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Proposed S corporation regulations under Secs. 1367 and 1368.

A thorough understanding of the interplay among the S corporation "basis," loss limitation, accumulated adjustment account, distribution, redemption and loan repayment rules is necessary in order to render competent tax planning, tax advisory and tax return preparation services to S corporations and S shareholders. The IRS has provided substantial guidance in these areas in proposed regulations under Secs. 1367 and 1368. As this article will explain, the regulations are generally favorable to taxpayers and provide some new planning opportunities. Nevertheless, they also propose an important ordering rule that tightens a statutory loss limitation provision.


The conceptual foundation underneath subchapter S is the ability to avoid double taxation on corporate profits. While S corporations enjoy the same nontax benefits as C corporations,(1) S corporations are generally not subject to tax at the corporate level.(2) Instead, each shareholder reports his share of corporate income on his individual income tax return. The shareholders are then entitled to withdraw such income from the corporation without additional tax. Such withdrawals are termed "distributions" under the S corporation rules, although they also represent "regular" corporate dividends under applicable state laws.

Scope of Proposed Regulations

Sec. 1368 and Prop. Regs. Secs. 1.1368-1 through - 4 establish the rules for measuring the tax effect of S distributions. These rules are interrelated with the stock and loan basis adjustment and loan repayment rules of Sec. 1367 and Prop. Regs. Secs. 1.1367-1 through -3. These rules, in turn, are interrelated with the income and loss passthrough and the loss limitation rules of Sec. 1366. The proposed regulations under Secs. 1367 and 1368 are to become effective for years beginning after the date final regulations are published in the Federal Register. It is anticipated that this will occur before the end of 1993.(3)

Losses and Basis Adjustments

Like S corporation income, S corporation losses and credits pass through and are reported, subject to various limitations, on the shareholder's income tax returns.(4) Sec. 1366(d)(1) provides that the aggregate amount of losses and deductions taken into account by an S shareholder for any tax year cannot exceed the sum of --the adjusted basis of the shareholder's stock in the S corporation (after making the positive stock basis adjustments of Sec. 1367(a)(1)), and --the shareholder's adjusted basis of any indebtedness of the S corporation to the shareholder (determined before any negative or positive debt basis adjustments under Sec. 1367(b)(2)). Thus, the stock and debt basis adjustment rules of Sec. 1367 have an important bearing on the loss and deduction limitation rules of Sec. 1366. The basis adjustment rules also have an impact on the taxability of stock dispositions (through sale or redemption), the taxability of shareholder loan repayments, the basis of gift stock and, as stated earlier, the taxability of S distributions.

Under Sec. 1367(a), the basis of each shareholder's stock in an S corporation is increased for any period by the sum of the shareholder's positive adjustments, and basis is decreased by the sum of the shareholder's negative adjustments. Prop. Regs. Sec. 1.1367-1(b) and (c) summarize the statutory positive and negative basis adjustment provisions in the Service's new simplified style, by not reiterating statutory language that is clear on its surface.

* The positive adjustments

The positive adjustments specified in Sec. 1367(a)(1) are: * The corporation's separately stated items of income (defined by reference to Sec. 1366(a)(1)(a)). * The corporation's nonseparately computed income (defined by reference to Sec. 1366(a)(1)(b)). * The excess of the corporation's deductions for depletion over the basis of the property subject to depletion.

Prop. Regs. Sec. 1.1367-1(b)(1) specifies that the shareholder's basis is not increased with respect to excess oil and gas depletion because, as explained in the preamble to the proposed regulations, each shareholder computes these deductions separately under Sec. 613A(c)(11).(5) Sec. 1367(b) provides that a shareholder only increases stock basis for items of income that are required to be included in gross income if the shareholder in fact includes the items in gross income on his return.

