. § 1.1362-6(a)(2)(ii)(C).
Elections Prior To Corporate Existence: An election will be invalid if it is filed before
the corporation comes into existence. Under Section 1362, only a small business corporation
may make an S election. Under Section 1361(b)(1), a small business corporation, in turn, must
be a domestic corporation. In general, a domestic corporation is one organized under domestic
law. See Treas. Reg. § 1.1361-1(c). If the entity is not in existence (i.e., not organized under
domestic law), it cannot make an election. For example, the Service has ruled that an S election
was invalid because it was made prior to the issuance of the certificate of incorporation. See
PLR 8807070; PLR 8530100.
If the initial S election is invalid for this reason, it is unclear whether the election can be
considered to be made for the following year. Query whether the invalidity of an S election for
this reason qualifies for inadvertent invalid election relief under Section 1362(f).
Two and One-Half Month Period: A new corporation must file its S election during
the first two and one-half months of its initial taxable year if the election is to be effective for
that year. The taxable year of a new corporation begins on the date that the corporation has
shareholders, acquires assets, or begins doing business, whichever occurs first. Treas. Reg. §
1.1362-6(a)(2)(ii)(C). Apparently, the first year will begin with the acquisition of any asset, even
if the asset acquired is a non-operating asset. See Artukovich v. Comm’r, 61 T.C. 100 (1973)
(corporation acquired cash). Note that a corporation may have shareholders well before it
acquires assets or begins business. See, e.g., Lyle v. Comm’r, 30 T.C.M. 1412 (1971).
Conversely, the Tax Court held in one case that a corporation began business but had no
shareholders. See Bone v. Comm’r, 52 T.C. 913 (1969) (existence began when corporation
acquired assets and began business, even though stock was not issued). Regulations provide that
incorporators that are treated as shareholders for purposes of state law are not treated as
shareholders for purposes of the S election. See Treas. Reg. § 1.1362-6(b)(3)(i).107
The two and one-half month period closes two months and 15 days from the date on
which the taxable year begins. Treas. Reg. § 1.1362-6(a)(2)(ii). However, Section 1362(b)(5)
provides that the Secretary may treat an election filed after the expiration of this two and onehalf month period (or the failure to make an election at all) as timely made for such year if the
Secretary determines that there was reasonable cause for the failure to timely make such election.
Pursuant to Section 1362(b)(5), the Service issued Rev. Proc. 2007-62 and Rev. Proc. 2003-43 to
107
However, where a subscriber to shares of stock in a corporation is considered a
shareholder under state law, the subscriber is considered a shareholder for purposes of
determining when a corporation’s taxable year begins, and thus when an S election can be made
for such taxable year of the corporation. See Rev. Rul. 72-527, 1972-1 C.B. 270.
- 160 provide procedures by which taxpayers can request relief for a late S election.108 See Section
II.B.1. above for more details.
2.
Avoiding Termination
Where the S corporation is the acquiring entity, a primary concern is whether the
acquisition will terminate the S election. This could occur, for example, where the transaction
caused the S corporation to become disqualified as a small business corporation (e.g., ownership
of stock by an ineligible shareholder or, under Former Section 1361(b)(2)(A), affiliation with the
target corporation). See Section 1361(b). However, the Service has expressed the view that an S
corporation that momentarily has a corporate shareholder in the course of a reorganization is not
disqualified from being an S corporation under Section 1361(b)(1)(B). See GCM 39768.109
If new shareholders receive more than 50 percent of the shares of the S corporation, they
can elect to revoke the election. See Section 1362(d)(1)(B). A buy-sell agreement or restrictions
on the transferability of stock might be used to block this tactic. These agreements and
restrictions usually will not constitute a second class of stock. See Treas. Reg. § 1.13611(l)(2)(iii).
3.
Other Considerations
The allocation of income and loss items in the year of acquisition between former and
current shareholders must be considered along with whether the corporation must pay recapture
taxes. The effect of corporate carryovers, such as earnings and profits and AAA, also must be
considered.
108
Rev. Proc. 2007-62 supplements Rev. Proc. 2003-43. Rev. Proc. 2003-43 supersedes
Rev. Proc. 98-55 as of June 9, 2003. Rev. Proc. 98-55 had superseded Rev. Proc. 97-40.
109
In GCM 39768, the Service cited with approval Rev. Rul. 72-320, 1972-1 C.B. 270,
and GCM 33336 (Sept. 23, 1966). The foregoing authorities held that an S corporation’s
momentary ownership of stock in another corporation in connection with a divisive “D”
reorganization did not terminate its S election under the affiliation rule of Former Section
1361(b)(2)(A). In TAM 9245004, the Service relied on GCM 39768 and Rev. Rul. 72-320 in
holding that an S corporation’s momentary ownership of 100 percent of the stock in a subsidiary
immediately prior to the subsidiary’s liquidation under Section 332 did not cause the S
corporation to be an ineligible corporation under Former Section 1361(b)(2)(A). The Small
Business Act of 1996 repealed the affiliation rule of Former Section 1361(b)(2)(A). Thus, an S
corporation today may be affiliated (as a shareholder) with a C corporation.
- 161 B.
Particular Transaction Structures Involving S Corporations
1.
Asset Acquisitions by S Corporations
a.
Taxable Asset Acquisitions
An S corporation may acquire target assets directly in exchange for cash or promissory
notes. Alternatively, the S corporation may acquire the target assets in a taxable merger. See
Rev. Rul. 69-6, 1969-1 C.B. 104.
Effect on S Election: In general, a purchase of assets by an S corporation should not
result in the termination of the S election.110 Where part of the consideration package includes S
corporation stock, the election will be terminated if (i) such stock is received by, or transferred
to, ineligible shareholders or (ii) the 100-shareholder limit is violated. In addition, if the S
corporation uses notes to acquire the assets, the S election will be terminated if the notes
constitute a second class stock.
Allocation of Income in Year of Acquisition: The income or loss generated by the
acquired assets apparently will be blended in with other income of the S corporation and
allocated to the S corporation’s shareholders under the usual per-share per-day rule of Section
1377(a)(1).
Corporate-Level Taxes: Because the acquired assets generally will have a cost basis,
Section 1374 should not apply even if the assets are acquired from a C corporation. However, if
the acquired assets generate passive income and the S corporation has accumulated earnings and
profits (e.g., from a prior tax-free merger of a C corporation into it), the Section 1375 tax and the
Section 1362(d)(3) termination provision could apply.
b.
Tax-Free Asset Acquisitions
An S corporation may make a tax-free asset acquisition using several formats, including a
statutory merger or consolidation under Section 368(a)(1)(A) or a conveyance of assets under
Section 368(a)(1)(C) (“C reorganization”), Section 368(a)(1)(D) (“acquisitive D
reorganization”), or Section 368(a)(1)(F) (“F reorganization”).111 In addition, Section 351 may
be used to acquire the assets of a target enterprise, including a sole proprietorship.
110
Prior to the Small Business Act of 1996, the S election would be terminated if the
acquired assets included an amount of subsidiary stock that would permit affiliation and the
subsidiary could not be disregarded as an inactive subsidiary under Former Section 1361(c)(6).
The Small Business Act of 1996 amended Section 1361(b)(2) to allow an S corporation to hold
stock of a subsidiary C corporation in this situation.
111
See PLR 200633008 (treating a merger of an S corporation into an LLC that validly
elects under Treas. Reg. § 301.7701-3 to be treated as an association taxable as a corporation as
of the effective date of the merger as an F reorganization); PLR 200622025 (treating a
conversion of an S corporation into an LLC that validly elects under Treas. Reg. § 301.7701-3 to
(Continued …)
- 162 -
(i)
Effect on Election
(a)
Merger
Where the S corporation acquires assets in a statutory merger, its status as an S
corporation should not be affected solely because of the merger itself. Rev. Rul. 79-52, 1979-1
C.B. 283; Rev. Rul. 69-566, 1969-2 C.B. 165; PLR 9410022; PLR 9206011; PLR 9115059; PLR
9115029; PLR 9040066. However, the S election may terminate if S corporation stock is
received by an ineligible shareholder (such as a corporation or a partnership) or the number of
shareholders exceeds the maximum permitted. In addition, if the target shareholders receive
more than 50 percent of the shares of the S corporation stock outstanding, they may revoke the S
election under Section 1362(d)(1). Further, the S corporation must make sure that if S
corporation securities are issued in the transaction, they do not constitute a second class of stock.
To date, the Service apparently has not attempted to recharacterize a merger into an S
corporation as a constructive receipt of S corporation stock by the target followed by the target’s
liquidation. Cf. West Shore Fuel, Inc. v. United States, 598 F.2d 1236 (2nd Cir. 1979). Even if
the Service treated a merger as such, it is unclear whether the momentary ownership of S
corporation stock by an ineligible shareholder (i.e., a target corporation) would cause the S
corporation to cease being a small business corporation. The Service has ruled privately on
numerous occasions that transitory ownership of S corporation stock will not result in the
termination of an S election. See, e.g., GCM 39768; TAM 9245004. See Section IX.A.2.,
above.
Where the target is also an S corporation, the Service has ruled that the target’s S election
does not terminate solely because of the merger, although the target’s final taxable year ends on
the date of the merger. See Section 381(b)(1); Rev. Rul. 64-94, 1964-1 C.B. 317; PLR 9350003.
