Final regs. clarify basis and distribution issues, but leave unanswered questions.

EXECUTIVE SUMMARY

Through the use of numerous examples, the first part of this two-part article examines the final regulations under Secs. 1367 and 1368, which shed light on the election of an S corporation split tax year, stock and debt basis issues and adjustments, and accumulated adjustments accounts. Part II, in the June issue, will address distributions to shareholders.

Introduction

The Subchapter S Revision Act of 1982 (SSRA) created new rules for determining a shareholder's stock and debt basis and developed new distribution rules. Although the Code provisions(1) were reasonably clear in many routine situations, guidance was lacking in others. Between 1982 and June 1992, the primary sources of assistance were the instructions to Form 1120S, U.S. Income Tax Return for an S Corporation; Publication 589, Tax Information on S Corporations; and letter rulings. In June 1992, the IRS issued proposed regulations(2) under Secs. 1367 and 1368 that provided some useful basis and distribution rules (as well as a number of confusing statements and cross-references).

In December 1993, the IRS issued final regulations(3) under Secs. 1367 and 1368, largely a restatement and refinement of the proposed regulations; some rules were added and various problems addressed that were not covered in the proposed rules. Although the final regulations provide welcome guidance, there is room for improvement.

This two-part article provides an in-depth discussion of the final regulations under Secs. 1367 and 1368, explores some new planning opportunities and pitfalls, and addresses certain ambiguities. Part I, below, examines disposition and basis rules and accumulated adjustments accounts (AAAs); Part II, in the June issue, will discuss distributions to shareholders.

Termination of Tax Year on Substantial Disposition

SSRA Section 2 enacted Sec. 1377(a) (2) to provide that an S corporation can elect to split its tax year into two portions on termination of a shareholder's interest. Sec. 1377 does not define "termination of interest," but specifically delegates authority to regulations. Temp. Regs. Sec. 18.1377-1,(4) issued in 1983, required complete termination of a shareholder's interest before the split-year election was available.

Regs. Sec. 1.1368-1 (g) (1) defines termination more liberally--either a complete termination or a "qualifying disposition" will allow an S corporation to split its tax year. Regs. Sec. 1.1368-1 (g) (2) (i) (A)-(C) define three types of qualifying dispositions:

1. Disposition by one shareholder of at least 20% of the corporation's outstanding stock in any 30-day period within the corporation's tax year.

2. A redemption treated as an exchange under Sec. 302(a) or 303(a) of at least 20% of the corporation's outstanding stock, from one shareholder, during any 30-day period within the corporation's tax year.

3. Issuance of new stock by the corporation, to one or more new shareholders during any 30-day period within the corporation's tax year.

Thus, there are now four possibilities for an interim closing. In some instances, an S corporation may have two or more qualifying dispositions within the same tax year.

* Observation: Regs. Sec. 1.1368-1 (g) (2) (B) permits an interim closing on a stock redemption treated as an exchange under Sec. 302(a) or 303(a). However, a redemption that does not meet one of these exchange tests may still permit a split-year election under Sec. 1377 (a) (2); Temp. Regs. Sec. 18.1377-1 allows the election when any shareholder terminated his entire shareholder interest.(5) Thus, an S corporation could redeem all of the stock of a shareholder who still retains a "forbidden" interest (e.g., as an officer or a director) and/or an indirect shareholder interest (i.e., through the Sec. 318 constructive ownership rules). This redemption would not qualify as an exchange under Sec. 302, but should be a termination of an entire shareholder interest purposes of a split-year election.

Electing a Split Year

Under Regs. Sec. 1.1368-1 (g) (2) (iii), the corporation makes the election by attaching a statement to its timely field original or amended Form 1120S. Regs. Sec. 1.1368-1 (g) (2) (ii) states that the election is used only for allocation and distribution purposes (i.e., the corporation does not file a separate 1120S for each period). Similarly, the election to split the year does not accelerate the reporting of income or loss to shareholders. By limiting the effect of the election to allocations of income and loss, distributions and basis, the election to split a tax year prevents the corporation from multiplying annual limitations (such as Sec. 179 deductions). Further, no portion of a split year is counted as a separate tax year for purposes of Sec. 1363(b) (4), which applies Sec. 291 to former C corporations for their first three tax years as S corporations. As is discussed in Part II of this article, a split-year election does not allow the corporation and its shareholders to make bypass elections (including the deemed-dividend election) for separate portions of the year.

According to Regs. Sec. 1.1368-1 (g) (2) (iii), the corporation must obtain consent from each shareholder who held stock at any time during the entire tax year (without regard to the split). However, that regulation then states that a shareholder is a shareholder as described in Sec. 1362 (a) (2), which refers to all persons who were shareholders the date of the S election.