* The negative adjustments

The negative adjustments specified in Sec. 1367(a)(2) are: * Distributions by the corporation not includible in the shareholder's income under Sec. 1368. * The corporation's separately computed items of loss and deduction (defined with reference to Sec. 1366(a)(1)(a)). * The corporation's nonseparately computed loss (defined with reference to Sec. 1366(a)(1)(b)). * Any expense of the corporation not deductible in computing its taxable income and not properly chargeable to a capital account (noncapital, nondeductible expenses). * Oil and gas property depletion to the extent the deduction does not exceed the shareholder's allocated portion of the property's adjusted basis.

The preamble specifies that the basis of a shareholder's stock is decreased by the amount of any loss or deduction that is allowed under Sec. 1366(d), regardless of whether the loss or deduction is disallowed or deferred under another Code provision (such as the passive loss rules of Sec. 469).

* Separate basis approach

The proposed regulations adopt a favorable "separate basis approach" to increasing and decreasing the basis of a shareholder's individual shares of stock. The basis of each share of stock is increased by the shareholder's pro rata portion of the corporation's positive adjustment items determined on a per share, per day basis, in accordance with Sec. 1377(a). This provides taxpayers with planning opportunities for the disposition of specific shares or blocks of stock by gift, sale or exchange. Negative adjustments are made in the same manner; however, a favorable "spill over" of losses rule is also provided. If the amount of negative adjustments to basis attributable to a particular share of stock exceeds its basis, the excess is applied to reduce (but not below zero) the remaining basis of all other shares of stock in the corporation owned by the shareholder, in proportion to the remaining basis of each of those shares. Although the preamble describes this spill-over treatment only for losses and deductions, Prop. Regs. Sec. 1.1367-1(c)(3) applies this treatment to all negative adjustments described in Sec. 1367(a)(2), which includes distributions. Nevertheless, because some confusion still exists among practitioners, the Service has been asked to clarify, in final regulations, that the spill-over rules also apply to distributions.(6)

* Ordering rules

The proposed regulations contain a basis adjustment ordering rule which, if included in the final regulations, will tighten the statutory loss limitation provision of Sec. 1366(d). Under Prop. Regs. Sec. 1.1367-1(e), adjustments are made to the basis of a share of stock in the following order: (1) increases for income items and excess nonoil and gas depletion; (2) decreases for nondeductible, noncapital expenses and oil and gas depletion that does not exceed basis; (3) decreases for items of loss or deduction; and (4) decreases for distributions.

The requirement to reduce basis for nondeductible, noncapital items before the decreases for losses and deductions can reduce the amount of losses and deductions taken into account under Sec. 1366(d).

Example 1: Shareholder L has a beginning stock basis of $10,000, no positive adjustment items for the year, $8,000 of nondeductible expenses and $8,000 of losses and deductions. Under the proposed regulations, L would be able to take only $2,000 of the losses and deductions into account, after first reducing the stock's basis by the $8,000 of nondeductible expenses.

The author is aware of no statutory support for this ordering rule. A pro rata reduction would appear to provide a more equitable result because both deductible and nondeductible items consume corporate assets, and should reduce stock basis, in the same manner.

Note that Sec. 1366(d)(2) provides that any loss or deduction that is disallowed because it exceeds the shareholder's basis in stock and debt carries over indefinitely, and is treated as incurred by the corporation in the succeeding tax year with respect to that shareholder. Accordingly, in some cases excess losses and deductions will benefit taxpayers in future periods. There is no provision in the Code for the carryover of nondeductible, noncapital items to subsequent years. This might have influenced the IRS in selecting the proposed ordering rules. The Service invited comments on the proposed Sec. 1367 ordering rules and may request similar comments concerning the carryover of nondeductible items when it issues proposed regulations under Sec. 1366. This invitation for comments on the proposed ordering rules might indicate that the rules are subject to change; and since the proposed regulations have not become effective, practitioners may not feel compelled to implement this adverse ordering provision.