Therefore, Section 1362(g) should not apply to the acquiring S corporation. See Rev. Rul. 70232, 1970-1 C.B. 177.
If the acquiring S corporation loses its S corporation status because of the merger,
Section 1362(g) will apply to prevent a new S election until the five-year waiting period expires.
This result may be avoided if the transaction is structured so that the target survives (e.g., a
reverse acquisition). The target then could make an S election without the restriction of Section
1362(g) (i.e., for the next taxable year instead of the fifth succeeding taxable year as under
Section 1362(g)).
be treated as an association taxable as a corporation as of the effective date of the conversion as
an F reorganization); PLR 200320013 (treating a series of transactions as an F reorganization of
an S corporation).
- 163 Query how Section 1362(g) applies if the target is a former S corporation subject to
Section 1362(g) and the acquiring S corporation loses its S corporation status as a result of the
reorganization? It would seem that a new 5-year waiting period would begin.
(b)
Consolidation
Where an S corporation and its target are merged into a new entity (i.e., a consolidation)
the existence of the S corporation will terminate. However, the S election does not terminate
under Section 1362(d) because the S corporation remains an S corporation for its final taxable
year. See Section 381(b)(1). Thus, the new entity should be able to make a new S election
without restriction under Section 1362(g). Rev. Rul. 70-232, 1970-1 C.B. 178; PLR 9040066;
PLR 8007089.
(c)
C Reorganization
Where an S corporation acquires assets in a C reorganization, there is greater risk that the
election will be terminated. A C reorganization contemplates the issuance of stock to a corporate
transferor. The result is that the S corporation will have an ineligible shareholder (i.e., the
corporate transferor). Even if the corporate transferor is immediately liquidated pursuant to
Section 368(a)(2)(G), ownership of stock by an ineligible shareholder technically occurred.
However, the Service has ruled privately that transitory ownership of S corporation stock by a
corporation will not result in the termination of the S election. See, e.g., PLR 8736014; PLR
8518034; PLR 8515043; PLR 8439013.
Importantly, in GCM 39768 (Dec. 1, 1988), the Service stated that an S corporation will
not lose its S corporation status merely because it has a momentary corporate shareholder in the
course of a reorganization, including a C reorganization. In addition, the Service has issued a
number of private rulings in the context of other reorganization transactions that indicate that the
presence of a transitory corporate shareholder will not result in the termination of the S election.
See PLR 8830025; PLR 8849015; PLR 8736014; cf. Rev. Rul. 69-566, 1969-2 C.B. 165.
(d)
Acquisitive D Reorganization
An acquisitive D reorganization generally requires that the S corporation acquire
“substantially all” of the assets of the target, and that the target be liquidated. See Sections
368(a)(1)(D), 354(b)(1). The assets may be transferred by direct conveyance or by a merger into
the S corporation. If the acquisition is completed using the merger format, the effects on the S
election should be similar to those of a Section 368(a)(1)(A) merger. If the acquisition is
completed by a direct conveyance of assets, the effects on the S election should be similar to
those of a Section 368(a)(1)(C) transaction.
Because of the continuity of interest requirement in a D reorganization (i.e., 50 percent
common control), the acquiring corporation may be treated as a successor corporation to the
target. See Treas. Reg. § 1.1362-5(b). If the acquiring corporation has not yet filed its S
election, and if the target was a former S corporation, Section 1362(g) may apply to the acquiring
corporation.
- 164 Note also that the 2004 JOBS Act amended Section 357(c) so that it no longer applies to
acquisitive D reorganizations. Section 357(c)(1)(B).112
(ii)
Allocation of Income or Loss in the Acquisition Year
Where the S election is not terminated, income items are allocated under the per-share
per-day rule of Section 1377(a)(1). If any shareholder terminates his interest as a result of the
reorganization, an election to close the books under Section 1377(a)(2) should be considered.
Absent an election to close the books, the allocation rules will shift income (loss) items among
the shareholders. Pre-acquisition income (loss) of the acquiring corporation may be shifted to
the former target shareholders; post-acquisition income (loss) attributable to the target’s assets
may be shifted to the acquiring S corporation’s shareholders. However, the target’s preacquisition income (loss) should not be included in the S corporation’s income. See Section
381(b)(1).
Where the S election is terminated, items of income (loss) would be allocated under
Section 1362(e)(2), unless all relevant shareholders elect to close the books under Section
1362(e)(3) or such closing is required under Section 1362(e)(6)(D).
(iii)
Carryover of Corporate Attributes
In general, the S corporation will succeed to the tax attributes of the acquired corporation
under Section 381. The basis of the acquired assets is generally a carryover basis. This may
subject the acquiring S corporation to Section 1374 or Former Section 1374. Similarly, if the
acquired assets were held in an S corporation subject to Section 1374, the acquiring S
corporation also may be subject to Section 1374. See IRS Ann. 86-128.
Section 1371(b)(1) states that no carryover from a C year may be carried to an S year.
However, it is unclear whether Section 1371(b)(1) applies only to attributes generated by the
corporation itself or those inherited from the target corporation via Section 381. Resolution of
this issue will be important if the acquiring S corporation is subject to Section 1374. Section
1374(b)(2) allows the S corporation to offset built-in gain with NOL carryovers arising in years
“for which the corporation was a C corporation.” This language implies that the target’s NOL
carryovers under Section 381 could not offset built-in gain. However, one can also argue that
predecessor and successor corporations should be treated as the same corporation.
Regulations under Section 1374 apparently resolve this issue by prohibiting an S
corporation from using a target’s NOL carryovers against NRBIG attributable to assets originally
held by the S corporation. See Treas. Reg. § 1.1374-8(b). However, these NOL carryovers still
should be available to offset any NRBIG attributable to the target’s assets. See id.
112
The amendment applies to transfers of money or other property, or liabilities assumed,
in connection with a reorganization occurring on or after October 22, 2004. See section 898(c),
P.L. 108-357.
- 165 Earnings and profits of the target also can carry over to the S corporation. If so, the
corporation may be subject to restrictions on passive investment income. See Sections
1362(d)(3) (termination of election), 1375 (annual tax). In addition, future S corporation
distributions may be subject to Section 1368(c) (treating certain distributions as dividends)
instead of Section 1368(b) (treating distributions as a return of basis or gain from the sale or
exchange of property).
(iv)
Pre-Reorganization Distributions
Pre-reorganization distributions generally should be governed by Section 1368. Cf. Rev.
Rul. 71-266, 1971-1 C.B. 262.
(v)
Distributions Pursuant to the Merger
Where distributions are made pursuant to the plan of reorganization (or
contemporaneously therewith), it is unclear whether such distributions are governed by Section
356 or Section 1368. Under Section 356(a)(1), boot distributions would be taxed to the extent of
gain realized; under Section 1368, by contrast, boot distributions may be treated as tax-free
distributions. See Section 1368(b)(1), (c)(1), (c)(3).
For example, individual A has a basis in target stock of $100 and receives in a merger
$20 in cash and stock of the acquiring S corporation worth $130. If Section 356(a)(1) controls,
A would be taxed on the $20. If Section 1368 controls, A would treat the $20 as a tax-free
distribution (assuming the AAA is sufficient if earnings and profits are present).
Section 1371(a) implies that subchapter S of the Code takes precedence over subchapter
C of the Code. This is supported by Former Section 1363(e) which, prior to the TAMRA of
1988, stated that Section 356 applies only to the extent that permitted property is distributed.
Thus, Former Section 1363(e) suggested that subchapter S of the Code will apply to boot
distributions. However, the TAMRA of 1988 repealed Former Section 1363(e).
If Section 356 controls, it would seem that Section 356(a)(2) should not treat distributions
as dividends where such distributions would be tax-free under Section 1368.
(vi)
Post-Reorganization Distributions
Post-reorganization distributions should be governed by the usual Section 1368 rules. In
cases where the acquiring S corporation does not have earnings and profits (and does not acquire
them from the target), distributions to the former target shareholders apparently may be treated
as tax-free distributions under Section 1368(b)(1) to the extent of basis. This is true even though
such shareholders hold the S corporation stock with a substituted basis and such basis does not
reflect allocations of S corporation income. See S. Rep. No. 97-640, supra, at 20.
However, if the S corporation inherits earnings and profits from the target, Section
1368(c) will apply to post-reorganization distributions. As a result, distributions to historic S
corporation shareholders may be transformed from tax-free distributions to taxable dividends.
For example, individual (“X”) forms an S corporation to acquire the assets of a target C
- 166 corporation in a tax-free reorganization. X contributes $1 million to be used as boot in the
reorganization. The S corporation succeeds to the target’s earnings and profits under Section
381. Distributions to X after the reorganization may be taxable as dividends even though they
actually represent a return of capital.
Where the acquiring S corporation has earnings and profits of its own, the corporation
should be maintaining an AAA. Because the AAA is a corporate-level account, all the
shareholders of the S corporation (including the former target shareholders) apparently may
benefit from distributions out of the AAA. Treas. Reg. § 1.1368-2(a)(1). Where two S
corporations are merged, the AAA of the survivor will equal the sum of the AAAs of each party
to the reorganization immediately before the merger. See Treas. Reg. § 1.1368-2(d)(2); see also
PLR 9008041; PLR 9002051; PLR 8946052. In addition, if the number of shareholders
increases because of the transaction, future distributions may deplete the AAA at a faster rate
than subsequent earnings can replenish the account.