* Observation: Regs. Sec. 1.1368-1 (g) (2) (iii) literally requires the consent to split years to be obtained from all persons who were shareholders on the day the corporation filed Form 2553, Election by a Small Business Corporation (which may have been as early as 1958), even if these persons no longer have any interest in the corporation. That regulation probably intends to provide that consent is required from any person who would be considered a shareholder during the tax year of the split, including shares owned under community property laws or other form of joint ownership. A change in the cross-reference from Sec. 1362 (a) (2) to Regs. Sec. 1.1362-6(b) (2)(6) would probably achieve the desired result and eliminate confusion.

Basis Rules

Stock

In general, Sec. 1367 requires that an S shareholder adjust stock basis for his share of the corporation's income, losses and deductions. The positive adjustments include both tax and tax-exempt income, under Sec. 1366(a) (1) (A); the negative adjustments include allowable deductions and losses under that section, as well as the corporation's nondeductible, noncapitalizable expenses. Basis must also be reduced for all distributions not included in the shareholder's income (e.g., distributions from accumulated earnings and profits (AE&P)). Sec. 1368(b) provides that distributions that exceed the shareholder's basis are treated as gains from the sale of the shareholder's stock.

Items adjusting stock basis: Secs. 1367(a) (1) (A) and 1366(a) (1) (A) provide that a shareholder's basis is increased for his pro rata share of the corporation's items of income, including "tax-exempt income," an undefined term. A logical interpretation would be to treat any item excluded from gross income under Secs. 101-137 as tax-exempt income; however, the IRS's position is that an S corporation's cancellation of debt income excluded by Sec. 108 is not tax-exempt income for purposes of Secs. 1366 and 1377.(7)

Similarly, Secs. 1367(a) (2) (B) and 1366(a) (1) (A) require a shareholder to reduce basis for expenses and losses of the corporation "the separate treatment of which could affect the liability for tax of any shareholder." Neither the Code nor the legislative history amplifies this statement. Regs. Sec. 1.1367-1 (c) (2) provides that the corporation's nondeductible expenses and losses reduce a shareholder's basis; further, the following (nonexclusive) list of disallowed expenses must be reported to shareholders, and reduce their bases:

* Illegal bribes, kickbacks and other payments disallowed by Sec. 162(c).

* Fines and penalties nondeductible under Sec. 162(f).

* Expenses and interest relating to tax-exempt income under Sec. 265.

* Losses disallowed under Sec. 267(a) (1).

* Meal and entertainment expenses disallowed under Sec. 274.

* Two-thirds of treble damages paid for violating antitrust laws disallowed by Sec. 162.

The aforementioned items are disallowed by the Code as a matter of public policy; although Regs. Sec. 1.1367-1(c) (2) does not mention them, the following items, which are currently nondeductible, also should not be treated as reductions of basis, but for reasons other than public policy:

* Losses sustained on the distribution of property to a shareholder. This loss disallowance, mandated by Sec. 311 (a), is similar to the loss disallowance under Sec. 267 (a) (1), for which basis reduction is required. In the case of Sec. 267(a) (1) disallowance, the shareholder may use the disallowed corporate loss to offset gain on the future sale of the property. No equivalent provision exists for property acquired by a shareholder when the loss is disallowed by Sec. 311 (a).

* Expenses of redemptions and reorganizations. Expenses incurred in connection with stock redemptions are disallowed under Sec. 162(k). That section does not explicitly require capitalization; it simply disallows a deduction.(8) However, in addressing this issue prior to enactment of Sec. 162(k), the Supreme Court disallowed appraisal and other expenses relating to a redemption because the transaction was capital in nature(9); similarly, expenses of a friendly takeover must be capitalized.(10) Given this rationale, redemption and reorganization expenses should not reduce a shareholder's basis.

Allocations of Income and Loss

Basis for separate shares: A shareholder may encounter several transactions in which basis is important (e.g., allocation of a portion of the S corporation's losses that are potentially deductible to the extent of stock and debt basis; determining whether a particular distribution exceeds stock basis). The S corporation rules do not specify whether a shareholder must limit losses or tax-free distributions to aggregate or per-share basis. Sec. 1366(d) (1) (A) limits a shareholder's total deduction for losses and deductions to his basis in the stock, rather than to the basis of a particular share; thus, it would appear that Congress intended to allow a shareholder a deduction for his share of the S corporation's losses, to the extent of his basis in all shares.

A shareholder may face other transactions in which per-share basis is an appropriate measure--for instance, a shareholder might dispose of some (but not all) of his stock, and need to calculate gain or loss on the shares relinquished. Under Regs. Sec. 1.331-1 (b) and (e), the basis in each share must be tracked when the corporation makes liquidating distributions that span more than one shareholder tax year; share basis is also important if a shareholder sustains a loss on stock, and some (but not all) of the shares qualify under Sec. 1244.

Regs. Sec. 1.1367-1 (b) (2) and (c) (3) follow the proposed regulations by requiring a workable mix of the share-by-share and aggregate methods of calculating stock basis; in general, they require each shareholder to maintain records establishing the basis of each share.

