Did the IRS interpret or rewrite sec. 1374?: final regulations for service organizations.

• Author: Buffington, George N.

In 1988, Congress enacted Sec. 1374 to impose a tax on S corporations with a built-in gain (BIG) arising from conversion from C corporation status, to the extent a net built-in gain is recognized during the first 120 months (recognition period) as an S corporation. The amount of the tax is computed by applying the highest C corporation tax rate to the net recognized BIG for the tax year.

At the end of 1994, the Treasury issued final regulations under Sec. 1374, dramatically limiting the extent to which deductions can offset gains, adding limits to the statute not intended by Congress and contradicting congressional reports.

The regulations are effective for tax years ending on or after Dec. 27, 1994, but only when the return for the tax year is filed under an S election on a transfer of assets from a C corporation to an S corporation under Sec. 1374(d)(8) occurring on or after that date.

The IRS introduced an accrual-method concept in the regulations for the purpose of computing the amount of recognized built-in gain or loss items. It also imposed the limits of Secs. 267(b) and 404(a)(5) to built-in losses under Sec. 1374. This approach is not authorized by the statute and, while seemingly rational on its face, is inconsistent with the congressional intent outlined in the committee reports to the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). This is particularly so when the statute is applied to compensation derived from accounts receivables.

The committee reports contain the following example:

As an example of these built-in gain and loss provisions, in the case of a cash basis personal service corporation that converts to S status and that has receivables at the time of the conversion, the receivables, when received, are built-in gain items. At the same time, built-in losses would include otherwise deductible compensation paid after the conversion to the persons who performed the services that produced the receivables, to the extent such compensation is attributable to such pre-conversion services. To the extent such built-in loss items offset the built-in gains from the receivables, there would be no amount subject to the built-in gains tax.

Therefore, at least for a cash-basis personal service corporation (PSC), compensation payable should be a built-in deduction so long as actually paid within the recognition period, without imposition of the restrictions under Sec. 267(b) or 404(a)(5).

In general, Regs. Sec. 1.1374-1A...