If the acquiring S corporation’s S election terminates as a result of the reorganization,
nontaxable cash distributions may be made during the PTTP to the extent of the shareholder’s
basis or the AAA, whichever is less. Section 1371(e)(1). However, such nontaxable cash
distributions may be made only to those shareholders who were shareholders of the S corporation
at the time of the termination. See Treas. Reg. § 1.1377-2(b).
If the assets of an S corporation are acquired by another S corporation in a reorganization
described in Section 381(a)(2), a PTTP does not arise with respect to the acquired S corporation.
Id. Presumably, a PTTP does not arise because the acquired S corporation’s AAA should carry
over and, thus, the acquiring S corporation may use the general rules under Section 1368 to make
tax-free distributions to the continuing shareholders.
(vii)
LIFO Recapture
As previously discussed, regulations under Section 1363(d) extend the application of the
LIFO recapture rules to an S corporation that succeeds to LIFO inventory in a tax-free asset
acquisition with a C corporation. See Treas. Reg. § 1.1363-2(a)(2). If the tax-free asset
acquisition takes the form of a merger, the acquiring S corporation in all likelihood would be
liable under state law for the additional Section 11 tax attributable to LIFO recapture. It is less
clear in a situation involving a C reorganization or an acquisitive D reorganization.
2.
Stock Acquisitions by S Corporations
In many cases, the target shareholders will insist on selling their stock rather than the
target’s assets. A stock acquisition by an S corporation creates additional risks not present in an
asset acquisition.
- 167 a.
Taxable Stock Acquisitions
(i)
Effect on Election Prior to the Small Business Act of
1996
Affiliation Issues: An acquisition of stock by an S corporation generally terminated the
S election if the corporation acquired sufficient stock of the target to satisfy the Section
1504(a)(2) tests. See Former Section 1361(b)(2)(A) (repealed by the Small Business Act of
1996).
If the target was immediately liquidated or spun-off, the S corporation status of the
acquiring corporation may have been preserved under a “momentary affiliation rule.” See Rev.
Rul. 73-496, 1973-2 C.B. 313; Rev. Rul. 72-320, 1972-1 C.B. 270. The parent-subsidiary
relationship should have lasted no longer than 30 days. See Rev. Rul. 73-496; PLR 8504028;
PLR 8439013; cf. PLR 8338080. The Tax Court had expressed its view, in dictum, that the
Service’s 30-day rule may have been invalid. See Haley Bros. Construction Corp. v. Comm’r,
87 T.C. 498 (1986). However, the Service continued to cite Rev. Rul. 73-496 in post-Haley
Bros. private rulings. See, e.g., PLR 9108059; PLR 8810045; PLR 8739010; PLR 8736014; see
also TAM 9245004.113
If the target corporation was immediately liquidated into the acquiring S corporation, the
transaction could have been viewed as a purchase of assets. See Snively v. Comm’r, 19 T.C. 650
(1953); Cullen v. Comm’r, 14 T.C. 368 (1950); Rev. Rul. 76-123, 1976-1 C.B. 94; cf. Rev. Rul.
67-274, 1967-2 C.B. 141. In this case, the acquisition of stock and the liquidation of the target
apparently would be ignored. However, in Revenue Ruling 90-95, 1990-2 C.B. 67, the Service
held that an acquiring corporation that purchases the stock of the target corporation and
immediately liquidates the target corporation as part of a plan to acquire the assets of the target is
treated as having made a qualified stock purchase followed by a liquidation, rather than having
made an asset acquisition. In light of the Service’s ruling in TAM 9245004, discussed below, it
would appear that Rev. Rul. 90-95 would apply to S corporations as well.
Corporation Status Issues: Alternatively, if the target corporation is liquidated
immediately, the Service also could have argued prior to the Small Business Act of 1996 that the
liquidation of the target was fully taxable both to the S corporation under Section 331 and to the
target under Section 336. Arguably, Sections 332 and 337 would not have applied because
Former Section 1371(a)(2) (repealed by the Small Business Act of 1996) treated the S
corporation as an individual in its capacity as a shareholder of another corporation. However,
since the acquiring S corporation generally would have a cost basis in its target stock, the S
corporation would not have recognized Section 331 gain on the target’s liquidation.
113
Moreover, in GCM 39768, the Service explicitly reaffirmed the momentary affiliation
rule of Rev. Rul. 72-320. GCM 39768 does not consider the continuing validity of the 30-day
liquidation rule of Rev. Rul. 73-496. Indeed, in reaffirming the holding in Rev. Rul. 72-320, the
GCM notes that the court in Haley Bros. did not address the validity of Rev. Rul. 72-320 –
arguably signaling capitulation to the Haley Bros. criticism of Rev. Rul. 73-496.
- 168 -
In TAM 9245004, the Service addressed the application of Former Section 1371(a)(2)
where an S corporation acquires all the stock of a target C corporation and immediately
thereafter liquidates the target. The Service concluded that Former Section 1371(a)(2) did not
prevent an S corporation from liquidating its C corporation subsidiary in a transaction to which
Sections 332 and 337 applies. The Service also ruled that Former Section 1361(b)(2)(A) (i.e.,
the affiliation rule) did not terminate the S election of the acquiring S corporation because it was
affiliated with the target only momentarily. Furthermore, the Service concluded that Former
Section 1371(a)(2) did not prevent an S corporation from making a qualified stock purchase
under Section 338. See TAM 9245004. Consistent with its position regarding Section 338 in
TAM 9245004, in PLR 9323024, the Service revoked an earlier private letter ruling (PLR
8818049) in which it had reached a contrary result.
Alternative Structures: Prior to the Small Business Act of 1996, an alternative to an
acquiring S corporation liquidating a target immediately after its acquisition was to merge the
acquiring S corporation into the target with the target surviving. See PLR 8648037; PLR
8643022. If the downstream merger was made immediately after the stock acquisition, the target
conceivably would not have been prevented from making an immediate S election due to the
existence of a transitory corporate shareholder (assuming all other requirements under Section
1362 were met). Cf. PLR 8810045. Also, the acquiring S corporation’s S election conceivably
would not have been terminated by the transitory affiliation with the target. The target then
could have elected S corporation status without Section 1362(g) applying (i.e., no initial
termination of S corporation status). Rev. Rul. 64-94, 1964-1 C.B. 317.
Similar results should have been obtained where the target was immediately spun-off by
the S corporation, and then the S corporation merged into the target. See PLR 8739010.
If the S corporation’s S election terminated, Section 1362(g) would have prevented a subsequent
S election until the close of the prescribed waiting period. Obtaining the Service’s consent to an
earlier effective date was (and still is) unlikely. See Rev. Rul. 78-364, 1978-2 C.B. 225.
(ii)
Effect on Election Pursuant to the Small Business Act of
1996
The Small Business Act of 1996 repealed both the affiliation rule of Former Section
1361(b)(2)(A) and the rule that treated an S corporation as an individual with respect to holding
stock of another corporation. See Former Section 1371(a)(2). Thus, it is clear that an acquisition
of stock by an S corporation that is sufficient to satisfy the Section 1504(a)(2) tests will not
terminate the S election. As a result, an acquired target need not be immediately terminated or
spun-off. Furthermore, it is clear now that an S corporation may engage in a Section 338
qualified stock purchase and a liquidation to which Sections 332 and 337 apply.
Also as a result of the Small Business Act of 1996, if (i) an acquired target would be
eligible to be an S corporation if its stock were held directly by the shareholders of its acquiring
parent S corporation and (ii) 100 percent of its stock is owned by such parent S corporation, the
parent S corporation may elect to treat the target as a QSub. If such an election is made, the
QSub is not treated as a separate corporation; instead, all of its assets, liabilities, and items of
- 169 income, deduction, and credit are treated as assets, liabilities, and items of income, deduction,
and credit of the parent S corporation. See Section III.H. above for more details.
Note: If the acquired target is a C corporation that has affiliated C corporation
subsidiaries, the target and its subsidiaries may elect to file consolidated federal income tax
returns. If the target and its subsidiaries already file consolidated returns, they generally are
required to continue filing consolidated returns (unless the parent C corporation is liquidated,
converts to QSub status, or is merged into the S parent or a QSub). See Treas. Reg. § 1.150275(a)(2).
(iii)
Allocation of Income or Loss in the Acquisition Year
Where the S election is not terminated, income items of the acquiring S corporation are
allocated under the per-share per-day rule of Section 1377(a)(1). Such allocation rules will shift
income (loss) items among the shareholders. Pre-acquisition income (loss) of the acquiring
corporation may be shifted to the former target shareholders; post-acquisition income (loss)
attributable to the target’s assets may be shifted to the acquiring S corporation’s shareholders.
Furthermore, the target’s pre-acquisition income (loss) should not be included in the S
corporation’s income.
Where the S election was terminated under the rules prior to the Small Business Act of
1996, items of income (loss) were allocated under Section 1362(e)(2), unless all relevant
shareholders elected to close the books under Section 1362(e)(3).
b.
Tax-Free Stock Acquisitions
In general, a tax-free stock acquisition may take the form of a B reorganization (Section
368(a)(1)(B)) or as a reverse subsidiary merger (Section 368(a)(2)(E)). Because the S
corporation issues under both formats are similar, only B reorganizations will be discussed.
