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Final Regs. Clarify Passthroughs, Distributions and Basis Adjustments This article discusses recent final regulations under Secs. 1366–1368 that explain how S corporation passthroughs and distributions affect a shareholder's stock basis. The regulations provide tax practitioners and S shareholders with the guidance they need to comply with current tax law. The article's many examples illustrate the differences in treatment from the proposed regulations. Nancy
J. Foran, Ph.D., CPA Michael
D. Harkness, Ph.D., CPA
For more information about this article, contact Dr. Foran at nforan@umd.umich.edu.
Executive Summary
Recent regulations1 clarify the S corporation passthrough, distribution and basis adjustment rules; they finalize August 1998 proposed regulations2 and apply to S tax years beginning after Aug. 17, 1998. For tax years beginning after 1996 and before Aug. 18, 1998, shareholders' stock basis adjustments and S corporation distributions must be determined reasonably, based on the Code and legislative history.
Passthrough of Items to Shareholders Regs. Sec. 1.1366-1 requires S shareholders to include their pro rata share of an S corporation's income, losses, deductions and credits (whether or not distributed) in their return for the tax year within which the corporation's tax year ends. S corporation items are divided into (1) separately stated items and (2) nonseparately computed income or loss. The separately stated items identified in Regs. Sec. 1.1366-1(a)(2) include (but are not limited to) the items listed in Exhibit 1.
Tax-Exempt Income Tax-exempt income must be separately stated. The proposed regulations defined it as income always permanently excludible from income, such as (1) Sec. 101 certain death benefits (i.e., life insurance proceeds) and (2) Sec. 103 state and local bond interest. Items that may result in income deferral—but not exclusion—are not exempt. Sec. 108 exclusion of income due to cancellation of debt (COD) and Sec. 109 lessee improvements on a lessor's property were specifically identified as nonexempt items. The Sec. 108 exclusion of COD income and attribute reduction provisions allow debtors to avoid immediate income recognition, but may result in income recognition later. Although some commentators objected to the exclusion of Sec. 108 income from exempt income, this treatment was retained; Treasury and the Service believe it is consistent with the Sec. 108 legislative history and the S corporation rules. The Sec. 108(a)(1)(D) legislative history states that excluding the discharge of qualified real property indebtedness income simply defers income to S shareholders and does not result in an adjustment to stock basis.3 The Sec. 108(d)(7)(A) legislative history supports the exclusion of COD income from exempt income. It states that (1) to treat S shareholders consistently, income exclusion and tax attribute reduction are made at the corporate level and (2) any COD income remaining after tax attribute reduction does not result in income or other tax consequences.4 The Tenth Circuit recently considered the Sec. 108 issue. In Gitlitz,5 the court did not allow shareholders of an insolvent S corporation to increase their stock basis to use suspended losses. The court held that held that if excluded COD income was allowed to pass through to shareholders to increase their stock basis, they would reap a tax windfall contrary to Congressional intent. Gitlitz states that (1) both the COD income exclusion and tax attribute reduction principles apply at the corporate level, (2) the timing of the tax attribute reductions and the passthrough of income items is critical and (3) attribute reduction precedes the income passthrough. Because attribute reduction precedes the income passthrough, the corporation's excluded COD income is absorbed before it can pass through to the shareholders and affect their stock basis; thus, no windfalls occurs. In Gitlitz, the net operating loss (NOL) attribute absorbed the corporation's excluded COD income. Thus, (1) no income items passed through to shareholders, (2) shareholders could not use S NOLs to offset their own income or adjust their stock basis and (3) shareholders' suspended losses disappeared and had no future tax consequences. The proposed regulations' preamble also distinguished between partnership and S corporation treatment of COD income. It stated that it is appropriate for partners, but not S shareholders, to increase the basis of their interests due to the exclusion of COD income, for two reasons. First, Sec. 108 applies at the corporate level for S corporations and at the partner level for partnerships, under Sec. 108(d)(6) and (7). Thus, COD income may be included by some partners and excluded by others. Second, partnership basis must be increased to offset the Sec. 752(b) basis reduction due to the decrease in partnership liabilities. Sec. 109 allows an income exclusion for the cost of improvements made by a lessee that revert to the lessor on lease termination or expiration. The reverted improvements may result in income to the lessor when the property is sold. Based on these arguments, the proposed definition of tax-exempt income was retained in the final regulations.
Aggregation of Deductions or Exclusions Regs. Sec. 1.1366-1(a)(5) requires shareholders to aggregate their separate deductions or exclusions with their pro rata share of the S corporation's separately stated deductions or exclusions to determine their allowable deduction or exclusion.