One item that should be considered is the treatment of whole life officer insurance premiums. Many practitioners treat the excess of premiums paid over the increase in cash surrender value (the net "book" expense) as a noncapital, nondeductible expense that reduces stock basis (but does not reduce the S corporation's accumulated adjustment account (AAA)). Frequently, this expense is used to reduce the "other adjustment account" on the S corporation income tax return as an expense related to future tax-exempt income. However, it may be more appropriate to consider that the entire premium payment increases the corporation's tax basis in the policy. Thus, the entire premium would represent a capital item that would not decrease stock basis. On cancellation or on collecting the proceeds the "net" difference realized would affect basis.

The other proposed ordering rules are consistent with related statutory provisions. Taking basis increases into account first is consistent with Sec. 1366(d), under which losses and deductions are taken into account, to the extent of stock basis, after making the positive basis adjustments. Similarly, taking distributions into account last is consistent with Sec. 1368(d). Although the legislative history can be interpreted differently, Sec. 1368(d) is generally construed to provide that the distribution rules are to be applied after making all of the other positive and negative basis (and AAA) adjustments.(7) This aspect of the distribution rules causes uncertainty with respect to the treatment of distributions made during a tax year. For example, calendar-year S corporations frequently make distributions during April to enable shareholders to pay tax on the S corporation's prior-year income. Although taxpayers generally think of such distributions as relating to the prior year, lower than expected income (or losses) for the year in which the distributions are actually paid can cause the distributions to be taxable. For this reason, and to promote simplification by conforming the S corporation rules to the partnership rules (under which distributions are taken into account after income but before losses), Section 602 of HR 13, the Tax Simplification Bill of 1993, will, if enacted, modify these S corporation provisions. Under the proposal, adjustments to basis and the AAA for S distributions would be made before applying the loss limitation for the year. This proposal, if enacted, would require the ordering rule in the proposed regulation to be modified.

* Capital contributions after fiscal year-end

An issue related to the basis ordering rules, which may be addressed when regulations are proposed under Sec. 1366, is the proper time for shareholders to take losses and deductions into account when capital contributions are made after the end of an S corporation's tax year, but before the end of the shareholder's tax year.(8) As noted, Sec. 1366(d)(1) limits, to the extent of basis, the amount of losses and deductions that may be taken into account for any tax year; however, the statute does not specify which tax year is controlling. Although former Sec. 1374(c)(2)(a) clearly specified that loss deductions were limited to basis "determined as of the close of the taxable year of the corporation," this language was deleted by the Subchapter S Revision Act of 1982 when Sec. 1374(c) was replaced by Sec. 1366(d). While Prop. Regs. Sec. 1.1367-1(d) specifies that basis adjustments are to be made at the end of a corporation's year and/or immediately before a disposition of shares during the year, it addresses only the positive and negative adjustments of Sec. 1367(a), omitting capital contributions or the timing of the loss limitation.

Loan Repayments

The proposed regulations provide "user friendly" guidance in the area of loan repayments. As noted previously, Sec. 1366(d) allows a shareholder whose losses and deductions exceed the basis in his stock to take additional losses and deductions into account to the extent of the shareholder's basis in loans to the S corporation.(9) Relatedly, Sec. 1367(b)(2) and Prop. Regs. Sec. 1.1367-2(b)(1) provide that if negative basis adjustment items (other than distributions) exceed the basis of all of the shareholder's stock (after making the positive adjustments), the excess is applied to reduce (but not below zero) the shareholder's basis in loans to the S corporation. Only loans outstanding at year-end are subject to basis reduction; however, if any shareholder terminates his interest in the corporation during the year, basis reduction applies to loans outstanding immediately before the termination. If the shareholder holds more than one debt, the basis reduction applies proportionately to the basis of each such debt.

