Proposed S corporation regulations under Secs. 1367 and 1368.

• Author: Tzinberg, Neil E.

A thorough understanding of the interplay among the S corporation "basis," loss limitation, accumulated adjustment account, distribution, redemption and loan repayment rules is necessary in order to render competent tax planning, tax advisory and tax return preparation services to S corporations and S shareholders. The IRS has provided substantial guidance in these areas in proposed regulations under Secs. 1367 and 1368. As this article will explain, the regulations are generally favorable to taxpayers and provide some new planning opportunities. Nevertheless, they also propose an important ordering rule that tightens a statutory loss limitation provision.

Background

The conceptual foundation underneath subchapter S is the ability to avoid double taxation on corporate profits. While S corporations enjoy the same nontax benefits as C corporations,(1) S corporations are generally not subject to tax at the corporate level.(2) Instead, each shareholder reports his share of corporate income on his individual income tax return. The shareholders are then entitled to withdraw such income from the corporation without additional tax. Such withdrawals are termed "distributions" under the S corporation rules, although they also represent "regular" corporate dividends under applicable state laws.

Scope of Proposed Regulations

Sec. 1368 and Prop. Regs. Secs. 1.1368-1 through - 4 establish the rules for measuring the tax effect of S distributions. These rules are interrelated with the stock and loan basis adjustment and loan repayment rules of Sec. 1367 and Prop. Regs. Secs. 1.1367-1 through -3. These rules, in turn, are interrelated with the income and loss passthrough and the loss limitation rules of Sec. 1366. The proposed regulations under Secs. 1367 and 1368 are to become effective for years beginning after the date final regulations are published in the Federal Register. It is anticipated that this will occur before the end of 1993.(3)

Losses and Basis Adjustments

Like S corporation income, S corporation losses and credits pass through and are reported, subject to various limitations, on the shareholder's income tax returns.(4) Sec. 1366(d)(1) provides that the aggregate amount of losses and deductions taken into account by an S shareholder for any tax year cannot exceed the sum of --the adjusted basis of the shareholder's stock in the S corporation (after making the positive stock basis adjustments of Sec. 1367(a)(1)), and --the shareholder's adjusted basis of any indebtedness of the S corporation to the shareholder (determined before any negative or positive debt basis adjustments under Sec. 1367(b)(2)). Thus, the stock and debt basis adjustment rules of Sec. 1367 have an important bearing on the loss and deduction limitation rules of Sec. 1366. The basis adjustment rules also have an impact on the taxability of stock dispositions (through sale or redemption), the taxability of shareholder loan repayments, the basis of gift stock and, as stated earlier, the taxability of S distributions.

Under Sec. 1367(a), the basis of each shareholder's stock in an S corporation is increased for any period by the sum of the shareholder's positive adjustments, and basis is decreased by the sum of the shareholder's negative adjustments. Prop. Regs. Sec. 1.1367-1(b) and (c) summarize the statutory positive and negative basis adjustment provisions in the Service's new simplified style, by not reiterating statutory language that is clear on its surface.

* The positive adjustments

The positive adjustments specified in Sec. 1367(a)(1) are: * The corporation's separately stated items of income (defined by reference to Sec. 1366(a)(1)(a)). * The corporation's nonseparately computed income (defined by reference to Sec. 1366(a)(1)(b)). * The excess of the corporation's deductions for depletion over the basis of the property subject to depletion.

Prop. Regs. Sec. 1.1367-1(b)(1) specifies that the shareholder's basis is not increased with respect to excess oil and gas depletion because, as explained in the preamble to the proposed regulations, each shareholder computes these deductions separately under Sec. 613A(c)(11).(5) Sec. 1367(b) provides that a shareholder only increases stock basis for items of income that are required to be included in gross income if the shareholder in fact includes the items in gross income on his return.

* The negative adjustments

The negative adjustments specified in Sec. 1367(a)(2) are: * Distributions by the corporation not includible in the shareholder's income under Sec. 1368. * The corporation's separately computed items of loss and deduction (defined with reference to Sec. 1366(a)(1)(a)). * The corporation's nonseparately computed loss (defined with reference to Sec. 1366(a)(1)(b)). * Any expense of the corporation not deductible in computing its taxable income and not properly chargeable to a capital account (noncapital, nondeductible expenses). * Oil and gas property depletion to the extent the deduction does not exceed the shareholder's allocated portion of the property's adjusted basis.

The preamble specifies that the basis of a shareholder's stock is decreased by the amount of any loss or deduction that is allowed under Sec. 1366(d), regardless of whether the loss or deduction is disallowed or deferred under another Code provision (such as the passive loss rules of Sec. 469).

* Separate basis approach

The proposed regulations adopt a favorable "separate basis approach" to increasing and decreasing the basis of a shareholder's individual shares of stock. The basis of each share of stock is increased by the shareholder's pro rata portion of the corporation's positive adjustment items determined on a per share, per day basis, in accordance with Sec. 1377(a). This provides taxpayers with planning opportunities for the disposition of specific shares or blocks of stock by gift, sale or exchange. Negative adjustments are made in the same manner; however, a favorable "spill over" of losses rule is also provided. If the amount of negative adjustments to basis attributable to a particular share of stock 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 those shares. Although the preamble describes this spill-over treatment only for losses and deductions, Prop. Regs. Sec. 1.1367-1(c)(3) applies this treatment to all negative adjustments described in Sec. 1367(a)(2), which includes distributions. Nevertheless, because some confusion still exists among practitioners, the Service has been asked to clarify, in final regulations, that the spill-over rules also apply to distributions.(6)

* Ordering rules

The proposed regulations contain a basis adjustment ordering rule which, if included in the final regulations, will...