Example 1: C is a calendar-year S corporation with 200 outstanding shares. In 1995, C reported $146,000 of taxable income and no separately reportable items and made no distributions to shareholders. A, who owned 50 shares with a basis of $25,000 on Dec. 31, 1994, purchased 40 additional shares from another shareholder on Sept. 23, 1995, for $16,000. A must adjust her basis in each share by the amount of income allocated on a daily basis. For 1995, the corporation's income per day per share was $2 ($146,000 [divided by] 365 [divided by] 200).

A's basis adjustment to each block of shares would be:

                             Original   Purchased
                            50 shares    40 share    Total

Basis before current-year
 adjustment                   $25,000     $16,000   $41,000

1995 income:
 (50 X 365 X $2)               36,500                36,500
 (40 X 100 X $2)                            8,000     8,000

End-of-year basis             $61,500     $24,000   $85,500

The separate-share basis calculations apply without exception to positive adjustments; however, losses and distributions could be subject to some strange limitations by using a per-share rule. In these circumstances, S corporation basis has no parallel in the C corporation rules. Adjustments to basis for a shareholder's portion of the S corporation's income, losses, deductions and distributions reflect the ability to flow items through from the entity to the shareholder, a complete departure from C corporation structure.

If a shareholder's loss allocated to one particular share exceeds the basis of that share, a "spillover" rule applies. The first step is to apply the basis reduction, on a per-share basis; to the extent that any share's basis is reduced to zero, the excess of the allocation over the basis is added back to that share, and is used to reduce the basis of other shares held by the taxpayer.

Example 2: The facts are the same as in Example 1. A's share ownership does not change in 1996; in that year, C sustains an ordinary loss of $182,500. Thus, the per-day, per-share loss is $2.50 ($182,500 [divided by] 365 [divided by] 200). A must reduce her basis in each share by $912.50 ($2.50 X 365). By allocating the daily loss to each share, A's basis adjustment for each block would be:

                             Original    Purchased
                            50 shares    40 shares    Total

Basis before current-year
 adjustment                   $61,500    $ 24,400    $85,500

1996 loss:
 (50 X $912.50)               (45,625)               (45,625)
 (40 X $912.50)                           (36,500)   (36,500)

Basis after loss
 adjustment                   $15,875    $(12,500)   $ 3,375

A's share of the loss does not exceed her aggregate basis in the 90 shares she owned throughout 1995. Therefore, under the limitations imposed by Sec. 1366(d)(1)(A), she should be able to claim the entire loss in 1995. Applying the spillover rule, A's final basis would be calculated as follows:

                             Original    Purchased
                            50 shares    40 shares     Total

Basis before current-year
 adjustment                   $61,500      $24,000    $85,500

1996 loss:
 (50 X $912.50)               (45,625)                (45,625)
 (40 X $912.50)                            (36,500)   (36,500)

Spillover adjustment          (12,500)      12,500          0

Basis after loss
 adjustment                   $ 3,375          $ 0    $ 3,375

Prop. Regs. Sec. 1.1367,1(c)(3) adopted the spillover rule, but apparently did not apply it specifically to distributions.(11) Regs. Sec. 1.1367-1(c)(3) specifies that distributions (and losses and deductions) allocated to a given share that exceed that share's basis are applied to other shares; if the shareholder has more than two blocks of stock, the spillover adjustments are applied to all other shares in proportion to the remaining basis of each.

Priority of basis adjustments: Sec. 1367(a)(1) and (2) provide that each shareholder's stock basis is adjusted, in order, for:

--taxable and tax-exempt income;

--losses, deductions (including nondeductible expenses) and credits; and

--distributions (other than those included in the shareholder's gross income).

The proposed regulations provided a more detailed breakdown of the order. Prop. Regs. Sec. 1.1367-1(e)(2) required that a shareholder's basis be reduced for nondeductible expenses before deductible losses and expenses. According to the preamble to the final regulations, several commentators objected to this rule; Regs. Sec. 1.1367-1(e) retains this rule (and, like the proposed rules, offers no justification for it), but Regs. Sec. 1.1367-1(f) allows a shareholder to elect to reduce basis for deductible losses and expenses before subtracting nondeductible expenses. The limitation and election apply only when the combined total of deductible and nondeductible expenditures exceeds the shareholder's stock basis, after making an appropriate adjustment for the current year's income items.

The election is irrevocable and binding on the shareholder for all future years, unless IRS consent to revoke is obtained. As a condition of the election, the shareholder must agree to reduce basis in future years for any nondeductible expenses of the current year that would have reduced basis had there been sufficient basis to absorb all of the nondeductible items.