(i)
Availability of Tax-Free Treatment
To qualify as a B reorganization, one corporation essentially must acquire control (within
the meaning of Section 368(c)) of another corporation solely in exchange for its voting stock.
See Section 368(a)(1)(B). An S corporation may acquire such control since an S corporation
now may own an amount of stock that satisfies the Section 1504(a)(2) requirements.114
114
Prior to the Small Business Act of 1996, where an S corporation was the acquiring
entity, there was some question as to whether an acquisition would qualify under Section
368(a)(1)(B) because Former Section 1371(a)(2) treated an S corporation as an individual in its
capacity as a shareholder. Thus, the target stock could have been treated as being acquired by an
individual. But see TAM 9245004 (Former Section 1371(a)(2) does not prevent an S
corporation from being treated as a corporation for purposes of Sections 338 and 332); GCM
39678 (Former Section 1371(a)(2) does not bar an S corporation from engaging in a divisive D
reorganization).
(Continued …)
- 170 -
(ii)
Effect on Election
As with a taxable stock acquisition, a tax-free acquisition prior to the enactment of the
Small Business Act of 1996 was likely to terminate the S election. See Former Section
1361(b)(2)(A); Section 1362(d)(2). If the acquired corporation was liquidated immediately after
acquisition, the transitory ownership of stock may have been ignored. Such a liquidation may
have caused the transaction to be viewed as a C reorganization. See Rev. Rul. 67-274, 1967-1
C.B. 141.
As a result of the Small Business Act of 1996, many of the S election termination
concerns that arose in a stock acquisition were ameliorated. However, care still must be taken to
ensure that the acquiring S corporation complies with the shareholder limitations (type of
shareholder and number of shareholders). See Section 1361(b)(1)(A), (B), (C). If the S election
terminates, Section 1362(g) will prevent a subsequent S election until the close of the prescribed
waiting period. Obtaining the Service’s consent to an earlier effective date is unlikely. See Rev.
Rul. 78-364, 1978-2 C.B. 225.
(iii)
Pre-Reorganization Distributions
Distributions prior to the B reorganization should be governed by Section 1368, even if
the S election is terminated because of the reorganization (e.g., because of an ineligible
shareholder or too many shareholders). Such a termination would be effective as of the date of
reorganization (i.e., the date the S corporation ceases being a small business corporation).
(iv)
Distributions Contemporaneously with the
Reorganization
Since boot is not permissible in a B reorganization, any contemporaneous distributions
should emanate from the target itself and not from the acquiring S corporation. See Rev. Rul.
75-360, 1975-2 C.B. 110. Accordingly, it seems that neither Section 1368 (unless the target is
also an S corporation) nor Section 356 should apply.
(v)
Post-Reorganization Distributions
If the acquiring corporation’s S election terminates in the transaction, post-reorganization
distributions of cash (not property) may be distributed tax-free during the PTTP. See Section
1371(e). Such tax-free cash distributions may be made to those shareholders who were
shareholders in the S corporation at the time of the termination. See Treas. Reg. § 1.1377-2(b).
However, the acquisition by the S corporation of control within the meaning of Section
368(c) also was likely to satisfy the Section 1504(a)(2) requirements. If so, the S election would
terminate and Former Section 1371(a)(2) no longer should have applied. See Former Section
1361(b)(2)(A). Therefore, the transaction should have qualified as a B reorganization, but at the
cost of termination of the S election.
- 171 -
c.
Alternatives to S Corporation Acquiring Stock of Target
(i)
Brother “S” – Sister “C” Merger
One alternative to a direct stock acquisition by an S corporation is the acquisition of
target stock by the S corporation’s shareholders (for cash or notes) followed by a merger of the
target into the S corporation.
(a)
Subchapter C Issues
If the merger qualifies for tax-free treatment under Section 368(a)(1)(A), the acquiring S
corporation would take the target’s assets with a carryover basis. However, there is a risk that
the merger would not qualify as a reorganization because historic shareholder continuity of
interest is lacking. See Yoc Heating Corp. v. Comm’r, 61 T.C. 168 (1973). But see Treas. Reg.
§ 1.368-1(e)(6) ex. 1.
If the merger is taxable, the target would be treated as selling its assets to the S
corporation in exchange for S corporation stock and then liquidating. See Rev. Rul. 69-6, 19691 C.B. 104. The Service’s position, ascertained through informal discussions, is that gain would
be reportable on the buyer’s side, not the seller’s side. Under this scenario, Sections 267 and
1239 may apply to the deemed sale. The target would be liable (and possibly the acquiring
shareholders as well under Section 6901) for tax on the deemed sale of assets. Furthermore, the
shareholders would also be liable for any tax on the deemed liquidation. However, since the
shareholders would have a cost basis in the target stock, any Section 331 gain should be minimal.
According to the Service, the Yoc Heating risk may be reduced if Section 338 is
elected.115 See PLR 8645041. Such an election would produce gain at the target level but the
receipt of stock generally would be tax-free. The result is that a Section 338 election guarantees
one level of immediate tax instead of two potential levels of tax.
Historic continuity issues can be avoided if the acquiring S corporation is merged into the
target and the target makes an S election (in which case the assets of both corporations may be
subject to Section 1374). Historic continuity also should not be a problem if the subsequent
merger constitutes an F reorganization. See Treas. Reg. § 1.368-1(b) (providing that neither the
continuity of business enterprise rules nor the continuity of interest rules apply to an F
reorganization); PLR 8849017; PLR 8807071; PLR 8807044. The transaction could also be
viewed as a stock purchase by the S corporation followed by the immediate liquidation of the
target. See Section IX.B.2.a., above.
115
Prior to the Small Business Act of 1996, an S corporation (as a shareholder of another
corporation) could not acquire stock in a transaction to which Section 338 applied. See Former
Section 1371(a)(2); Former Treas. Reg. § 1.338-2(b)(1). However, as discussed above, the
Small Business Act of 1996 effectively repealed this prohibition.
- 172 (b)
Subchapter S Issues
The merger of the target into the S corporation itself should not affect the acquiring
corporation’s S election. Thus, the income (loss) items for the entire year should be allocated
under Section 1377(a)(1).
If the merger is tax-free, the acquired assets will have a carryover basis. Any built-in
gain will be subject to Section 1374 if that Section is otherwise applicable. See Section
1374(d)(8); Treas. Reg. § 1.1374-8; IRS Ann. 86-128. If the S corporation is subject to Former
Section 1374, the assets received instead will be subject to Former Section 1374. See IRS Ann.
86-128.
If the merger is taxable, it apparently will be treated as a taxable asset acquisition by the
S corporation. See Section IX.B.1.a., above.
(ii)
Brother “S” – Sister “S” Structure
If the shareholders deem the risk associated with a stock acquisition by the S corporation
to be too great, the shareholders may consider acquiring the target stock directly and electing S
corporation status for the target.
X.
S CORPORATION AS A TARGET
Where an S corporation is the target, its shareholders may sell their stock in the
corporation or cause the corporation to sell its assets directly to the purchaser. The decision will
turn on such tax issues as (i) whether an asset sale would produce less gain or more loss (due to
higher inside basis versus outside basis); (ii) whether the character of the gain or loss on an asset
sale differs from a stock sale; (iii) whether a corporate-level tax will be imposed because of the
sale; and (iv) whether (and to what extent) the installment method of reporting is available.
A.
Asset Dispositions
The assets of an S corporation may be acquired directly in exchange for cash, notes, or
other property. Alternatively, the assets of the S corporation may be acquired in a taxable
merger or a tax-free reorganization. See Rev. Rul. 69-6, 1969-1 C.B. 104; PLR 200628008
(involving a state law cash merger of S corporations into a disregarded LLC owned by
partnership). In addition, in PLR 9032031, an S corporation dropped its assets down to a newlyformed subsidiary and immediately exchanged the subsidiary stock for stock in an acquiring
corporation. The Service ruled that the transaction would be treated as a taxable sale of the S
corporation’s assets for the acquiring corporation’s stock. Finally, the assets of an S corporation
may be treated as being acquired directly in a transaction to which Section 338(h)(10) applies.
1.
Taxable Asset Dispositions – Direct Sale of Assets
Effect on Election: The sale of assets by the S corporation to the purchaser alone should
not cause the termination of the S election. However, if the S corporation has accumulated
earnings and profits, interest income on any installment note received or investment income
- 173 derived from cash proceeds may cause a termination of the S election under Section 1362(d)(3)
(excess passive investment income).
Allocation of Income in Year of Sale: The usual Section 1377(a)(1) rules should apply.
The character and amount of the gain is determined at the corporate level. See Section 1366.
Such gain or loss is passed through to the shareholders and increases (decreases) their basis in
the S stock (or debt if Section 1367(b) applies).
Income or loss is allocated to the shareholders as the corporation recognizes income
under its normal method of accounting. Where an installment obligation is received, gain may
be deferred until payment is received.
However, a deferred taxable asset sale may trigger more immediate gain recognition than
a stock sale would. First, under Section 453(b)(2), installment method reporting is not available
on the sale of inventory or dealer dispositions. Second, under Section 453(i), recapture income is
recognized in the year of sale. Third, under Section 453A, interest may be charged on nondealer
installment sales (i.e., casual sales) of property used in a trade or business or held for the
production of income if (i) the sales price exceeds $150,000, and (ii) the face amount of all such
obligations held by the taxpayer for the taxable year exceeds $5 million. Fourth, a pledge of an
installment obligation arising from such a sale may be treated as a payment. See Section
453A(d).
