Final regs. clarify passthroughs, distributions and basis adjustments.

• Author: Foran, Nancy J.
• Position: S corporations

This article discusses recent final regulations under Secs. 1366-1368 that explain how S corporation passthroughs and distributions affect a shareholder's stock basis. The regulations provide tax practitioners and S shareholders with the guidance they need to comply with current tax law. The article's many examples illustrate the differences in treatment from the proposed regulations.

Recent regulations(1) clarify the S corporation passthrough, distribution and basis adjustment rules; they finalize August 1998 proposed regulations(2) and apply to S tax years beginning after Aug. 17, 1998. For tax years beginning after 1996 and before Aug. 18, 1998, shareholders' stock basis adjustments and S corporation distributions must be determined reasonably, based on the Code and legislative history.

Passthrough of Items to Shareholders

Regs. Sec. 1.1366-1 requires S shareholders to include their pro rata share of an S corporation's income, losses, deductions and credits (whether or not distributed) in their return for the tax year within which the corporation's tax year ends. S corporation items are divided into (1) separately stated items and (2) nonseparately computed income or loss. The separately stated items identified irt Regs. Sec. 1. t3661 (a)(2) include (but are not limited to) the items listed in Exhibit 1 on p. 706.

Exhibit 1: Separately stated items (Regs. Sec. 1.1366-1 (a)(2))

1. The combined net amount of capital gains and losses, grouped by holding periods, tax rate and any other relevant classification.

2. The combined net amount of Sec. 1231 gains and losses, grouped by holding periods, tax rate and any other relevant classification.

3. Charitable contributions paid by the corporation within its tax year, grouped by the Sec. 170(b) percentage limit.

4. Taxes paid or accrued to foreign countries or U.S. possessions.

5. Items involved in the determination of tax credits, except for the Sec. 34 credit for certain uses of gasoline and special fuels.

6. Sec. 165(d) wagering ITansaction gains and losses.

7. Sec. 175 soil and water conservation expenditures.

8. Sec. 179 expense election.

9. Sec. 213 medical expenses.

10. Subchapter B, Part VII, additional itemized deductions for individuals at Sec. 212 et seq. (e.g., production-of-income expenses).

11. Itemized deductions for which the Sec. 67 2% floor on miscellaneous itemized deductions or the Sec. 68 overall limit on itemized deductions applies.

12. Portfolio income or losses, as defined in the Sec. 469 passive activity regulations.

13. Tax-exempt income.

14. Sec. 56 alternative minimum tax (AMT) adjustments and Sec. 57 AMT preferences.

15. Items identified by the IRS in guidance (including tax forms and instructions).

    Tax-Exempt Income

    Tax-exempt income must be separately stated. The proposed regulations defined it as income always permanently excludible from income, such as (1) Sec. 101 certain death benefits (i.e., life insurance proceeds) and (2) Sec. 103 state and local bond interest. Items that may result in income deferral--but not exclusion--are not exempt. Sec. 108 exclusion of income due to cancellation of debt (COD) and Sec. 109 lessee improvements on a lessor's property were specifically identified as nonexempt items.

    The Sec. 108 exclusion of COD income and attribute reduction provisions allow debtors to avoid immediate income recognition, but may result in income recognition later. Although some commentators objected to the exclusion of Sec. 108 income from exempt income, this treatment was retained; Treasury and the Service believe it is consistent with the Sec. 108 legislative history and the S corporation rules. The Sec. 108(a)(1)(D) legislative history states that excluding the discharge of qualified real property indebtedness income simply defers income to S shareholders and does not result in an adjustment to stock basis.(3) The Sec. 108(d) (7) (A) legislative history supports the exclusion of COD income from exempt income. It states that (1) to treat S shareholders consistently, income exclusion and tax attribute reduction are made at the corporate level and (2) any COD income remaining after tax attribute reduction does not result in income or other tax consequences.(4)

    The Tenth Circuit recently considered the Sec. 108 issue. In Gitlitz,(5) the court did not allow shareholders of an insolvent S corporation to increase their stock basis to use suspended losses. The court held that held that if excluded COD income was allowed to pass through to shareholders to increase their stock basis, they would reap a tax windfall contrary to Congressional intent. Gitlitz states that (1) both the COD income exclusion and tax attribute reduction principles apply at the corporate level, (2) the timing of the tax attribute reductions and the passthrough of income items is critical and (3) attribute reduction precedes the income passthrough. Because attribute reduction precedes the income passthrough, the corporation's excluded COD income is absorbed before it can pass through to the shareholders and affect their stock basis; thus, no windfalls occurs. In Gitlitz, the net operating loss (NOL) attribute absorbed the corporation's excluded COD income. Thus, (1) no income items passed through to shareholders, (2) shareholders could not use S NOLs to offset their own income or adjust their stock basis and (3) shareholders' suspended losses disappeared and had no future tax consequences.

    The proposed regulations' preamble also distinguished between partnership and S corporation treatment of COD income. It stated that it is appropriate for partners, but not S shareholders, to increase the basis of their interests due to the exclusion of COD income, for two reasons. First, Sec. 108 applies at the corporate level for S corporations and at the partner level for partnerships, under Sec. 108(d)(6) and (7). Thus, COD income may be included by some partners and excluded by others. Second, partnership basis must be increased to offset the Sec. 752(b) basis reduction due to the decrease in partnership liabilities.

    Sec. 109 allows an income exclusion for the cost of improvements made by a lessee that revert to the lessor on lease termination or expiration. The reverted improvements may result in income to the lessor when the property is sold.

    Based on these arguments, the proposed definition of tax-exempt income was retained in the final regulations.

    Aggregation of Deductions or Exclusions

    Regs. Sec. l. 1366-1(a) (5) requires shareholders to aggregate their separate deductions or exclusions with their pro rata share of the S corporation's separately stated deductions or exclusions to determine their allowable deduction or exclusion.

    Example 1:(6) A owns 50% of M Corp.'s stock. M is an S corporation. In 2000, M purchases and places into service $10,000 of property and elects to expense it under Sec. 179. A's pro rata share of such property is $5,000. Because the aggregate amount of A's pro rata share and separately acquired Sec. 179 expense may not exceed $20,000 in 2000, A may elect to expense up to $15,000 of separately acquired Sec. 179 property.

    The final regulations' preamble clarifies that this example intends to illustrate that a shareholder's total Sec. 179 deduction cannot exceed the individual limit; it does not mean to imply that shareholders must elect to expense their share of the S corporation's Sec. 179 property before electing to expense their separately acquired property.(7) The final regulations do not modify the example and do not provide additional examples of the aggregation rule.

    Character of Items

    Generally, the character of an item passed through to a shareholder is determined at the corporate level. Regs. Sec. 1.1366-l(b) provides exceptions for the contribution of (1) non-capital gain property and (2) capital loss property, if an S corporation is formed or availed of by shareholders for a principal purpose of selling or exchanging the property to change the nature of the gain or loss. In such case, the property retains the character it had in the shareholder's hands before the contribution. Several commentators had argued that the IRS lacked the authority to recharacterize gain or loss at the shareholder level. Others suggested limiting the recharacterization rule to sales or exchanges within a specified time period. The...