Example 3: R is a shareholder in M, an S corporation; at the beginning of 1995, her stock basis was $5,000. In 1995, M sustained an ordinary loss and incurred meal and entertainment expenses. R's share of the ordinary loss is $4,500, and her share of the disallowed portion of the meal and entertainment expenses is $1,500. M has no income items for 1995, and R receives no distributions. Under the general rule, R would report the following:

Beginning basis             $5,000

Less: disallowed expenses   (1,500)

Allowable deduction         $3,500

The portion of the loss that exceeds R's basis, $1,000 ($6,000 - $5,000), would be carried forward to 1996. Use of the election would yield a greater deduction in 1995:

Beginning basis             $5,000

Less: allowable deduction   (4,500)

Reduction for disallowed
 expenses                    $ 500

Under the election, R would carry forward the remaining $1,000 of disallowed expenses.

* Planning opportunity: In most situations in which a shareholder's total of deductible and nondeductible losses and expenses exceeds his basis, the election would be beneficial, because it allows the shareholder a current, rather than a deferred, deduction. In some situations, however, the general ordering rule may work to the shareholder's advantage (e.g., when the shareholder's basis is less than the total of the disallowed losses and deductions and the tax benefit of a suspended deduction might be greater in a future year than in the year in which the losses and deductions are sustained).

Absent the carryforward agreement under the election, no Code section or regulation requires a shareholder to carry forward any portion of nondeductible losses and expenses that exceeds his basis for the year in which the corporation incurs such items.(12)

Apparently, although the regulations do not so specify, any nondeductible expenses carried forward under the election would reduce basis in the succeeding year, after reduction for any current-year deductible losses. The elective ordering rule does not change the general rule that all losses and nondeductible items reduce basis before distributions. The preamble to the final regulations notes that the IRS had received several requests to change the ordering rules so that distributions would reduce basis after income, but before current-year losses and deductions; it states that the construction of the Code is precise on this point, and does not allow regulations to permit distributions to reduce basis before losses and deductions.

* Observation: S. 1690, the S Corporations Reform Bill of 1993, Section 223, would change the ordering of basis adjustments; in a year in which the corporation sustained losses and made distributions to shareholders, the distributions would reduce basis before losses would be taken into account.

Year of termination of shareholder's interest: Under Regs. Sec. 1.1367-1(d)(3), when a corporation elects to split its tax year, all shareholders must adjust basis and observe the loss and distribution rules for each portion of the year. Thus, distributions to a continuing shareholder could be taxable, if the shareholder's basis and share of income in that portion of the year were insufficient to absorb distributions in the same period.

Basis of Shareholder Debt

There are two situations in which a shareholder's debt basis may be adjusted. First, under Sec. 1367(b)(2)(A) and Regs. Sec. 1.1367-2(b)(1), if a shareholder's portion of losses from the S corporation exceeds stock basis at the end of a given year, the shareholder's debt basis is reduced (but not below zero) by the excess loss. For this purpose, "debt" is the debt held by the shareholder at the end of the corporation's tax year. Thus, a loan could be made near year-end to allow a deduction for losses.

The second adjustment to debt basis occurs only after debt basis has been reduced to zero by absorbing a shareholder's portion of prior-year losses. Regs. Sec. 1.1367-2(c)(1) provides that a shareholder's portion of the corporation's "net increase" in a subsequent year must be applied to restore the basis of outstanding debt, up to the original adjusted basis in such debt. "Net increase" is defined as the sum of the corporation's income items, less current-year losses and shareholder distributions (other than dividends). For this purpose, "debt" is the debt held by the shareholder at the beginning of the corporation's tax year in which the net increase arises.

The Regs. Sec. 1.1367-1(c) general ordering rule, which requires reduction for nondeductible items before basis is computed for deductible items, applies to both stock and debt basis. Similarly, the Regs. Sec. 1.1367-1(f) elective ordering rule, and the shareholder's agreement to reduce basis in the future for disallowed items of the current year, also apply to debt basis.

Regs. Sec. 1.1367-2(b)(3) provides for a proportionate reduction of debt basis if a shareholder has two or more debt instruments outstanding. The current-year loss is apportioned to the various debt instruments according to the current basis of each.

Example 4: D is a shareholder in Y, a calendar-year S corporation. D's basis in his Y stock is $3,000 at the end of 1995; shortly before the end of that year, he loans Y $10,000. D's share of Y's losses in 1995 is $7,000; thus, he reduces his stock basis to zero ($3,000 - $3,000), and reduces his debt basis to $6,000 ($10,000 - $4,000).

In 1996, D loans the corporation an additional $9,000; his share of Y's loss for 1996 is $12,000. Because D has a zero stock basis, he applies the 1996 loss to his debt basis as follows:

                                   Date of loan
                                  1995      1996      Total

Original loan                    $10,000    $9,000    $19,000

Less: prior basis reductions     (4,000)       (0)    (4,000)

Basis before current-year loss     6,000     9,000     15,000

Percent debt basis                40%(1)    60%(2)       100%

Less: 1996 loss                  (4,800)   (7,200)   (12,000)

Basis at end of 1996             $ 1,200    $1,800    $ 3,000

(1) $6,000/$15,000.