Corporate-Level Taxes: A sale of assets by the S corporation may generate corporatelevel tax under Section 1374 if the S election was made after December 31, 1986.116 Corporatelevel tax under Section 1374 may not be avoided where the S corporation sells its assets for a
note maturing after the close of the ten-year recognition period. See Section IV.A.9. above for a
discussion of the special issues raised by an installment sale in a Section 1374 context.
2.
Taxable Asset Dispositions – Taxable Merger
Where the asset sale takes place via a taxable merger, the same general tax consequences
should ensue as a direct sale of assets (i.e., the target S corporation is deemed to sell its assets
and then liquidate). See Rev. Rul. 69-6, 1969-1 C.B. 104; PLR 9008068; CCA 201049025
(addressing Section 1374 tax in forward triangular cash merger of S corporation into C
corporation).
a.
Installment Sale Issues
If notes are issued in exchange for the S corporation’s assets in such a taxable merger,
additional issues must be considered.
116
Former Section 1374 may apply if an S election was made before 1987. See PLR
8809083; Section IV.A.15., above.
- 174 If Section 453B(h) Applicable: Section 453B(h) applies if the following conditions are
met: (i) the installment obligation must be distributed in a complete liquidation of an S
corporation; and (ii) the receipt of the obligation by the shareholders is not treated as payment for
their stock as a result of meeting the requirements of Section 453(h)(1). See, e.g., PLR
200326015. Generally, the receipt of an installment obligation satisfies the requirements of
Section 453(h)(1) if (i) such receipt occurs in a liquidation to which Section 331 applies, (ii) such
installment obligation was received by the S corporation in respect of a sale or exchange of
property, except for dealer property and inventory (unless such property was sold in a bulk sale),
during the 12-month period beginning on the date a plan of complete liquidation was adopted by
the S corporation, and (iii) the liquidation is completed during such 12-month period.
If Section 453B(h) applies, then the distribution of the installment obligation by the S
corporation in a transaction to which Sections 331 and 336 apply will not accelerate the deferred
corporate-level gain under Section 453B(a). Cf. Section 453(B)(d) (a liquidating distribution of
an installment obligation does not accelerate deferred corporate-level gain in a transaction to
which Section 337(a) applies). However, Section 453B(h) does not prevent the S corporation
from incurring the taxes under Sections 1374 and 1375.
Furthermore, Section 453(h) apparently requires that stock basis be allocated between the
installment obligation and the other assets distributed in the liquidation. See Treas. Reg. §
1.453-11. This effectively splits the liquidation transaction into two parts for the receiving
shareholders: (i) a non-taxable exchange for stock with respect to the installment obligation and
(ii) a taxable exchange (under Section 331) with respect to the other assets received. Apparently,
Treas. Reg. § 1.453-11 accomplishes this bifurcated approach by treating, with respect to each
shareholder, all the assets received in a liquidating distribution as received as part of the overall
installment sale price for the shareholder’s stock. Thus, the existence of other assets may cause
an effective acceleration of deferred corporate-level gain at the shareholder level. This potential
problem can be ameliorated by distributing some or all of the other assets prior to adopting a
plan of liquidation, which will reduce or eliminate stock basis.
Regardless of the existence of a stock basis allocation issue, Section 453(h)(1) will treat
the receipt of the installment payments as payments in exchange for the former shareholders’
stock. However, the character of the resulting gain or loss will be determined as if it had been
realized by the S corporation in the transaction in which the installment obligation was issued
originally. See Section 453B(h). Thus, the deferred corporate-level gain will be taken into
account under Section 331 as payments are received by the former shareholders.
If Section 453B(h) Inapplicable: The corporate-level gain deferred by Section 453 will
be accelerated if the liquidating distribution of the installment obligations does not meet the
requirements of Section 453B(h). This gain will pass through to the shareholders pursuant to
Section 1366. However, the shareholders will not have received the cash related to the
installment obligations until the notes are actually paid. Because this gain also increased the
shareholders’ stock bases, subsequent cash payments on the installment obligations will be
treated as a return of capital (i.e., the gross profit ratio will be reduced – possibly to zero).
- 175 In contrast, if the S corporation sells assets on an installment basis and remains in
existence, the gain could be deferred until the S corporation receives payment without concern
for the requirements of Section 453B(h). However, care must be taken if the S corporation has
earnings and profits because the interest income from the installment obligation should qualify as
passive income. Under Section 1362(d)(3), the S election could terminate if passive investment
income exceeds prescribed levels for three consecutive years. If the S election terminates, the
installment gain will be subject to double tax. Even if Section 1362(d)(3) is avoided, Section
1375 could require the S corporation to pay a corporate-level tax on excess passive investment
income. Sections 1362(d)(3) and 1375 can be avoided by structuring the installment payments to
fail the 25 percent gross receipts test.
b.
Effect on Election
In a taxable merger, the S corporation’s taxable year ends when its existence is
terminated. The S corporation does not qualify for any of the termination events in Section
1362(d) merely by reason of the termination of its taxable year. See Rev. Rul. 70-232, 1970-1
C.B. 178; Rev. Rul. 64-94, 1964-1 C.B. 317. Thus, the S election continues until the
corporation’s existence ceases.
c.
Allocation of Income (Loss) in Year of Disposition
Because the S election is not terminated during the S corporation’s final taxable year, an
S termination year should not arise. See Rev. Rul. 70-232; Rev. Rul. 64-94. As a result, income
(loss) items recognized until the deemed liquidation should be allocable under Section
1377(a)(1).117 If the reorganization occurs mid-year, the pass-through of income (loss) items to
the shareholders will be accelerated because the year closes early. However, the deemed
liquidation itself will not cause a shifting of income (loss) items among the shareholders.
3.
Deemed Asset Dispositions – Section 338(h)(10)
A corporation may acquire an S corporation by purchasing its stock and may treat the
stock acquisition as an acquisition of assets. See Section 338. If a Section 338(h)(10) election is
made, the target S corporation (“old T”) is deemed to sell all of its assets to a new S corporation
(“new T”) and distribute the proceeds to the old S corporation shareholders in liquidation. The
sale of target stock included in the qualified stock purchase is ignored.
a.
The Election
Regulations provide that a Section 338(h)(10) election can be made for an S corporation
if the purchasing corporation acquires the stock of the S corporation from the shareholders in a
qualified stock purchase. See PLR 201211009 (permitting rescission of transaction in order to
allow individual purchasers of S corporation stock to form holding company and to properly
117
Section 1362(e) should not apply. Were Section 1362(e) to apply, a short C year for
the day of the merger would be created. See Section 1362(e). This would produce double tax.
- 176 elect under Section 338(h)(10)). Treas. Reg. § 1.338(h)(10)-1(c)(1).118 Note that a purchasing
corporation cannot make a multiple-step qualified stock purchase of an S corporation because, if
the purchasing corporation attempted such a transaction, the S corporation would have an
ineligible shareholder prior to the completion of the qualified stock purchase. See Sections
338(h)(2), 1362(d)(2); Treas. Reg. § 1.338(h)(10)-1(b)(4), (e) ex. 10.
The Section 338(h)(10) election is made jointly by the purchasing corporation and the S
corporation shareholders on Form 8023 not later than the 15th day of the 9th month beginning
after the month in which the acquisition date occurs. Treas. Reg. § 1.338(h)(10)-1(c)(2). All S
corporation shareholders, selling or not, must consent to the making of the Section 338(h)(10)
election. Id. Once made, the election is irrevocable. Treas. Reg. § 1.338(h)(10)-1(c)(3).
b.
Consequences of the Election
In General: The S corporation recognizes gain or loss as if it had sold all of its assets in
a single transaction at the close of the acquisition date to an unrelated person (the “deemed
sale”). Treas. Reg. § 1.338(h)(10)-1(d)(3). The S corporation is then deemed to have transferred
all of its assets to the S corporation shareholders and ceased to exist (the “deemed liquidation”).
Treas. Reg. § 1.338(h)(10)-1(d)(4).
The S corporation’s S election continues in effect through the acquisition date (including
the time of the deemed asset sale and the deemed liquidation) notwithstanding Section
1362(d)(2)(B). Treas. Reg. § 1.338(h)(10)-1(d)(3).119 If the S corporation has subsidiaries that it
has elected to treat as QSubs, those QSubs remain QSubs through the close of the acquisition
date. Id. The S corporation’s final tax return is the return for the taxable year ending at the close
of the acquisition date, and it includes the deemed sale of assets under Section 338. Id.
The S corporation shareholders (whether or not they sell their stock) take their pro rata
share of the deemed sale gain into account under Section 1366 and increase or decrease their
basis in the S corporation stock under Section 1367. Treas. Reg. § 1.338(h)(10)-1(d)(5). Then,
the S corporation shareholders (whether or not they sell their stock) are treated as if, after the
118
On January 12, 1994 (T.D. 8515), the Treasury Department promulgated regulations
relating to Section 338(h)(10) elections. These regulations were replaced by temporary
regulations issued January 5, 2000 (T.D. 8858). The temporary regulations are generally
effective for stock purchases occurring after January 5, 2000. The temporary regulations were
replaced by final regulations issued February 12, 2001 (T.D. 8940). The final regulations are
generally effective for stock purchases occurring after March 15, 2001. For purposes of S
corporations and their shareholders, the temporary and final regulations contain the same rules.
