Election to close S year under sec. 1368 regulations.

• Author: Kata, Susan C.

Adjustments to stock basis for an S shareholder's share of the income or loss, and the tax effects of any distributions, are generally determined at the end of the corporation's tax year. If a shareholder disposes of stock during the year, the adjustments are effective immediately prior to the date of disposition.

Under Sec. 1377(a), each item of income or loss is deemed to occur pro rata throughout the S corporation's tax year. If a shareholder terminates his interest in the corporation during the year, the corporation may elect, with the consent of all the shareholders, to treat the year as if it consisted of two tax years, the first of which ends on the date of the termination. If such an election is made, the stock basis would be adjusted for the actual income or loss earned through the date of termination, rather than for a pro rata allocation of the entire year's income.

In June 1992, proposed regulations under Sec. 1368 were issued, which provided for an election to treat a tax year as two separate tax years when a shareholder disposes of substantial amounts of stock (20% or more). Final regulations, issued Dec. 30, 1993, further expand the situations in which the corporation may make the election and are somewhat less burdensome than the proposed regulations.

Under Regs. Sec. 1.1368-1(g)(2 when a "qualifying disposition" takes place, an S corporation may elect to treat its tax year as if it consists of separate tax years for purposes of allocating income and loss, and adjusting the accumulated adjustments account (AAA), earnings and profits and shareholders' stock basis. The "first" tax year ends on the date that the shareholder makes a qualifying disposition of stock. A qualifying disposition is any one of the following:

1. A disposition of 20% or more of the corporation's outstanding stock during any 30-day period within the corporation's tax year.

2. A redemption under Sec. 302(al or 303(a) of 20% or more of the outstanding stock of the corporation during any 30-day period within the corporation's tax year.

3. An issuance of stock representing more than 25% of the previously outstanding stock to new shareholders during any 30-day period within the corporation's tax year.

The corporation makes the election by attaching a statement to its tax return for the tax year in which the qualifying disposition occurs. The election statement must --state that the corporation is electing, under Regs. Sec. 1.1368-1(g)(2)(i), to treat the tax...