(2) $9,000/$15,000.

Under Regs. Sec. 1.1367-2(c)(2), if a shareholder holds more than one debt instrument:

* Any net increase is first applied to restore the reduction of basis in any debt repaid (in whole or in part) by the corporation to the shareholder in the tax year.

* Any remaining net increase is applied to restore each outstanding debt in proportion to the amount that the basis of each has been reduced. This rule applies to all debts held by the shareholder if none have been repaid during the year of basis restoration.

Example 5: The facts are the same as in Example 4. At the beginning of 1997, the basis of the $10,000 1995 loan had been reduced by $8,800. By the end of 1997, Y had repaid that loan, but not the $9,000 1996 loan; D's share of Y's 1997 income is $9,000. Thus, $8,800 of D's portion of Y's 1997 income will restore the basis of the 1995 loan to the original $10,000 and D will report no gain on the repayment. The remaining $200 of income is added to the basis of the loan D made in 1996; hence, D's total debt basis at the end of 1997 is $2,000 ($1,800 + $200). Alternatively, had Y not repaid any portion of the debts as of the end of 1997, D would have restored basis to the two loans as follows:

                                Date of loan
                               1995      1996      Total

Original loan                 $10,000    $9,000   $19,000

Basis at end of 1996          (1,200)   (1,800)   (3,000)

Prior reductions                8,800     7,200    16,000

Percent of prior reductions    55%(1)    45%(2)      100%

Restoration                     4,950     4,050     9,000

Basis at end of 1997          $ 6,150    $5,850   $12,000

(1) $8,800/$16,000.

(2) $7,200/$16,000.

* Observation: Shareholders who have loaned the corporation money that is repaid in the following year will benefit from the fact that basis is first restored to any repaid debt. When the corporation has sufficient income to generate the cash flow necessary for repayment, the shareholder-creditor will be required to report the income on his tax return for the year of repayment. If Regs. Sec. 1.1367-2(c)(2) did not allow restoration of debt in that same year, the shareholder-creditor would report both the corporation's income and a gain on the repayment.

Regs. Sec. 1.1367-2(a) adopts a reasonable and expedient treatment of open advances by shareholders to S corporations. An open advance (i.e., one not formalized by a note or other written instrument) may qualify as debt to a shareholder for basis purposes, although the shareholder may be required to substantiate the loan's existence.(13) The regulation treats all open advances as a single note. This rule applies to both basis reduction and restoration, and should provide welcome relief from the bookkeeping burdens that would otherwise be required.

Generally, under Regs. Sec. 1.1367-2(d)(1), the basis reduction and restoration adjustments apply as of the last day of the corporation's tax year, with three exceptions:

1. If the corporation repays the debt before the end of its tax year, basis restoration is effective immediately before the date of repayment; however, the adjustment includes all items allocated to the shareholder through year-end.

2. If the shareholder has disposed of his entire shareholder interest during the corporation's year, the debt basis adjustments are effective immediately before the shareholder terminates the interest.

3. If there is a split tax year due to a qualifying disposition or termination of a shareholder's interest, each portion of the corporation's tax year is a separate year for basis adjustments purposes.

Situations Not Addressed in the Regulations

Subsequent reacquisitions of stock: A shareholder may dispose of all of his shares in an S corporation, then reacquire that corporation's stock in a later year. A shareholder who had suspended losses at the time of the disposition would have no opportunity to use these losses after the disposition. Sec. 1366(d)(2) provides that such losses are treated as incurred by the corporation in the succeeding tax year with respect to that shareholder. On its face, the statute appears to allow a shareholder to use losses after a disposition of stock if he reacquires shares in the same corporation in the year following the disposition.

Example 6: C disposed of all of her shares in X, an S corporation, on Nov. 5, 1995; both are calendar-year taxpayers. On that date, she had been allocated $20,000 of losses from X in excess of her basis. If C is never again an X shareholder, she loses an opportunity to deduct the losses.

However, if C again became an X shareholder in 1996, Sec. 1366(d)(2) would treat her $20,000 of previously suspended losses as a deduction of X in 1996 with respect to C; C could then claim the losses in 1996, provided her basis was sufficient to allow the deduction. If her basis were less than $20,000 on Dec. 31, 1996, she would reduce it to zero, and suspend any additional losses until 1997.

What if C acquired her new X shares in 1997? It would not be unreasonable to assume that the $20,000 of excess losses was treated by X as a loss incurred with respect to C in 1996, which was suspended until 1997 and claimed as a deduction by the corporation in that year. However, the Code and regulations are silent on this question.