The final regulations' preamble clarifies that this example intends to illustrate that a shareholder's total Sec. 179 deduction cannot exceed the individual limit; it does not mean to imply that shareholders must elect to expense their share of the S corporation's Sec. 179 property before electing to expense their separately acquired property.7 The final regulations do not modify the example and do not provide additional examples of the aggregation rule.
Character of Items Generally, the character of an item passed through to a shareholder is determined at the corporate level. Regs. Sec. 1.1366-1(b) provides exceptions for the contribution of (1) noncapital gain property and (2) capital loss property, if an S corporation is formed or availed of by shareholders for a principal purpose of selling or exchanging the property to change the nature of the gain or loss. In such case, the property retains the character it had in the shareholder's hands before the contribution. Several commentators had argued that the IRS lacked the authority to recharacterize gain or loss at the shareholder level. Others suggested limiting the recharacterization rule to sales or exchanges within a specified time period. The preamble to the final regulations states that the rules are reasonable and will be retained. It also provides that the IRS will consider the length of time between the contribution of the property and the S corporation's sale or exchange of it when determining whether the intent of the contribution was to change the character of gain or loss.
Shareholders' Gross Income Regs. Sec. 1.1366-1(c) states that a shareholder's gross income includes his pro rata share of the S corporation's gross income, plus his share of separately stated income and deduction items. This rule would apply, for example, when shareholders determine (1) gross income from farming for purposes of Secs. 175 and 6654(i), (2) if they are required to file an income tax return under Sec. 6012(a) and (3) whether the Sec. 6501(e) six-year statute of limitations (SOL) on assessment and collection applies for an omission of more than 25% of gross income. This gross income rule is similar to the Sec. 702(c) partnership gross income rule and was retained in the final regulations (despite a comment that it be deleted or that a de minimis exception be adopted for minority shareholders).
Passthrough Deduction Limits Regs. Sec. 1.1366-2 limits a shareholder's recognition of loss and deduction items to the sum of (1) his stock basis and (2) the basis in any debt owed to him by the corporation. Any loss or deduction in excess of this limit retains its character and is treated as incurred in the corporation's first succeeding and subsequent tax years.
Basis Limit In determining a shareholder's stock basis for the passthrough of loss and deduction items, Regs. Sec. 1.1366-2(a)(3) requires basis to be increased by the shareholder's portion of the S corporation's (1) separately stated income (including tax-exempt income), (2) nonseparately computed income and (3) depletion deductions in excess of the property's basis. Basis is decreased by the shareholder's portion of the:
The shareholder's portion of the S corporation's nonseparately computed loss and separately stated losses and deductions are disregarded. NCNDE and certain oil and gas depletion deductions are disregarded if a Regs. Sec. 1.1367-1(g) election is made. For purposes of the loss limit rules, the basis of corporate debt owed to a shareholder is determined without regard to (1) separately stated deductions and losses, (2) nonseparately computed losses, (3) NCNDE and (4) certain oil and gas depletion deductions.
Basis of Stock Acquired by Gift For stock acquired by gift, Regs. Sec. 1.1366-2(a)(6) states that the stock's basis is its Sec. 1015(a) loss basis—i.e., the lower of (1) the stock's fair market value (FMV) or (2) the donor's adjusted basis at the gift date. A commentator argued that Sec. 1015 loss basis should apply only to the disposition of an asset and does not affect the asset's depreciation basis or the deductibility of expenses due to the asset's use or operation. The final regulations' preamble asserts that the loss basis rule is used to determine the amount of passthrough losses and deductions, not an asset's depreciable basis. If a donee used the donor's basis to take depreciation deductions and S NOLs, the donee would benefit from the loss attributable to the donor. The gift basis rules prevent a donee from recognizing any loss attributable to the donor when the gifted property is ultimately sold. Thus, the final regulations retain the use of the loss basis.
Limit Allocation Under Regs. Sec. 1.1366-2(a)(4), the loss and deduction limit is allocated among the shareholder's pro rata portion of each loss and deduction item based on a ratio of such item to the total of all current- and prior-year disallowed loss and deduction items.