As discussed above, since Treas. Reg. § 1.338-1(b) generally treats “new T” as a new
corporation unrelated to “old T” for purposes of Subtitle A of the Code, “new T” can make an S
election without regard to the five-year reelection prohibition of Section 1362(g) (i.e., “new T” is
not treated as the successor of “old T”). See PLR 200453007.
119
- 177 deemed asset sale and before the close of the acquisition date, they received the S corporation’s
assets in a deemed liquidation to which Sections 331 and 336 generally apply. Id.
Determination of Deemed Sale Gain: Regulations provide that the sales price of the
assets in the deemed sale equals the “aggregate deemed sales price” or “ADSP.” ADSP is the
sum of: (i) the grossed-up amount realized on the sale to the purchaser of the purchaser’s
recently purchased S corporation stock; and (ii) the S corporation’s liabilities. The deemed sales
price for each asset is determined by allocating the ADSP among the assets in accordance with
Treas. Reg. §§ 1.338-6 and -7. Then, the deemed sale gain with respect to each asset is
calculated by subtracting the asset’s adjusted basis from its deemed sales price.
Installment Sale Treatment: However, the entire deemed sale gain may not be
recognized immediately if any of the stock sold in the qualified stock purchase was sold on an
installment sale basis. Generally, regulations provide that, to the extent that installment
obligations were used to acquire recently purchased stock of the S corporation, the S corporation
will be treated as receiving identical installment obligations from “new T” in the deemed asset
sale. See Treas. Reg. § 1.338(h)(10)-1(d)(8)(i). All other consideration that is deemed to be
received in the sale is treated as cash. See id. Furthermore, in the deemed liquidation, the S
corporation is treated as distributing such installment obligations to the shareholders. See Treas.
Reg. § 1.338(h)(10)-1(d)(8)(ii). All other consideration that is deemed to be received in the
liquidation is treated as cash. See id. Thus, these rules treat an installment sale of stock to a
purchasing corporation to which Section 338(h)(10) applies in the same manner as a direct
installment sale of S corporation assets to the purchasing corporation followed by the liquidation
of such S corporation. See Treas. Reg. § 1.338(h)(10)-1(e) ex. 10; PLR 200603017; see also
Section X.A.2.a., above.
Stock Sale Effects: No gain or loss is recognized on the sale or exchange by the S
corporation shareholders of the S corporation stock included in the qualified stock purchase.
Treas. Reg. § 1.338(h)(10)-1(d)(5)(iii). In the preamble to the final regulations under Section
338(h)(10), the Treasury Department provides that the payment of differing amounts of
consideration to selling shareholders (as the result of varying federal and state tax liabilities of
the selling shareholders) does not cause the S corporation to violate the second class of stock
requirement of Section 1361(b)(1)(D). See T.D. 8940, 2001-1 .B. 101; Treas. Reg. § 1.13611(l)(2)(v).
Nonselling Shareholders: S corporation shareholders that retain stock in the former S
corporation do not recognize gain or loss with respect to any deemed sale of such stock. See
Treas. Reg. § 1.338(h)(10)-1(e) ex. 10. However, as discussed above, they take into account
(and adjust their stock basis for) their pro rata share of the gain or loss recognized with respect to
the former S corporation’s deemed asset sale, and they are treated as receiving the former S
corporation’s assets in a deemed liquidation to which Sections 331 and 336 generally apply.
Furthermore, such shareholders are treated as acquiring the S corporation stock so retained on
the day after the acquisition date for its fair market value (i.e., their stock basis increases or
decreases to fair market value if it has not otherwise been adjusted to fair market value as a result
of the deemed asset sale). Treas. Reg. § 1.338(h)(10)-1(d)(5)(ii). Consequently, the holding
period for the retained stock starts on the day after the acquisition date. Id.
- 178 -
Determination of Basis Step-Up: The resulting bases of the former S corporation’s
assets are determined by calculating an aggregate basis amount and allocating that amount
among all the assets. The adjusted grossed-up basis for the S corporation’s assets is determined
in accordance with Treas. Reg. § 1.338-5 and is allocated among the assets under the residual
method set out in Treas. Reg. §§ 1.338-6 and -7. Treas. Reg. § 1.338(h)(10)-1(d)(2).
c.
Effective Dates
The above rules apply to an S corporation and its shareholders if the S corporation has an
acquisition date after January 5, 2000. See Treas. Reg. § 1.338(i)-1(a) (the temporary and final
regulations contain the same rules for S corporations and their shareholders). Former regulations
under Section 338(h)(10) will apply with respect to an S corporation with an acquisition date on
or after January 20, 1994 but before or on January 5, 2000. See Former Treas. Reg. § 1.338(i)1(a).
d.
Deemed Ownership of Stock Held by a QSST
The Service has determined that gain from the deemed sale of assets resulting from a
Section 338(h)(10) election that is allocable to the stock held by QSSTs must be reported as gain
of the trusts, not their income beneficiaries. See PLR 9828006.
In PLR 9828006, two trusts (“T1” and “T2”) acquired the stock of an S corporation
(“X”). The respective income beneficiaries of T1 and T2 then elected under Section 1361(d)(2)
to treat these trusts as QSSTs. The income beneficiaries of T1 and T2 reported all pass-through
items of income, deduction, and credit allocable to the X stock held by the trusts. All of X’s
shareholders, including T1 and T2, agreed to sell all of their X stock to Y, a publicly-traded
corporation. As part of the agreement, the shareholders of X and Y filed an election under
Section 338(h)(10). Gain resulted from the deemed sale of X’s assets pursuant to the Section
338(h)(10) election.
The Service relied on Treas. Reg. § 1.1361-1(j)(8) to determine that any corporate gain or
loss resulting from the deemed sale of X’s assets that is allocable to the X stock held by T1 and
T2 is reportable for tax purposes by T1 and T2, not by their income beneficiaries. Accord PLR
201232003; PLR 199920007.
4.
Tax-Free Asset Dispositions
a.
Availability of Reorganization Provisions
If the S corporation disposes of its assets in an A, C, or D reorganization, a threshold
issue is whether the reorganization provisions of the Code apply to any of such transactions.
Prior to the Small Business Act of 1996, Former Section 1371(a)(2) created uncertainty
regarding this issue. But see GCM 39768 (Dec. 1, 1988) (concluding that Former Section
1371(a)(2) did not bar an S corporation from transferring its assets in an A, C, acquisitive D,
divisive D, or F reorganization). The Small Business Act of 1996 repealed Section 1371(a)(2).
- 179 See H. Rep. No. 104-586, 104th Cong., 2d Sess. 92 (1996). Thus, it now appears certain that an
S corporation may dispose of its assets in an A, C, or D reorganization.
b.
Effect on Election
Where an S corporation is acquired in a merger, consolidation, C reorganization, or
acquisitive D reorganization, the S corporation’s taxable year ends when it ceases to exist. See
Section 381(b)(1). The S corporation does not qualify for any of the termination events in
Section 1362(d) merely by reason of the termination of its taxable year. See Rev. Rul. 71-266,
1971-1 C.D. 262 (C Reorganization); Rev. Rul. 70-232, 1970-1 C.B. 178 (consolidation); Rev.
Rul. 64-94, 1964-1 C.B. 317 (merger); PLR 8307119 (merger). Thus, the S election continues
until the corporation’s existence ceases. If the acquiring corporation is a C corporation, it should
be able to elect S corporation status immediately (unless Section 1362(g) already applies to the
acquiring corporation) because Section 1362(g) is triggered (and the definition of a “successor
corporation” is met) only when an S election is terminated under Section 1362(d). See Section
1362(g); Treas. Reg. § 1.1362-5(b).
c.
Allocation of Income (Loss) in Year of Disposition
As discussed above, the S corporation does not qualify for any of the termination events
in Section 1362(d) merely by reason of the termination of its taxable year. Because the S
election does not terminate, an S termination year should not arise. See Rev. Rul. 64-94, 1964-1
C.B. 317; Rev. Rul. 70-232, 1970-1 C.B. 178. Thus, income (loss) items recognized until the
reorganization should be allocable under Section 1377(a)(1).120 If the reorganization occurs midyear, the pass-through of income (loss) items to the shareholders will be accelerated because the
year closes early. However, the reorganization itself will not cause a shifting of income (loss)
items among the shareholders.
d.
Carryovers
Typically, in an A, C, or acquisitive D reorganization, the target’s attributes are inherited
by the acquiring corporation. See Section 381. However, where the target is an S corporation,
some uncertainty exists regarding the application of Section 381 because Section 1371(b)(2)
provides that no carryforward and no carryback “shall arise at the corporate level for a taxable
year for which a corporation is an S corporation.”
Comment: It appears that this provision should not block the carryover of tax attributes
that are exclusively corporate-level items, such as the AAA and any remaining accumulated
earnings and profits. In fact, Treas. Reg. § 1.1368-2(d)(2) provides that the AAA carries over to
an acquiring S corporation.
120
Section 1362(e) should not apply. Were Section 1362(e) to apply, a short C year for
the day of the merger would be created. See Section 1362(e).
- 180 However, it is unclear whether the AAA carries over to an acquiring C corporation. C
corporations do not have an AAA. Section 381(c) does not expressly allow such a carryover.
