Did the IRS interpret or rewrite sec. 1374?: final regulations for service organizations.

In 1988, Congress enacted Sec. 1374 to impose a tax on S corporations with a built-in gain (BIG) arising from conversion from C corporation status, to the extent a net built-in gain is recognized during the first 120 months (recognition period) as an S corporation. The amount of the tax is computed by applying the highest C corporation tax rate to the net recognized BIG for the tax year.

At the end of 1994, the Treasury issued final regulations under Sec. 1374, dramatically limiting the extent to which deductions can offset gains, adding limits to the statute not intended by Congress and contradicting congressional reports.

The regulations are effective for tax years ending on or after Dec. 27, 1994, but only when the return for the tax year is filed under an S election on a transfer of assets from a C corporation to an S corporation under Sec. 1374(d)(8) occurring on or after that date.

The IRS introduced an accrual-method concept in the regulations for the purpose of computing the amount of recognized built-in gain or loss items. It also imposed the limits of Secs. 267(b) and 404(a)(5) to built-in losses under Sec. 1374. This approach is not authorized by the statute and, while seemingly rational on its face, is inconsistent with the congressional intent outlined in the committee reports to the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). This is particularly so when the statute is applied to compensation derived from accounts receivables.

The committee reports contain the following example:

As an example of these built-in gain and loss provisions, in the case of a cash basis personal service corporation that converts to S status and that has receivables at the time of the conversion, the receivables, when received, are built-in gain items. At the same time, built-in losses would include otherwise deductible compensation paid after the conversion to the persons who performed the services that produced the receivables, to the extent such compensation is attributable to such pre-conversion services. To the extent such built-in loss items offset the built-in gains from the receivables, there would be no amount subject to the built-in gains tax.

Therefore, at least for a cash-basis personal service corporation (PSC), compensation payable should be a built-in deduction so long as actually paid within the recognition period, without imposition of the restrictions under Sec. 267(b) or 404(a)(5).

In general, Regs. Sec. 1.1374-1A imposes a corporate-level tax on the sale or exchange of assets to the extent the gain realized reflects unrealized appreciation in the C corporation as of the date of conversion to S status. In addition, pursuant to the accrual-method rule, an S corporation's income items are also generally treated as recognized BIG if the item would have been taken into account before the recognition period by a taxpayer using the accrual method of accounting. The regulations apply the same test to built-in deduction items. Thus, accrual concepts, such as the "all events" test and economic performance requirement, are applied in determining whether an item constitutes a built-in deduction.

Example: P is a calendar-year cash-basis C corporation. In 1993, a lawsuit is filed against P seeking damages in the amount of $1,000,000. P elects to become an S corporation as of Jan. 1, 1994. In 1994, P loses the lawsuit and damages are assessed in the amount of $400,000. P pays the damages and properly claims a deduction for that amount.

Assuming P would not have been allowed a deduction prior to the beginning of the recognition period if it had used the accrual method of accounting, the $400,000 deduction is not considered a built-in loss.

Regs. Sec. 1.1374-4 restricts recognized built-in losses by imposing Sec. 267(a)(2) to allow a deduction only if (1) all events have occurred that establish the fact of the liability to pay the amount, and the exact 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 who owned (actually and by attribution) less than 5% of the corporation's stock (by vote and value), both at the beginning of the recognition period and at the time of payment. In the preamble to the final regulations, Treasury asserted that the additional requirements under Sec. 267(a)(2) are necessary because of the particular difficulty in determining whether amounts paid to related parties are attributable to services performed, before or after the beginning of the recognition period.

Regs. Sec. 1.1374-4(c)(2) provides that an amount properly deducted under Sec. 404(a)(5) for deferred compensation is recognized built-in loss to the extent (1) all events have occurred that establish the fact of the liability to pay the amount, and the exact 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).

The accrual-method test outlined in the final regulations is much stricter than the normal "all events" test cited in Sec. 461(h)(4), which only requires that the amount of the liability be determined with reasonable accuracy. Additionally, with respect to an accrual to a related party, the 5% rule outlined in the regulations is much stricter than the 50% rule that would normally preclude a C corporation from deducting compensation or other items accrued to a related party under Sec. 267. Because many professional corporations that converted to S status were 100% owned by a sole employee, this aggressive action by the Treasury will affect only a few taxpayers.

While the accrual method has superficial appeal as a simple way to measure net BIG at the time of conversion, there is no authority in the law for limiting built-in losses to amounts paid within 2 1/2 months after conversion.

In fact, the committee reports are in direct conflict with the final regulations, stating that as long as the amounts are paid in the recognition period, they will be built-in losses, and therefore reduce receivable-type built-in gains.

The approach consistent with the statute and its history is to take a snapshot at date of conversion. In the case of service organizations in which salaries are typically paid when and as receivables are collected, the salary could be declared in the minutes of the board of directors' meeting, or a formula based on a historical percentage of salaries paid relative to cash-basis income could be used, in conjunction with a 2 1/2-month rule as alternatives. Authority for a snapshot approach is in the committee reports, as described in the example above.

Congress's rationale for offsetting BIG in the form of receivables with built-in loss in the form of a promise of compensation is consistent with the common practice of a PSC eliminating its current taxable income for the year by payments of compensation. Most service organizations should not have a built-in gain issue. This is clear from Congress's intent as stated in the legislative history.

With the final regulations in place, cash-basis taxpayers with zero-basis receivables contemplating converting to S status are advised to accrue compensation for those who performed the services that generated the receivables and actually pay it within 2 1/2 months of the conversion.

For those now faced with an IRS audit on the issue, particularly when the Service is attempting to apply the regulations retroactively, contrary to the regulations' prospective effective date, no taxpayer should accept the IRS's approach because (1) retroactive application of the regulations is not authorized by the statute and (2) the regulations are invalid to the extent they attempt to impose Sec. 267 in conflict with the legislative history and explicit language of the statute.