Basis following tax-free reorganization: Numerous rulings have allowed S corporations to engage in mergers, divisions and other tax-free reorganizations.(14) In general, Sec. 358(a)(1) provides for a substituted-basis computation when a shareholder surrenders stock in one corporation and receives stock in another. The Tax Court has allowed a shareholder basis in a surviving corporation for debt paid by that shareholder of the corporation extinguished in the reorganization.(15) There has been no guidance on the survival of certain other attributes following a reorganization; for instance, it is questionable whether a person who owned stock in an extinguished corporation whose losses exceeded basis could offset the suspended losses with income from a successor S corporation; guidance on this point would have been welcome.

Similarly, could the income of a new corporation following a divisive reorganization allow a shareholder to deduct losses that had exceeded the basis of stock and debt in the prereorganization corporation? As is discussed below, although Regs. Sec. 1.1368-2(d)(2) and (3) provide sensible guidance on the effects of these transactions on the corporation's AAA, they offer no assistance with the shareholder basis problems.

Basis for Sec. 1244 losses: If a shareholder sustains losses on Sec. 1244 stock, Regs. Sec. 1.1244(d)-2(a)(16) limits the ordinary loss to the original basis. Any reductions in the original basis as a result of S corporation losses will permanently reduce the amount of potential ordinary loss under Sec. 1244, because Sec. 1244(d)(1)(B) does not permit any addition to basis after acquisition for purposes of measuring ordinary loss. The Sec. 1367 regulations should provide that when a shareholder has had both increases and decreases to his basis in Sec. 1244 stock, any decreases in basis should be applied first to reduce increases, rather than to original basis.

Example 7: G acquired Sec. 1244 stock in GHI Corporation for $100,000 in 1996. In that year, G's share of GHI's income was $25,000, but G received no distributions. In 1997, G's share of losses was $20,000; thus, at the end of 1997, G's basis was $105,000. At the beginning of 1998, G sold all of his shares for $75,000, resulting in a loss of $30,000. There is no guidance on whether G's basis reduction in 1997 is applied to the 1996 increase or to his original basis. If the reduction applies to offset his 1996 basis increase, his Sec. 1244 loss would be $25,000 and his capital loss would be $5,000. If the 1997 reduction applied against his original basis, his Sec. 1244 loss would be $5,000 and his capital loss would be $25,000. Neither the Sec. 1244 nor the Sec. 1367 regulations provide guidance on this matter.

Character of gain on repayment of reduced-basis loan: If a shareholder's debt basis has been reduced and the corporation repays the loan, the courts have generally held that the excess over such basis is taxable(17); partial payment of a reduced-basis debt must be apportioned between basis and gain.(18) On repayment, the shareholder must determine whether the gain is capital gain or ordinary income.

Rev. Rul. 64-162(19) held that repayment of a reduced-basis note resulted in capital gain to the shareholder; Rev. Rul. 68-537(20) held that repayment of an open advance for which the shareholder's basis had been reduced resulted in ordinary income. The repayment of a loan could also cause recapture of an at-risk amount under Sec. 465(e), although the gain from the distribution would usually provide an increase to the amount at risk. Additionally, if the S corporation holds rental activities, or the shareholder does not materially participate in the corporation's trade or business activities, the gain could constitute passive activity income to the shareholder.(21)

Economic outlay requirement: In numerous cases, shareholders have attempted to claim basis in S corporations for guarantees of corporate debt and similar arrangements; most decisions have held that a shareholder receives no basis for a guarantee of a corporation's loan from an outside lender until the shareholder advances his own funds to the corporation.(22)

In Letter Ruling (TAM) 9403003,(23) a shareholder owned a controlling interest in two S corporations. One of the S corporations borrowed money from a bank. The corporation then loaned this amount, plus other funds, to the second S corporation. The second corporation repaid all of its loans to the first corporation; the same day, the first corporation distributed the entire amount of the loan repayment to the shareholder, who immediately loaned the proceeds of the distribution to the second corporation.

The IRS held that the shareholder had not made the requisite economic outlay to claim basis. The term "economic outlay," which the IRS, the Tax Court and other courts have used as the primary criterion for basis, does not appear in the Code or the legislative history to the SSRA, or in the Sec. 1367 regulations.

Distributions and Corporate Accounts

AAAs

The Sec. 1368 regulations provide useful guidance on some problematic aspects of AAAs; especially welcome is the improvement over the proposed regulations governing AAA calculations due to a stock redemption and the limited rule on the distribution of property with a fair market value in excess of basis.

However, there are some gaps and omissions. For instance, the preamble to the regulations states that the AAA must be maintained only by corporations that have AE&P. Although a corporation with no AE&P does not need to maintain the AAA to determine the tax treatment to shareholders of distributions in the current year, it is a good idea for a corporation with no AE&P to maintain this account, for several reasons:

1. The corporation may be a target in a merger or other tax-free reorganization with another S corporation (or with a C corporation) in the future, and the surviving corporation may need to calculate the target's AAA, including all income, losses and deductions from 1983 until the year of the reorganization.