Losses and Deductions Nontransferable Regs. Sec. 1.1366-2(a)(5) states that losses and deductions in excess of the basis limit are personal and cannot be transferred by the shareholder. If a shareholder sells or transfers all of his stock, disallowed losses and deductions are permanently lost. If a portion of the stock is sold or transferred, the disallowed losses and deductions are retained, not reduced proportionately. A request made during the comment period to allow disallowed losses to be transferred when stock is transferred as part of a divorce settlement was denied; Sec. 1366(d) states that the disallowed losses and deductions apply only to the shareholder whose investment limited such loss or deduction. A suggestion to allow former shareholders who reacquire the S stock to also reacquire the previously disallowed losses and deductions was also denied. The final regulations' preamble states that, under Sec. 1366(d), disallowed losses and deductions carry over to the next tax year. When a shareholder completely terminates his interest, he is not a shareholder in the succeeding tax year; thus, the disallowed items cannot carry over.
PTTP Disallowed losses and deductions can be deducted during the post-termination transition period (PTTP) to the extent of the shareholder's stock, but not debt, basis. Regs. Sec. 1.1366-2(b)(2) clarifies that losses and deductions in excess of stock basis at the end of the PTTP are permanently disallowed. The basis of stock acquired by gift is the stock's loss basis. Losses and deductions in excess of the basis limit must be allocated among the individual loss and deduction items.
Liquidations, Reorganizations and Divisions Regs. Sec. 1.1366-2(c) provides that, in the case of a liquidation or reorganization, a shareholder's disallowed losses will carry over to his stock in the acquiring S corporation. If the acquiring corporation is a C corporation, the PTTP begins the day after the last day of the S corporation's existence; the PTTP rules apply to the S shareholders who become shareholders of the acquiring C corporation. If an S corporation transfers part of its assets to another corporation in a Sec. 368(a)(1)(D) divisive D reorganization and a Sec. 355 distribution of the stock and securities of the controlled corporation occurs, a shareholder's disallowed losses and deductions are allocated between the distributing corporation and the controlled corporation as to the shareholder. (The proposed regulations required the allocation to be based on the relative value of a shareholder's stock in the distributing and controlled corporations immediately after the distribution.) In response to comments that the term "value" was ambiguous and that its computation involves many issues, the final regulations permit the allocation to be based on any reasonable method. Regs. Sec. 1.1366-2(c)(2) lists the following reasonable methods: 1. The relative FMV of the corporations immediately after the distribution. 2. The relative adjusted basis of the corporations' assets immediately after the distribution. 3. Any method that allocates losses and deductions to either corporation, if they are clearly attributable to one of the corporations.
Family Groups If a family member provides services or capital to an S corporation without receiving reasonable compensation, Regs. Sec. 1.1366-3 allows the IRS to reallocate S corporation items among the family to reflect the reasonable value of the services or capital provided. "Reasonable value" will be based on the facts and circumstances, including comparable services and capital that could be obtained from individuals other than family members or shareholders. Reallocation may also occur when a family member holds an interest in a passthrough entity that does not receive reasonable compensation for services or capital provided to the S corporation. "Family" includes the shareholder's spouse, ancestors, lineal descendants and trusts that primarily benefit these persons.
Special Rules Regs. Sec. 1.1366-4 clarifies that the Sec. 1374 built-in gains (BIG) tax and the Sec. 1375 excess net passive investment income (PII) tax are allocated among the net items that produced the tax and reduce the amounts passed through to shareholders. Thus, if BIG tax is imposed, it is treated as an S corporation loss and allocated proportionately among the net recognized BIGs that created the tax. The character of the loss is determined by the item to which the loss is allocated. If the excess net PII tax is imposed, it is allocated among the PII items, based on the ratio of each item to the total net PII; the tax reduces those items.
Thus, the tax is $28,000 (0.35 x $80,000 ENPI). The tax is allocated $11,667 ($28,000 x ($50,000/$120,000)) to the dividend income and $16,333 ($28,000 x ($70,000/$120,000)) to the rental income. The dividend income passed through to shareholders is $38,333 ($50,000 – $11,667); the rental income passthrough is $53,667 ($100,000 – $30,000 – $16,333).
Basis Adjustments Before the enactment of the Small Business Job Protection Act of 1996 (SBJPA), stock basis was adjusted for income (whether taxable or not), deduction (whether deductible or not) and loss items before being adjusted for distributions. Because Congress believed that the basis adjustment rules for S corporations should be the same as those applicable to partnerships, SBJPA Section 1309 was enacted, requiring distribution adjustments to be made before considering deduction (whether deductible or not) and loss items. Regs. Sec. 1.1367-1(e) provides the basis adjustment ordering rules for tax years beginning before 1997; Regs. Sec. 1.1367-1(f) states the rules for tax years beginning after Aug. 17, 1998. Exhibit 2 summarizes the basis adjustment ordering rules. Regs. Sec. 1.1367-1(g) retains the ordering election that allows shareholders to reduce basis for deduction and loss items before NCNDE.