* Planning for reduced basis loans

S shareholders frequently make loans to their S corporations in order to take additional losses and deductions into account. Thereafter, as illustrated below, careful planning is necessary because taxpayers will recognize taxable income if any portion of the loan is repaid before the basis is fully restored. Sec. 1367(b)(2)(b) provides that if, in any year after there has been a debt basis reduction, all of the positive basis adjustments exceed all of the negative adjustment items (including distributions), the net increase applies to restore debt basis before it increases basis in stock. Prop. Regs. Sec. 1.1367-2(c) provides that the restoration applies only to indebtedness held on the first day of the tax year in which the net increase arises.

When the bases of multiple reduced basis loans are restored, the restoration is generally applied in proportion to the amount that the basis of each outstanding debt has been reduced. However, Prop. Regs. Sec. 1.1367-2(c)(2) provides a favorable rule under which any restoration is applied first to any indebtedness repaid in whole or in part during the year. Prop. Regs. Sec. 1.1367-2(d)(1) provides a similar timing rule in that all debt basis adjustments (reductions and restorations) are generally made at the close of the tax year (or on termination of a shareholder's interest). The exception occurs when debt is disposed of or repaid during a year; then restoration adjustments are effective immediately before the disposition or first repayment. These favorable rules will minimize income recognition on loan repayments.

When elections are made to terminate the tax year under Sec. 1377(a)(2) (termination of a shareholder's interests) or Prop. Regs. Sec. 1.1368-1(g)(2) (disposition of a substantial amount of stock), the debt basis adjustments are made two (or more) times, as if the year consists of separate years.

Although these rules treat loan repayments in a favorable manner, careful planning is still necessary with respect to reduced basis loans.

Example 2: A shareholder's stock basis at the beginning of the year is zero and his basis in a $20,000 loan to the corporation has been reduced, in prior years, to zero. If current year income is $10,000, the corporation would not be able to repay any portion of the loan without the recognition of gain or income by the shareholder. Although the basis of the $20,000 face value loan would be restored from zero to $10,000, any loan repayment (including an amount less than or equal to $10,000) would be allocated (in this case 50% each) between (1) the return of basis and (2) income or gain.(10) Repayment of written notes results in capital gain income while repayment of debt not evidenced by a written note results in ordinary income.

* Open account debt

The proposed regulations do not address the treatment of open account debt, except to invite comments. It appears appropriate to treat all open indebtedness of a shareholder as a single debt, along with each separate debt instrument, which the proposed regulations treat as separate debts.(11)


One of the basic principles of S corporation taxation is that shareholders are able to receive tax-free distributions to the extent of the corporate earnings they report on their personal income tax returns. However, not all distributions are tax free. Sec. 1368 provides two sets of rules for measuring the tax effect of distributions to shareholders. One set of rules applies to distributions from S corporations that have no accumulated earnings and profits (AE&P); the other applies to S corporations with AE&R In general, the separate rules are designed to enable former C corporations to distribute their postelection taxable earnings tax free, but to subject postconversion distributions of preelection E&P to the same dividend taxation that would have resulted before the election.

In accordance with Sec. 1368(a), these distribution rules apply to "regular" distributions, but not to "special" distributions such as distributions in redemption of stock, in complete liquidation, or in corporate organizations or reorganizations. Under Sec. 1371 such "special" distributions are generally subject to the normal subchapter C rules.

* S corporations without E&P

For S corporations without AE&P, Sec. 1368(b) provides that distributions are tax free to the extent of a shareholder's adjusted basis in the stock. Distributions in excess of the adjusted bases of all of the shareholder's shares of stock are treated as gain from the sale or exchange of property (capital gain).

* S corporations with E&P

For S corporations with E&P, under Sec. 1368(c)(1), distributions to the extent of an S corporation's AAA are also tax free to the extent of the recipient shareholder's stock basis, and then represent gain from the sale or exchange of property. Under Sec. 1368(c)(2), distributions in excess of the corporation's AAA are treated as taxable dividends to the extent of the corporation's AE&P.

