S corporation distribution regulations.
The regulations provide needed guidance on a number of issues.
* Stock basis. S shareholders have their stock bases increased for income items and decreased by deductions, losses and distributions. While tax practitioners tended to monitor stock basis as an aggregate number for each shareholder under the new regulations, basis recordkeeping on a per share calculation is required.
If the loss or deduction allocable to a share exceeds its basis, the excess is applied to reduce the remaining bases of other shares of stock owned by the shareholder in proportion to the remaining basis of each of those shares.
This procedure would entail extra recordkeeping for S shareholders who acquired their stock at different prices.
* Debt basis. For S shareholders who have made direct loans to an S corporation, pass-through losses may be claimed to the extent of both stock basis and debt basis.
After debt basis is reduced by pass-through losses, it later may be restored by undistributed S net income.
The regulations confirm that debt basis is reduced only for debts held at corporate tax yearend and that subsequent basis restoration occurs only for debt held on the first day of the tax year.
Furthermore, the regulations clarify basis restoration procedures when the shareholder had multiple loans with the S corporation during a tax year.
* Former previously taxed income. Before the law was rewritten in 1982, income taxed to an S shareholder but not withdrawn was known as previously taxed income. The regulations confirm that S shareholders with old previously taxed income balances may withdraw these amounts tax free to the extent there is an actual distribution of money in excess of the corporate accumulated adjustments account (the post-1982 version of previously taxed income).
* Election to alter distribution tiers. IRC section 1368 provides a favorable set of distribution tiers, treating withdrawals from S corporations as coming first from the nontaxable accumulated adjustments account and previously taxed income before reaching the harmful "earnings and profits" dividend tier.
On rare occasions, such as when an S corporation desires to strip out its earnings and profits to eliminate a section 1375 passive investment tax, it is advantageous to make an election to alter these distribution rules so as to first withdraw from the earnings and profits layer.
While the code simply allowed an election to bypass the accumulated adjustments account to meet this objective, the new regulations give additional flexibility by allowing an election to bypass any previously taxed income layer, along with a deemed dividend election for entities with insufficient cash to make an actual earnings and profits distribution.
* Election in case ofpartial disposition of stock. Under current law, a shareholder who disposes of an interest in an S corporation before yearend cannot be certain of the tax consequences because the income or loss allocation will involve a pro rata share of the entire year's operations.
To alleviate this uncertainty, the proposed regulations provide that, if a shareholder disposes of 20% or more of the corporation's issued stock during any 30-day period during the corporation's tax year, the corporation may elect to close its books on the date of the 20%-ormore disposition in order to allocate income or loss among the shareholders for the S year.
Observation: These proposals would not be effective until S corporation tax years beginning after final regulations are issued. Hearings on the proposals are scheduled for September.