For S tax years beginning (1) before 1994 and (2) after 1996 but before Aug. 18, 1998, Regs. Sec. 1.1367-3 requires stock basis to be determined in a reasonable manner, taking into account the law and legislative history. Regs. Sec. 1.1367-1(h), Examples 2 and 5 (describing the basis adjustment ordering rules) are considered to be reasonable for tax years beginning after 1996 and before Aug. 18, 1998. The distribution rules affect all distributions, including those received by shareholders who terminate their interest in an S corporation, when a Sec. 1377(a)(2) election is made to treat the S corporation's tax year as two tax years. In addition, if an S corporation elects to terminate its tax year due to (1) a qualifying disposition (under Regs. Sec. 1.1368-1(g)(2)) or (2) a Sec. 1377(a)(2) termination of a shareholder's interest, the stock basis adjustments are determined as if the tax year consisted of separate tax years.
Because shareholders must report a capital gain when distributions exceed their stock basis, the change in basis ordering may cause them to report smaller gains and losses.
Distributions The tax effect of an S corporation's distribution to a shareholder is determined after considering (1) his stock basis, (2) the AAA and (3) Secs. 1367 and 1368 adjustments. For S tax years beginning before 1997, Regs. Sec. 1.1368-1(e)(1) retains the rules in effect before the issuance of the proposed regulations. The effect of a distribution is to be determined after taking into account (1) the shareholder's stock basis adjustments identified in Sec. 1367 (i.e., the basis adjustments described above), ignoring decreases due to distributions not includible in income and (2) the AAA adjustments specified in Sec. 1368(e)(1)(A), ignoring decreases due to distributions. Sec. 1368(e)(1)(A) provides that AAA adjustments are similar to basis adjustments, but AAA can be negative and is not adjusted for (1) tax-exempt income and related expenses or (2) Federal taxes attributable to a C tax year. Because AAA, unlike basis, can be reduced to a negative number by deductions and losses, the order in which the deduction, loss and NCNDE items are taken into account does not matter. Thus, elective ordering rules are not needed for AAAs. For S tax years beginning after Aug. 17, 1998, Regs. Sec. 1.1368-1(e)(2) requires the effect of a distribution to be determined after taking into account (1) positive stock basis adjustments and (2) AAA adjustments other than a net negative adjustment (defined by Sec. 1368(e)(1)(C)(ii) as the excess of AAA reductions (other than distributions) over AAA increases for the tax year).
AAA Ordering Rules Regs. Sec. 1.1368-2(a)(4) and (5) provide AAA ordering rules, and are summarized in Exhibit 3. For S tax years beginning before 1997, Regs. Sec. 1.1368-2(a)(4) retains the rules that applied before the proposed amendments, and are set forth in the "Before 1997" column of Exhibit 3. For S tax years beginning after Aug. 17, 1998, the AAA adjustment order specified in the proposed regulations was unclear. A commentator stated that the proposed regulations seemed to require AAA to be adjusted in the order used for stock basis adjustments—i.e., (1) increased by income (other than tax-exempt income) and by the excess of depletion deductions over the property's basis and (2) decreased by distributions, NCNDE, certain oil and gas deductions and by deductions and losses. The commentator stated that, although the SBJPA changed the stock basis adjustment order, the AAA adjustment order is changed only when a net negative adjustment occurs. Consistent with this comment, the final regulations clarify that for S tax years beginning after Aug. 17,1998, the AAA adjustment order changed only when there is a net negative adjustment.10 The regulations specify the AAA adjustment order listed in the "After 8/17/98" column of Exhibit 3.
Because distribution decreases must be made without considering net negative adjustments, shareholders may report more nontaxable distributions, but deduct smaller losses.
For S tax years beginning after 1996 and before Aug. 18, 1998, the treatment of corporate distributions must be determined in a reasonable manner, taking into account the law and legislative history. Regs. Sec. 1.1368-4 states that the final regulations are considered to be reasonable for this purpose.
Conclusion As the S election has increased in popularity, issues concerning the passthrough of items of income, deduction and loss have become more numerous and complex. Tax law changes designed to address these problems created a need to amend the S corporation regulations. Recent final regulations clarify the proposed regulations and address commentators' concerns. The regulations provide tax practitioners and S shareholders with the guidance they need to comply with current tax law.
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