Qualifying disposition under regs. sec. 1.1368-1(g): the importance of the form.

• Author: Orbach, Kenneth N.

Shareholder basis in stock of an S corporation generally is increased on a per-share, per-day basis by the corporation's items of income (including tax-exempt income) and nonseparately computed income. Basis is decreased by corporate items of loss and deduction, nonseparately computed loss, nondeductible expenditures not chargeable to a capital account, and by corporate ordinary distributions to the extent not included in the shareholder's income. Adjustments for depletion also may be required (Sec. 1367(a)). With certain exceptions and modifications, the corporation's accumulated adjustments account (AAA) is similarly adjusted (Sec. 1368(e)).

Since the amount of each of these items may not be known until the end of the corporation's tax year, a shareholder who disposes of a substantial interest in the corporation prior to the end of the year may not be certain of the tax consequences of the disposition or of any predisposition distributions to the shareholder. In order to partially alleviate this problem, the proposed regulations under Sec. 1368 generally provided that if a shareholder disposed of at least 20% of the corporation's outstanding stock, the corporation could elect to treat the tax year as two separate years, the first ending at the close of the day of the qualifying disposition. This election treats the tax year as separate tax years for purposes of allocating income and loss items; for making adjustments to AAA, earnings and profits, and shareholder basis; and for determining the tax effects of ordinary distributions.

Final Regs. Sec. 1.1368-1(g) adopted the proposed rule. However, the definition of a qualifying disposition was expanded. Thus, a qualifying disposition is:

1. A disposition (e.g., sale, exchange, gift) by a shareholder of at least 20% of the corporation's outstanding stock in one or more transactions during any 30-day period during the corporation's tax year;

2. A Sec. 302(a) or 303 redemption of at least 20% of the corporation's outstanding stock from a shareholder in one or more transactions during any 30-day period during the corporation's tax year; or

3. An issuance of an amount of stock equal to at least 25% of the previously outstanding stock to one or more new shareholders during any 30-day period during the corporation's tax year.

Condition #1 is illustrated in Example 1.

Example 1: X is an S corporation with 100 shares of stock outstanding. E owns 50 shares of X. E sells 20 shares to individual F. This...