2. The corporation may survive a tax-free reorganization with a C or an S corporation that has AE&P in some future year. The historic AAA of both corporations would then be needed.

3. The corporation may terminate its S election, and the post-termination transition period would begin. During that period, the former S corporation would be able to distribute its AAA as a reduction of shareholder basis.

The preamble to the final regulations recognizes the first possibility, stating that the corporation would be required to calculate its AAA in that situation, but offering no instructions on how to do so. The Sec. 1368 regulations refer to rules applicable to corporations that have AE&P, but are silent as to other corporations.

* Observation: All corporations should follow the rules prescribed for corporations that have AE&P, to ensure consistent treatment following tax-free reorganizations and terminations of S elections. A corporation that voluntarily maintained such an account should follow all of the same rules, including distribution elections, noncash property distributions, etc.

General rules: Sec. 1368 gives little direct guidance on maintaining the AAA; Sec. 1368(e) merely refers to all items that adjust shareholder stock and debt basis, which in turn refer to certain items of income, loss, deduction, etc., that pass through from the S corporation to the shareholders. By inference, the AAA is a corporate-level account, because it combines adjustments to the stock of all shareholders. There are two distinctions between the shareholder basis adjustments and the AAA.

* Under Sec. 1368(e) (1) (A), tax-exempt income and related expenses are adjustments to shareholder basis, but are not reflected in the AAA.

* Under Sec. 1368(e) (1) (A), losses, which may not reduce a shareholder's stock and debt basis below zero, may create a negative AAA.

Regs. Sec. 1.1368-2(a) (1) provides that the AAA is a corporate-level account that does not consist of portions allocated to individual shareholders. This position is generally reasonable, especially in light of the legislative history of the SSRA, which intended to eliminate the fragmentation of shareholder "previously taxed income" accounts under prior law. In at least one instance, however, the corporation must obtain information from its shareholders to properly calculate the annual adjustments. Under Regs. Sec. 1.1368-2(a) (3) (i) (D), any depletion claimed by shareholders on oil and gas property held by the S corporation must reduce the AAA.

Effect of distributions: Secs. 1368(e) (1) (A) and 1367 (a) (2) (A) provide that a distribution included in a shareholder's gross income does not reduce the AAA; there are two types of such distributions:

* A distribution that exceeds the AAA, but does not exceed the corporation's A&EP, is treated as a dividend under Sec. 1368(c) (2).

* A distribution that is not from AE&P, but exceeds the shareholder's basis, is gain from a deemed sale of the stock, under Sec. 1368(b) (2).

Regs. Sec. 1.1368-2(a) (4) (iii) appears to be more liberal, omitting Sec. 1368 (c) (2) distributions from the list of items that reduce the AAA. While Sec. 1371 (c) (3) requires the AE&P (not the AAA) to be reduced for a distribution treated as a dividend, Regs. Sec. 1.1368-2(a) (4) (iii) states that a distribution that exceeds a shareholder's basis reduces the AAA, but not below zero. The preamble acknowledges that the IRS received comments on this in the proposed regulations, but retained the current rule because of the undue complexity that would result from requiring an S corporation to obtain information from each shareholder regarding the taxability of his distribution. The Service may be justifiably concerned about complexity, but the AAA is not strictly a corporate-level account if any shareholder claims depletion on oil and gas property held by the corporation; thus, the rationale for the distribution rule seems to be weak and inconsistent.

* Observation: Only rarely does a distribution exceed a shareholder's basis without exceeding the AAA; this would most likely occur when a shareholder has purchased stock at a bargain price, received stock with a step-down in basis on the death of a former shareholder of if the corporation incurred significant expenses with respect to tax-exempt income, but did not realize an equal or greater amount of such income.

Timing rules: Regs. Sec. 1.1368-2(a) (3) (ii) states that the AAA is to be reduced for any item not currently deductible under the Code; presumably, this rule applies to reduce basis for items that may not be currently deductible at the shareholder level. A shareholder must reduce basis for any flowthrough losses that do not exceed his stock or debt basis (e.g., capital losses), even if they exceed the shareholder's limit on his personal return, and for losses suspended under the at-risk or passive loss rules.

However, the statement in Regs. Sec. 1.1368-2(a) (3) (ii) is not specifically limited to shareholder-level limitations, and thus could be construed to mean that a deduction suspended at the corporate level may cause an immediate reduction in AAA. Under this interpretation (which is questionable), an amount accrued to a cash-basis shareholder that is not deductible until paid (under Sec. 267 (a) (2) and (e)) would reduce AAA when accrued, if the corporation is on the accrual method. Any deduction suspended at the corporate level would not pass through to the shareholders until the corporation's tax year in which the deduction is allowed; thus, it should reduce shareholder basis, and the corporation's AAA, when the deduction is allowed to the corporation, and not in any other year. However, the regulations stop short of providing that the AAA is governed by the corporation's proper tax accounting method for all transactions.