Regardless, Treas. Reg. § 1.1377-2(b) implies that the AAA should carry over to an acquiring C
corporation because the regulation provides that a PTTP arises in this situation and one of the
reasons for a PTTP is to permit a C corporation to make tax-free cash distributions under Section
1371(e), which it will be unable to do if it does not acquire the S corporation’s AAA.
Furthermore, in the past, the Service has allowed nonspecified items to carry over to the
acquiring corporation.
e.
Suspended Losses
An S corporation generally will not have net operating loss carryovers because losses
pass through to the shareholders. However, where losses have been suspended under Section
1366(d)(2), special rules apply.
Losses suspended under Section 1366(d)(2) carry over with respect to the stock of the
acquiring corporation. See Treas. Reg. § 1.1366-2(c)(1). If the acquiring corporation is an S
corporation, a loss suspended under Section 1366(d)(2) is treated as incurred by the acquiring S
corporation with respect to the relevant shareholder if such shareholder is a shareholder of the
acquiring S corporation. See id. If the acquiring corporation is a C corporation, a PTTP arises
the day after the last day that the S corporation was in existence, and the rules under Sections
1366(d)(3) and 1377(b) 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 id. Apparently,
suspended losses of a former shareholder who does not become a shareholder of the acquiring
corporation simply expire. See Treas. Reg. § 1.1366-2(a)(5), (b)(2).
Section 1366(d)(3) allows loss recognition to the extent of the shareholder’s stock basis
as of the close of the PTTP. See FSA 200223052 (concluding that a shareholder of a target S
corporation, who is also a shareholder of the acquiring C corporation, is permitted to apply losses
suspended under Section 1366(d) against the shareholder’s historic basis in the stock of the
acquiring C corporation). It seems that the former S shareholder could make contributions to the
acquiring corporation in order to create stock basis for purposes of Section 1366(d)(3). See
Treas. Reg. § 1.1366-2(b)(2); FSA 200223052.
f.
Pre-Reorganization Distributions
Distributions by an S corporation prior to the reorganization should be governed by
Section 1368. See Rev. Rul. 71-266, 1971-1 C.B. 262. However, if such distributions ultimately
are funded by the acquiring corporation (e.g., repayment of debt used to make a distribution), the
distribution may be treated as a boot distribution. It is unclear how boot distributions are taxed
where a target S corporation is involved. See Section IX.B.1.b.(v), above.
g.
Distributions Pursuant to the Reorganization
If the target S corporation distributes money or property during the reorganization, it is
unclear whether Section 1368 or Section 356 controls. See Section IX.B.1.b.(v), above.
- 181 h.
Post-Reorganization Distributions
The treatment of post-reorganization distributions by the acquiring corporation is
uncertain because the Code does not provide for the treatment of S corporation attributes in a
reorganization transaction. It appears that the AAA carries over to an acquiring S corporation.
No statutory authority exists for such a result. However, the Service takes the position that the
AAA will carry over where the acquiring entity is also an S corporation. See Treas. Reg.
§ 1.1368-2(d)(2); PLR 8751013. Compare PLR 8810045 (no ruling possible on whether the
AAA is allocated in a divisive D reorganization between the transferee and transferor
corporations).
If AAA Carries Over to Acquiring S Corporation: If the AAA does carry over to an
acquiring S corporation, it is unclear whether Section 1371(e)(1) will apply to cash distributions
out of the AAA. Section 1371(e) on its face does not require a distribution by the former S
corporation. A successor corporation potentially could make distributions from the AAA to its
shareholders. However, Section 1371(e) would apply only to the former S corporation
shareholders who acquired stock of the successor corporation. See Treas. Reg. § 1.1377-2(b).
Comment: If the AAA does carry over to an acquiring S corporation, it appears that the
issue of whether Section 1371(e) can apply will be relevant only if the acquiring S corporation
has a negative AAA of its own. If the acquiring S corporation has a positive AAA of its own,
subsequent cash distributions would be tax-free under Section 1368(c), regardless of the
application of Section 1371(e). However, if the acquiring S corporation has a negative AAA of
its own, the two AAAs will net. See Treas. Reg. § 1.1368-2(d)(2). Thus, the resulting AAA of
the acquiring S corporation may not be large enough to support tax-free cash distributions under
Section 1368(c).
If AAA Carries Over to Acquiring C Corporation: If the acquiring corporation were a
C corporation, it appears that post-reorganization distributions would qualify for tax-free
treatment under Section 1371(e) if the AAA carries over (but only to the extent of the AAA and
shareholder stock basis, whichever is lower). See Section V.E., above.
B.
Stock Dispositions
1.
Sales of Stock
The shareholders of a target S corporation may decide to sell the stock of their
corporation instead of the assets.
a.
Effect on Election
A sale of stock generally will affect the S election only if the stock is sold to an ineligible
shareholder or the sale causes the total number of shareholders to exceed 100. Where an
ineligible shareholder acquires the stock, such ownership may be disregarded as being transitory
if the ineligible shareholder immediately disposes of its stock. See PLR 8739010.
- 182 b.
Allocation of Income (Loss) Items in the Year
If the S election is not terminated, income (loss) items will be allocated under Section
1377(a)(1), unless the shareholders make a Section 1377(a)(2) election to close the books. Such
an election may prove invaluable. For example, where losses are incurred by the S corporation
prior to the sale, post-sale income could eliminate such loss. In addition, after the sale, the buyer
may cause the S corporation to change its method of accounting to the detriment of the selling
shareholders. An election to close the books would help prevent such surprises to the selling
shareholders.
If the S election is terminated, the allocation may be made under Section 1362(e)(2).
Under this provision, income or loss will be allocated between the S and C short years on a daily
pro rata basis. However, if the sale encompasses 50 percent or more of the shares of stock
outstanding, the shareholders are required to close the books for purposes of allocating between
the S and C short years. Section 1362(e)(6)(D).
c.
Amount and Character of Gain or Loss on the Sale
The amount of gain or loss on the sale of stock depends on the shareholder’s stock basis.
A shareholder’s stock basis should reflect the income (loss) items allocated for the year of sale.
Treas. Reg. § 1.1367-1(d) provides that, if a shareholder disposes of stock during the S
corporation’s taxable year, the stock basis adjustments with respect to that stock are effective
immediately prior to the disposition.
Generally, the character of gain will be capital in nature. But see, e.g., Sections 304, 306,
121
341.
d.
Pre-Sale Distributions
A pre-sale distribution by the S corporation may result in a tax-free distribution to the
selling shareholder. Under Section 1368, the selling shareholder could cause the S corporation to
distribute excess cash to the extent of basis without triggering immediate gain. The stock could
then be sold on the installment basis for a reduced price. Each installment would carry a higher
percentage of gain, but such gain would be deferred.
e.
Post-Sale Distributions
If the S election is not terminated, post-sale distributions to the acquiring shareholders
may be treated as nondividend distributions under Section 1368. As discussed above, the AAA
is a corporate level account; its benefits are not limited to specific shareholders (as the PTI
account was under prior law).
121
Note that, for taxable years beginning after December 31, 2002 and not beginning
after December 31, 2008, the Jobs and Growth Act of 2003 repealed Section 341.
- 183 Where the buyer purchases the stock for notes, withdrawals from the AAA would allow
the buyer to satisfy the acquisition indebtedness with tax-free cash (to the extent of basis). This
is not possible where a C corporation is purchased, since the withdrawal of target earnings would
be taxable to the buyer as a dividend. If the S corporation’s AAA is not sufficient to cover the
acquisition debt, a bootstrap redemption should be considered by the parties.
If the S election is terminated, the acquiring shareholders cannot take advantage of
Section 1371(e) (tax-free distributions to the extent of basis or the AAA, whichever is less). See
Treas. Reg. § 1.1377-2(b).
f.
Section 338(g) Election
Although an S corporation is a pass-through entity, a Section 338(g) election by the buyer
of S corporation stock will produce multiple levels of tax. First, the selling shareholders will
recognize gain or loss on their stock sales. Second, the deemed asset sale by the target
corporation pursuant to Section 338 causes gain or loss to be recognized by the target
corporation as a C corporation subject to double-levels of tax. This occurs because of the
interaction of Sections 1362(e) and 338(a)(2).
The purchase of S corporation stock by a corporation terminates the S election. See
Section 1362(d)(2). The termination creates an S termination year consisting of (i) a short S year
that ends on the day before the acquisition date and (ii) a one-day short C year that includes only
the acquisition date. See Section 1362(e)(1). However, the Section 338(g) election causes the S
corporation target to be treated as a new corporation beginning on the day after the acquisition
date. See Section 338(a)(2). Thus, another short C year begins on the day after the acquisition
date. As a result, the deemed sale will take place in the one-day short C year that consists of the
acquisition date, and the gain or loss resulting from the deemed sale will be allocated to such
taxable year so that the target corporation will take such gain or loss into account as a C
corporation subject to double-levels of tax rather than as an S corporation generally subject to
one level of tax. See Section 1362(e)(6)(C), (D).
g.
Section 1411 Net Investment Income Tax
Section 1411, effective for tax years beginning after December 31, 2012, imposes a 3.8
percent tax on the lesser of an individual’s net investment income and the excess of his modified
adjusted gross income over a threshold amount ($250,000 for married taxpayers, $200,000 for
single taxpayers). Section 1411(c)(4) provides that this tax generally applies to the disposition of
an interest in an S corporation or a partnership, but only “to the extent of the net gain which
would be so taken into account by the transferor if all property of the partnership or S
corporation were sold for fair market value immediately before the disposition of such interest.”