Under Sec. 1368(c)(3), any remaining distributions are treated as made by an S corporation without E&P (i.e., tax free to the extent that the shareholder has additional stock basis and then gain from the sale or exchange of property). Prop. Regs. Sec. 1.1368-1(d)(2) provides that a distribution by an S corporation to a shareholder with prepreviously 1983 taxed income (PTI) is treated as a distribution made out of PTI after the AAA has been exhausted but before a distribution is deemed to be a dividend out of E&P. Distributions of PTI decrease the shareholder's stock basis (but not below zero) and are then treated as gain from the sale or exchange of property.

* The accumulated adjustment account

Prop. Regs. Sec. 1.1368-2(a) clarifies that the AAA is an account of the S corporation that is not apportioned among shareholders. Frequently, tax practitioners need to explain to their clients that S shareholders do not have partnership "type" capital accounts in their S corporations. Absent special shareholder agreement provisions, an S shareholder has no inalienable right to a share of undistributed earnings unless and until the corporation declares a dividend distribution. This concept has become a frequent issue in divorce proceedings.

The AAA, which is used to measure the taxability of distributions from S corporations with AE&P, is adjusted, under Sec. 1368(e), for each S period (after 1982) in a manner similar to the basis adjustments under Sec. 1367. The differences are that the AAA is not increased with respect to tax-exempt income and it is not decreased by expenses related to tax-exempt income (and Federal taxes related to C corporation years). Additionally, unlike the basis of stock, the AAA may be reduced below zero, if losses and deductions (but not distributions) exceed income; and under Prop. Regs. Sec. 1.1368-2(a)(3)(ii), the AAA is reduced by the entire amount of any loss or deduction, even though a portion of the loss or deduction may be disallowed to a shareholder under Sec. 1366(d)(1) or another Code provision.

Note that common temporary (or timing) differences between book income and taxable income do not affect the AAA, except in the period in which they enter into the determination of taxable income. Additionally, they should not be posted to the corporation's "other adjustment account" because they do not represent permanent tax-exempt income or related expenses (which adjust basis, but not the AAA). Accordingly, the total of an S corporation's AAA, other adjustment account, PTI and E&P will not equal its "book" retained earnings account when there are timing differences.

As discussed earlier, Sec. 1368(d) and Prop. Regs. Sec. 1.1368-1(e) provide that the distribution rules are to be applied after making all of the adjustments to stock basis and the AAA (except decreases for distributions). Although it does not appear to be important, Prop. Regs. Sec. 1.1368-2(a)(2) provides that the AAA account is adjusted for the increase items before it is adjusted for the decrease items other than distributions.

* Optional elections to accelerate the distribution of E&P

The proposed regulations provide three elections that allow taxpayers to modify the ordering rules for determining the source of distributions. These elections, which should facilitate planning, are designed to assist taxpayers who want to accelerate the distribution of C corporation E&P. This is frequently desired to avoid the Sec. 1375 S corporation level tax on excess passive investment income and the Sec. 1362(d)(3) S election termination that may occur after three consecutive years of excess passive investment income. Neither of these provisions applies, and an S corporation can earn unlimited passive investment income, when it does not have C corporation E&R

