Final regulations on treatment of built-in gain on conversion from C to S.

The IRS has released Regs. Sec. 1.1374-4 on the taxation of builtin gain on the conversion of a C corporation to an S corporation. The final regulations are effective for tax years ending on or after Dec. 27, 1994, but only for S corporations whose election is effective on or after Dec. 27, 1994.

Although the final regulations generally adopt the provisions of the proposed regulations issued on Dec. 7, 1992, a number of significant changes have been made.

First, the Service rejected suggestions that the final regulations should not use the accrual method rule to determine whether an item of income or deduction is included in net recognized built-in gain or to what extent it is included. Regs. Sec. 1.1374-4(c) provides that an amount properly deducted under Sec. 267(a)(2) is recognized buil-tin loss to the extent that (1) all events have occurred to establish the fact of the liability, and the 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 that owned less than 5% of the stock. Regs. Sec. 1.1374-4(c)(2) also provides that an amount properly deducted under Sec. 404(a)(5) is recognized built-in loss to the extent that (1) all events have occurred that establish the fact of the liability, and the 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).

Second, Regs. Sec. 1.1374-4(d) extends the time that Sec. 481 adjustments may be treated as recognized built-in gain or loss to the entire 10-year recognition period. (The proposed regulations had limited the rule to the first year of the recognition period.) However, the adjustments must continue to relate to items attributable to periods before the recognition period.

Third, Regs. Sec. 1.1374-7 clarifies the rule for valuing inventory. The value of an S corporation's inventory on the first day of the recognition period generally is determined by reference to a sale of the S corporation's entire business to a buyer that expects to continue operating the business. The buyer and seller are presumed not to be under any compulsion to buy or sell and to have reasonable knowledge of all relevant facts. Relevant facts include (1) the replacement cost of the inventory; (2) its expected retail selling price; (3) the seller's incentive to demand a price for the inventory that provides compensation and a fair return for expenditures the seller incurred to obtain, prepare, carry and dispose of the inventory before the sale of the business; and (4) the buyer's incentive to pay a price for the inventory that provides compensation and a fair return for similar expenditures the buyer expects to incur after the sale of the business. It is expected that the value of an S corporation's inventory as determined under the final regulations will generally be less than its anticipated retail price, but greater than its replacement cost.

Fourth, Regs. Sec. 1.1374-4(i) retains the lookthrough rule for partnership interests. However, the small-interest exception has been expanded to apply to a tax year if the S corporation's interest in the partnership represents less than 10% of the partnership's profits and capital at all times during both the tax year and the prior tax years in the recognition period, and if it has a value of less than $100,000 as of the beginning of the recognition period. However, if the S corporation subsequently contributes an asset that it held on the conversion date to the partnership, the fair market value of the S corporation's partnership interest as of the beginning of the recognition period is determined as if the asset had been contributed to the partnership at the beginning of the recognition period (Regs. Sec. 1.13744(i)(5)(ii)).