Coordination of elections by S shareholders to close the books for allocation purposes.

The proposed regulations under Sec. 1377 give guidance on how taxpayers are to coordinate the three different elections that S corporations can make concerning the closing of the books. Depending on the circumstances, S corporations can make an election to close the books under Sec. 1362 (e) (3) (termination of S status), Sec. 1377 (a) (2) (termination of shareholder status) or Regs. Sec. 1.1368-1 (g) (2) (qualifying disposition of stock).

Although the events that may allow an S corporation to make one of these elections are not mutually exclusive, it appears the IRS intends that only one election can be made in any one situation. Under Prop. Regs. Sec. 1.1377-1 (b) (1), if a transfer results in a termination of the shareholder's entire interest as a shareholder and the transfer also constitutes a qualifying disposition under Regs. Sec. 1.1368-1 (g) (2) (i), the terminating election rules under the Sec. 1377 proposed regulations take precedence and a qualifying disposition election cannot be made. The Service apparently has asserted this priority on the elections because the Sec. 1377 (a) (2) election is statutorily derived, while the Regs. Sec. 1.1368-1 (g) (2) election is not.

If a termination of a shareholder's entire interest results in a termination under Sec. 1362 (d) (2), however, Prop. Regs. Sec. 1.1377-1 (b) (1) provides that the corporation may not make a shareholder termination election under Sec. 1377(a) (2). When a corporation's election to be an S corporation terminates, the portion of the corporation's tax year ending at the close of the day preceding the day for which the terminating event is effective is treated as an S short year, and the remainder is treated as a C short year. Thus, because the day on which a terminating event occurs is the first day of a C short year, as of that date there is no S corporation tax year that may be divided into two separate years under Sec. 1377 (a) (2).

Under Sec. 1362(e) (2), the income or loss for the entire S termination year is allocated on a pro rata basis between the S and C short years. However, if the corporation makes an election under Sec. 1362 (e) (3), the corporation allocates income and loss to each short tax year under the corporation's normal tax accounting rules. Thus, when a corporation makes an election under Sec. 1362 (e) (3), an S shareholder may achieve a result similar to the result of an election under Sec. 1377(a) (2) and these proposed regulations (which also require an allocation of income and loss to each short tax year under normal accounting rules).

Thus, in order of apparent subordination, an election under Regs. Sec. 1.1368-1 (g) (2) is subordinate to an election under Sec. 1377 (a) (2), and an election under Sec. 1377 (a) (2) is subordinate to an election under Sec. 1362 (e) (3).