Election to bypass AAA: Under Prop. Regs. Sec. 1.1368-1(f)(1)(i) and (f)(2), which have statutory authority in Sec. 1368(e)(3), an S corporation and all of its shareholders may elect to bypass the AAA with respect to all distributions during the tax year. Thus, distributions would be treated as made first from PTI (see below), then from E&P and, finally, under Prop. Regs. Sec. 1.1368-1(f)(2)(ii), from the AAA. This election is sometimes used to "clean out" E&P during a former C corporation's first S year, without having to distribute the income earned in the initial S year. The proposed regulations also provide a favorable rule under this election in which distributions are treated as made first out of subchapter C E&P and then out of (pre- 1983) S corporation E&P.(12) Election to bypass PTI: When an S corporation has PTI with respect to one or more of its shareholders, an election to bypass PTI can be made under Prop. Regs. Sec. 1.1368-1(f)(1)(iii) and (f)(4). This election can be made separately or in conjunction with the election to bypass the AAA. Deemed dividend election: The third election, the deemed dividend election under Prop. Regs. Sec. 1.1368-1(f)(1)(ii) and (f)(3), can be made only if the election to bypass the AAA is also made. This may represent an unintentional trap the Service could correct in the final regulations. Both the preamble and Prop. Regs. Sec. 1.1368-1(f)(3) provide that an S corporation that makes the election to bypass the AAA may also make the deemed dividend election. Thus, it appears that an election to make a deemed dividend would be defective unless an election to bypass the AAA is also made. The Service should consider providing in the final regulations that a deemed dividend election also represents an election to bypass the AAA.

The deemed dividend is a hypothetical distribution that is treated as made by the corporation from its subchapter C E&P. It is considered to be a distribution in money to the shareholders in proportion to their stock ownership, and immediately contributed back to the corporation as a capital contribution, all on the last day of the corporation's tax year. This election might be desirable if the corporation lacks sufficient liquid assets to distribute all of its E&P. However, it will still be necessary to distribute enough funds to cover the shareholder's tax on the deemed distribution, unless the shareholders have sufficient outside funds.

The amount of the deemed dividend is limited to the amount of the S corporation's subchapter C E&P. A statement must be attached to the election, made on a timely filed original or amended return, which includes the amount of the deemed dividend that is distributed to each shareholder. Each shareholder who owns stock on the last day of the tax year must provide a written consent, executed under penalties of perjury, to treat the deemed dividend consistently with these rules.(13)

* Election to close books on substantial disposition

Under Prop. Regs. Sec. 1.1368-1(g)(2), another new election, to close the books at an interim date, is available to S corporations when a shareholder disposes of 20% or more of the issued stock during any 30-day period of the corporation's tax year. All shareholders during the corporation's full tax year must sign the election. Under this "substantial disposition" election the year is treated as consisting of separate years for purposes of allocating income and loss, making adjustments to AAA, basis and E&P, and determining the tax effects of distributions. Absent the election, income for the entire tax year, including potentially significant transactions occurring after a substantial distribution of stock, is allocated to all shareholders on a per share, per day basis. The Service has provided the election to allow shareholders to avoid the uncertainty of not being able to determine the tax consequences associated with midyear stock dispositions until after year-end. A similar election to use the interim closing of the books method is available under Sec. 1377(a)(2), when a shareholder terminates his entire interest in an S corporation, and under Sec. 1362(e)(3), to apportion income and losses between the short S year and the short C year during an S termination year. This apportionment method under Sec. 1362(e)(3) becomes mandatory, under Sec. 1362(e)(6)(d), when there is a 50% or more change in ownership during the S termination year. The proposed regulations do not permit the election when a shareholder's interest is reduced due to events other than a direct disposition of stock.

* Other considerations

The proposed regulations also provide special rules for allocating the AAA between distributions when there are multiple distributions which, in the aggregate, are in excess of the AAA.(14) Further allocations are specified when money and loss property (basis greater than fair market value) are distributed and total distributions exceed the AAA.(15) Special rules concerning AAA adjustments are also provided with respect to redemptions, reorganizations and corporate divisions.(16)

