Election to close S year under sec. 1368 regulations.

Adjustments to stock basis for an S shareholder's share of the income or loss, and the tax effects of any distributions, are generally determined at the end of the corporation's tax year. If a shareholder disposes of stock during the year, the adjustments are effective immediately prior to the date of disposition.

Under Sec. 1377(a), each item of income or loss is deemed to occur pro rata throughout the S corporation's tax year. If a shareholder terminates his interest in the corporation during the year, the corporation may elect, with the consent of all the shareholders, to treat the year as if it consisted of two tax years, the first of which ends on the date of the termination. If such an election is made, the stock basis would be adjusted for the actual income or loss earned through the date of termination, rather than for a pro rata allocation of the entire year's income.

In June 1992, proposed regulations under Sec. 1368 were issued, which provided for an election to treat a tax year as two separate tax years when a shareholder disposes of substantial amounts of stock (20% or more). Final regulations, issued Dec. 30, 1993, further expand the situations in which the corporation may make the election and are somewhat less burdensome than the proposed regulations.

Under Regs. Sec. 1.1368-1(g)(2 when a "qualifying disposition" takes place, an S corporation may elect to treat its tax year as if it consists of separate tax years for purposes of allocating income and loss, and adjusting the accumulated adjustments account (AAA), earnings and profits and shareholders' stock basis. The "first" tax year ends on the date that the shareholder makes a qualifying disposition of stock. A qualifying disposition is any one of the following:

1. A disposition of 20% or more of the corporation's outstanding stock during any 30-day period within the corporation's tax year.

2. A redemption under Sec. 302(al or 303(a) of 20% or more of the outstanding stock of the corporation during any 30-day period within the corporation's tax year.

3. An issuance of stock representing more than 25% of the previously outstanding stock to new shareholders during any 30-day period within the corporation's tax year.

The corporation makes the election by attaching a statement to its tax return for the tax year in which the qualifying disposition occurs. The election statement must --state that the corporation is electing, under Regs. Sec. 1.1368-1(g)(2)(i), to treat the tax year as if it consisted of separate tax years; --set forth the facts relating to the qualifying disposition (e.g., sale, gift, stock issuance or redemption); --state that each shareholder who held stock in the corporation during the tax year consents to the election; and --be signed by an officer of the corporation under penalties of perjury.

A single election statement may be filed for all qualifying dispositions during the tax year. Once made, the election is irrevocable. Note that the final regulations eliminate the requirement contained in the proposed regulations that all shareholders who held stock in the corporation during the year must sign the election statement.

The final regulations are generally effective for tax years beginning on or after Jan. 1, 1994. For tax years beginning before Jan. 1, 1994, the tax treatment of distributions and basis adjustments must be determined in a reasonable manner. Return positions consistent with the final regulations are deemed reasonable.

Example: Corporation CS is owned 100% (100 shares) by A. On Jan. 1, 1994, the balance in the AAA is $3,000 and A's stock basis is $4,000; there are no earnings and profits. On July 1, 1994, A sells 50 CS shares to B for $5,000. For the calendar year 1994, CS has taxable income of $15,000, of which $5,000 was earned through July 1, 1994, and $10,000 was earned between July 2, 1994 and Dec. 31, 1994. CS makes the election under Regs. Sec. 1.1368-1(g)(2)(i) to treat its tax year as if it consisted of separate tax years, the first of which ends at the close of business on July 1, 1994, the date of the qualifying disposition.

A's stock basis is adjusted for the income earned by CS through July 1, 1994 and A will realize a gain of $500 on the sale of 50 shares to B, computed as follows: $5,000 proceeds received -- $4,500 basis attributed shares sold ($40 per share beginning basis + $50 per share income earned through July 1, 1994 x 50 shares sold). For the period July 2, 1994 through Dec. 31, 1994, A and B will each be allocated $5,000 of income ($10,000/2) and their stock bases will be adjusted for the same amount. As a result, A's stock basis at Dec. 31, 1994 is $9,500 ($4,000 beginning basis + $5,000 income earned by CS through July 1, 1994 -- $4,500 basis attributed to shares sold + $5,000 income allocated to A for the period July 2, 1994 through Dec. 31, 1994). B's stock basis at Dec. 31, 1994 is $10,000 +$5,000 amount paid for stock + $5,000 income allocated to B for the period July 2, 1994 through Dec. 31, 19941.

If CS did not make the election to treat its tax year as separate tax years, the entire year's income of $15,000 would be allocated pro rata among the shares based on the number of days the shares were held by A and B. A would realize a loss of $740 on the shares she sold to B +$5,000 proceeds received -- basis of $5,740 ($40 per share beginning basis + $150 per share earnings x 182 days = $74.80 x 50 shares sold). A's stock basis on Dec. 31, 1994 would again be 9 500 ($4,000 beginning basis share earnings x 100 shares x 182 days and 50 shares x 183 days -- $11,240 -- $5,740 basis attributed to shares sold). B's stock basis on Dec. 31, 1994 would be $8,760 ($5,000 amount paid for stock + $150 per share earnings x 50 shares x 183 days = $3,760).

In the example, A recognizes net income of $10,500 for the year whether or not the corporation makes the election under Regs. Sec. 1.1368-1(g)(2)(i); however, the character of the income changes. With the election, A recognizes $500 of capital gain and $10,000 of ordinary income from the corporation, compared with a $740 capital loss and $11,240 of ordinary income without the election. B, on the other hand, is allocated $5,000 of income if the election is made and only $3,760 if it is not. When a substantial disposition of stock in an S corporation takes place, the effects of an election to close the corporation's tax year should be carefully analyzed.

From Susan C. Kata, CPA, Blum, Shapiro & Company, P.C., West Hartford, Conn.