Final regulations on treatment of built-in gain on conversion from C to S.

• Author: Starr, Samuel P.
• Position: C corporation to S corporation

The IRS has released Regs. Sec. 1.1374-4 on the taxation of builtin gain on the conversion of a C corporation to an S corporation. The final regulations are effective for tax years ending on or after Dec. 27, 1994, but only for S corporations whose election is effective on or after Dec. 27, 1994.

Although the final regulations generally adopt the provisions of the proposed regulations issued on Dec. 7, 1992, a number of significant changes have been made.

First, the Service rejected suggestions that the final regulations should not use the accrual method rule to determine whether an item of income or deduction is included in net recognized built-in gain or to what extent it is included. Regs. Sec. 1.1374-4(c) provides that an amount properly deducted under Sec. 267(a)(2) is recognized buil-tin loss to the extent that (1) all events have occurred to establish the fact of the liability, and the amount of the liability can be determined as of the beginning of the recognition period, and (2) the amount is paid in the first 2 1/2 months of the recognition period or is paid to an individual that owned less than 5% of the stock. Regs. Sec. 1.1374-4(c)(2) also provides that an amount properly deducted under Sec. 404(a)(5) is recognized built-in loss to the extent that (1) all events have occurred that establish the fact of the liability, and the amount of the liability can be determined as of the beginning of the recognition period, and (2) the amount is not deductible under Sec. 267(a)(2).

Second, Regs. Sec. 1.1374-4(d) extends the time that Sec. 481 adjustments may be treated as recognized built-in gain or loss to the entire 10-year recognition period. (The proposed regulations had limited the rule to the first year of the recognition period.) However, the adjustments must continue to relate to items attributable to periods before the recognition period.

Third, Regs. Sec. 1.1374-7 clarifies the rule for valuing inventory. The value of an S corporation's inventory on the first day of the recognition period generally is determined by reference to a...