Section 1411(c)(4)(A). Section 1411(c)(4)(B) provides for a similar rule for losses from a
disposition. Section 1411(c)(4) generally applies only to property not held in an active trade or
business. Proposed regulations were published on December 5, 2012. See Prop. Treas. Reg. §
1.1411-7; 77 Fed. Reg. 72,611.
The preamble to the proposed regulations explains that section 1411(c)(4) is intended to
achieve parity between interest sales and assets sales. The proposed regulations provide that the
- 184 transferor of the S corporation stock should compute the gain or loss from the sale of the S
corporation’s underlying properties using a deemed asset sale method, and then determine if,
based on the deemed sale, there is an adjustment to the transferor’s gain or loss on the disposition
of the stock. Prop. Treas. Reg. § 1.1411-7(c). These rules must be applied on a property by
property basis. Prop. Treas. Reg. § 1.1411-7(c)(3). The proposed regulations provide special
rules for property held in more than one trade or business, gain or loss from goodwill, the
interaction with section 338(h)(10), installment sales, and for sale by a QSST.
2.
Redemptions
A redemption occurs where the corporation acquires all or some of a shareholder’s stock
in exchange for property. See Section 317(b). A redemption often occurs in connection with a
shareholder’s sale of stock where the corporation has excess cash or unwanted assets, or where
the transactions must be tailored to the buyer’s ability to pay the purchase price. See Zenz v.
Quinlivan, 213 F.2d 914 (6th Cir. 1954). In addition, the Service treats the acquisition of target
stock with borrowed funds as a redemption by the target (and not a purchase of stock) to the
extent that the debt is secured by target assets or the target assumes the debt. See Rev. Rul. 78250, 1978-1 C.B. 83; PLR 8546110; PLR 8542020; PLR 8539056.
a.
Effect on Election
A redemption alone should not affect the S election.
b.
Allocation of Income or Loss in the Year
Unless the shareholders make an election under Section 1377(a)(2) to close the books, the
general allocation rules will apply. Also, the distribution of appreciated property will trigger
gain at the corporate level, which will be allocated to all shareholders under Section 1377(a).
c.
Distributions
The redemption will qualify for sale or exchange treatment under Section 302(a) if any
one of the Section 302(b) tests is satisfied. If Section 302(b) is not met, the redemption will be
treated as a Section 301 distribution. See Section 302(d).
(i)
Section 302(a) Redemptions
Shareholder Level: The usual Section 302 rules will apply to the shareholder. Thus,
gain will be recognized in an amount equal to cash plus fair market value of property received
less the basis of the shares redeemed.
S Corporation Level: A Section 302(a) redemption decreases the AAA by an amount
equal to the ratable share of the corporation’s AAA attributable to the redeemed stock as of the
redemption date. See Treas. Reg. § 1.1368-2(d)(1)(i); PLR 9412032. For example, if 60 percent
of the shares are redeemed, the AAA will be reduced by 60 percent.
- 185 Furthermore, the AAA is adjusted for (i) the effect of income (loss) items for the year, (ii)
ordinary distributions, and then (iii) for redemption distributions. See Treas. Reg. § 1.13682(d)(1)(ii). Section 1368(e)(1)(C) provides that, for purposes of determining the tax treatment of
ordinary distributions that (i) would be subject to Section 301(c) but for Section 1368, and (ii)
are made during a taxable year by an S corporation having earnings and profits, a net negative
adjustment to the AAA (i.e., the excess of the decreases in AAA other than for distributions over
the increases in AAA) for that taxable year is disregarded. See Treas. Reg. § 1.1368-2(a)(5).
Note, however, that such net negative adjustment is taken into account prior to adjusting the
AAA for redemption distributions. Id.
The S corporation’s earnings and profits will also be reduced under Section 312. See
Treas. Reg. § 1.1368-2(d)(1)(iii).
(ii)
Section 302(d) Redemptions
If the redemption is covered by Section 302(d) (because Section 302(a) is inapplicable),
the redemption will be treated as an ordinary Section 301 distribution. The result is that Section
1368 will apply.122
Where the shareholder’s interest is completely terminated and the corporation does not
have earnings and profits, a Section 302(a) redemption and a Section 1368 distribution will
produce similar results. Both are tax-free to the extent of basis with capital gain generally
thereafter. However, if a shareholder’s holdings are only partially redeemed, a redemption
distribution may be wholly tax-free under Sections 1368(b)(1) or (c)(1); under Section 302(a), by
contrast, gain may result. Thus, in this case, Section 1368 would produce more favorable results.
See PLR 201207002.
122
The Treasury Department and the Service published proposed regulations on October
18, 2002 that generally applied to such dividend-equivalent redemptions. Under the proposed
regulations, a shareholder receiving such a dividend-equivalent redemption generally would have
recognized a suspended loss in the redemption equal to the shareholder’s basis in the redeemed
stock; under current regulations, by contrast, the shareholder would recognize no such loss but
rather would reallocate the basis in such redeemed shares to any remaining shares held (or
deemed to be held) by the shareholder. Compare Former Prop. Treas. Reg. § 1.302-5, 67 Fed.
Reg. 64,331-02 (Oct. 18, 2002), with Treas. Reg. § 1.302-2(c). Presumably, these proposed
regulations would have applied only to an S corporation redemption distribution treated as being
made out of accumulated earnings and profits under Section 1368(c)(2). On April 19, 2006, the
Treasury Department and the Service withdrew the proposed regulations. See IRS
Announcement 2006-30, 2006-1 C.B. 879. According to IRS Announcement 2006-30, several
comments were received expressing two predominant concerns: (i) some commentators thought
that the approach taken by the proposed regulations was an unwarranted departure from current
law; and (ii) some commentators questioned whether the proposed regulations could create the
potential for two levels of tax for companies filing consolidated returns.
- 186 Where the corporation has accumulated earnings and profits, and the distribution exceeds
the AAA, the excess will be taxed as dividend income to the extent of such earnings and profits.
Distributions taxed as dividends do not receive any basis offset. Thus, in such cases, redemption
treatment under Section 302(a) would be preferable to ordinary distribution treatment under
Section 1368.
C.
Complete Liquidation
1.
General Tax Consequences
An S corporation could liquidate in a transaction to which Sections 332 and 337 apply if
it had the required corporate shareholder. However, an S election terminates on the day that an S
corporation has any corporate shareholder. See Section 1362(d)(2). Thus, it appears that such a
liquidation would transform from a liquidation of an S corporation into a liquidation of a C
corporation.
However, an S corporation may liquidate in a transaction to which Sections 331 and 336
apply because such a transaction does not require a corporate shareholder.123 Generally, such a
liquidation will result in only one level of tax (i.e., tax on the gain recognized at the S
corporation level and no gain to tax at the shareholder level).
Under Section 336, the S corporation will recognize gain on a liquidating distribution of
property as if such property were sold to the shareholders at its fair market value. The S
corporation may recognize loss as well, but certain limits apply. See Section 336(d). Such loss
and gain will be taken into account by the shareholders pursuant to Section 1366, and such loss
and gain will adjust the shareholders’ basis in stock (and debt under certain circumstances)
pursuant to Section 1367. If the S corporation distributes encumbered assets in exchange for
stock in complete liquidation, there is no adjustment of the stock basis associated with the
assumption of the liability. ILM 201237017.
Under Section 331, distributions in complete liquidation are treated as payment in
exchange for the stock of the S corporation. Thus, the shareholders recognize gain or loss to the
extent that the fair market value of property and cash received (less liabilities assumed) exceed
their basis in stock. Note, however, that stock basis is adjusted for any gain or loss recognized at
the corporate level under Sections 336 and 1367 before gain or loss is determined under Section
331. These adjustments to stock basis are the mechanism that reduces any gain or loss that
would otherwise be recognized under Section 331 (i.e., a potential two-level liquidation tax can
be reduced to a potential one-level liquidation tax).
123
Former Section 1363(d) seemed to apply to complete liquidations. However, section
1006(f)(7) of the TAMRA of 1988 deleted Former Section 1363(d), so that Section 336 now
applies to the complete liquidation of an S corporation.
- 187 Any gain or loss recognized pursuant to Section 331 should be capital unless Section
1244 applies. Furthermore, each shareholder takes a fair market value basis in property received.
Section 334(a).
Query what the tax consequences may be if the “liquidating” S corporation is insolvent.
Cf. Prop. Treas. Reg. § 1.332-2 (providing that Section 332 does not apply when a corporate
shareholder fails to receive at least partial payment for the liquidating corporation’s stock that the
shareholder owns).
2.
Effect on Election
Presumably, the S election ceases with the corporate existence of the S corporation,
which should occur upon the final liquidating distribution. However, until that time, the S
election should remain valid. See Rev. Rul. 70-232, 1970-1 C.B. 178; Rev. Rul. 64-94, 1969-1
C.B. 317. See Section X.A.4.b., above.
3.
Allocation of Income and Loss in Year of Liquidation
Allocation of gains and losses arising in the S corporation’s final year should not be
affected by the liquidation. Since a complete liquidation terminates the taxable year, a bunching
of income may result if the S corporation is a fiscal year taxpayer. However, fiscal year S
corporations should not be prevalent in light of the taxable year requirements of S corporations.
See Section II.A.6., above.