Effective Dates

The Sec. 1367 basis regulations are effective for tax years beginning after 1993, according to Regs. Sec. 1.1367-3. For all earlier years, taxpayers must take a reasonable position, based on the language of the statute and the legislative history; for this purpose, the rules contained in Regs. Secs. 1.1367-1 and -2 are reasonable positions.

The Sec. 1368 regulations are also effective for tax years after 1993. For all earlier years, taxpayers must take a reasonable position, based on the language of the statute and the legislative history; for this purpose, the rules in Regs. Secs. 1.1368-1, -2 and -3 are reasonable positions, with the exception of Regs. Sec. 1.1368-1 (f) (3), the deemed dividend rule.

Part II of this article, in the next issue, discusses distributions to shareholders.

(1) Secs. 1361-1363, 1366-1368, 1371-1375, 1377-1379.

(2) PS-264-82 (6/9/92), amended 9/14/92.

(3) TD 8508 (12/30/93).

(4) TD 7872 (1/21/83).

(5) See also Prop. Regs. Sec. 1.1377-1 (b) (4).

(6) Regs. Sec. 1.1362-6 (b) (2) lists the consent rules for shares held under community property laws, jointly, and by estates and trusts.

(7) IRS Letter Ruling (TAM) 9423003 (2/28/94). See also Pollack, "Sec. 108(a) (1) Excluded COD Income," 26 The Tax Adviser 259 (May 1995).

(8) See S. Rep. No. 99-313, 99th Cong., 2d Sess. 222 (1986), discussing then Sec. 162 (1).

(9) Hilton Hotels Corp., 397 US 580 (1970) (25 AFTR2d 70-967, 70-1 USTC [paragraph]9349), rev'g and rem'g 410 F2d 194 (7th Cir. 1969) (23 AFTR2d 69-1180, 69-1 USTC [paragraph]9336).

(10) INDOPCO, Inc., Sup. Ct., 1992 (69 AFTR2d 92-694, 92-1 USTC [paragraph]50,113).

(11) Prop. Regs. Sec. 1.1367-1(c) (3) subjected all stock basis adjustments "described in section 1367(a) (2)" to the spillover rule. Those adjustments include all distributions included in the shareholder's gross income. Thus, the proposed regulation applied the spillover rule to distributions not treated as dividends or capital gain distributions. Comments in the preamble to the final regulations indicated that there was some confusion on this issue.

(12) Sec. 1366(d)(2) requires a carryforward of losses and deductions disallowed due to the basis limitation of Sec. 1366(d)(1). Losses and expenses disallowed by other Code provisions are not subject to the carryforward rule.

(13) For recent cases in which a shareholder was denied basis due to failure to substantiate loans to his S corporation, see John E. Sperl, TC Memo 1993-515, and Arnold W. Shaver, Jr., TC Memo 1993-619.

(14) See, e.g., GCM 39768 (12/1/88); Rev. Ruls. 64-94, 1964-1 (Part 1) CB 317, 69-566, 1969-2 CB 165, 79-52, 1979-1 CB 283; IRS Letter Rulings 8534077 (5/29/85), 8351110 (9/22/83), 9350003 (9/1/93) and 9410022 (12/8/93).

(15) Lamar Hunt, TC Memo 1990-248.

(16) The regulation has not been updated to reflect changes made by the SSRA.

(17) See, e.g., Joe M. Smith, 48 TC 872 (1967), aff'd in part and rev'd in part, 424 F2d 219 (9th Cir. 1970) (25 AFTR2d 70-936, 70-1 USTC [paragraph] 9327).

(18) See Darby Investment Corp., 37 TC 839 (1962), aff'd, 315 F2d 551 (6th Cir. 1963) (11 AFTR2d 1242, 63-1 USTC 9396).

(19) Rev. Rul. 64-162, 1964-1 CB 304.

(20) Rev. Rul. 68-537, 1968-2 CB 372; see also Smith, note 17.

(21) See Rev. Rul. 95-5, 1995-1 CB 100, holding that gain from a distribution in excess of basis may result in passive activity income.

(22) The IRS formally stated its position in Rev. Ruls. 71-288, 1971-2 CB 319 (clarifying Rev. Rul. 70-50, 1970-1 CB 178), and 75-144, 1975-1 CB 277 (amplifying Rev. Rul. 70-50), and has won many cases on this point. Edward M. Selfe, 778 F2d 769 (11th Cir. 1985) (57 AFTR2d 86-464, 86-1 USTC [paragraph] 9115), is a notable exception. In Sperl, note 13, and Shaver, Jr., note 13, the Tax Court continued to support the IRS's position that there is no basis without economic outlay.

(23) IRS Letter Ruling (TAM) 9403003 (9/29/93).