The proposed AAA adjustment rule for reorganizations can be problematic with respect to many common business transactions. Prop. Regs. Sec. 1.1368-2(d)(2) provides that when an S corporation acquires the assets of another corporation in a tax-free reorganization to which Sec. 381(a)(2) applies, it will succeed to and merge its AAA with the AAA of the other corporation. Under the proposed regulations, the AAA of the acquiring corporation after the transaction is the sum of the corporations' AAAs before the transaction. This rule appears to be inconsistent with Sec. 1371(a)(1), which applies subchapter C principles to similar S corporation transactions, and it appears inconsistent with other provisions in the proposed regulations in which subchapter C principles are applied. The rule creates a potential trap when the acquiring corporation has made distributions during the year and the acquired corporation has a negative AAA. In this situation, under the proposed regulations, distributions that would have been tax free without the acquisition could become taxable dividends. Under subchapter C principles, similar to those applicable to E&P under Sec. 381(c)(2), it would seem that the negative AAA should be maintained in a separate account and should be reduced (or restored up to zero) only by postacquisition positive adjustments.

Although the proposed regulations do not address the alternative minimum tax (AMT), S corporations and their shareholders should presumably maintain separate stock basis and AAA records for AMT purposes.


The IRS should be commended for the thoughtful and well-reasoned approach it has taken to the many complex and interrelated issues presented in Secs. 1367 and 1368. The author understands that the Service is considering the comments it has received concerning the proposed regulations. One comment submitted by the American Institute of Certified Public Accountants (AICPA) Tax Division's S Corporation Taxation Committee is to allow taxpayers the ability to elect to apply the final regulations, when appropriate, on a retroactive basis. A copy of the AICPA comments submitted to the IRS may be obtained by sending, along with the request, a stamped, self-addressed 9" x 12" envelope to AICPA Tax Division--S Corporation Taxation Committee, 1455 Pennsylvania Avenue, N.W., Washington, D.C. 20004-1007.

Editor's note: Mr. Tzinberg is a member of the AICPA Tax Division's S Corporation Taxation Committee. (1) Starr, 730 T.M. S Corporations: Formation and Termination, at A-2. (2) S Corporations that have been C corporations (or which acquire C corporation assets in certain transactions) may be subject to corporate level taxes with respect to built-in gains under Sec. 1374, excess net passive income under Sec. 1375, LIFO recapture under Sec. 1363, and investment tax credit recapture. (3) See proposed 1993 Business Plan for the Internal Revenue Service and the Office of Tax Policy, at 17. (4) Sec. 1366(a). (5) TD PS-264-82 (6/9/92), amended 9/14/92. (6) American Institute of Certified Public Accountants S Corporation Taxation Committee Comments on Proposed Regulations under Sections 1367 and 1368, at 2. (7) The Joint Committee on Taxation's Technical Explanation of the Tax Simplification Act of 1993 (HR 13) (1/8/93), at 172, indicates that present law "appears" to require that the adjustments to basis for items of income and loss for any tax year apply before the adjustment for distributions applies. The lack of certainty on this point seems to relate to inconsistent language in the Senate Finance Committee Report on the Subchapter S Revision Act of 1982. While the report stated that income and loss will apply to adjust basis before the distribution rules apply, it also stated that this follows rules generally analogous to partnership rules. This is inconsistent since partnership distributions adjust basis after income but before losses.

Adjusting basis for income and loss before distributions is consistent with the IRS's prior position as expressed in Letter Rulings 8842024 (7/25/88) and 8712049 (12/23/86). (8) Secs. 1378 and 444 permit certain S corporations to use fiscal years. (9) A majority of the courts have held that a shareholder's basis in corporate indebtedness does not include the amount of corporate debt guaranteed by the shareholder. The only exception that the author is aware of is the Eleventh Circuit decision in Edward M. Selfe, 778 F2d 769 (11th Cir. 1985)(57 AFTR2D 86-464, 86-1 USTC [Paragraph] 9115), in which the court found that basis could be increased if the facts demonstrate that shareholders "in substance" borrowed funds and subsequently advanced them to the S corporation. (10) Rev. Rul. 68-537, 1968-2 CB 372. (11) AICPA comments, note 6, at 6. (12) Prop. Regs. Sec. 1.1368-1(f)(2)(iii). (13) Prop. Regs. Sec. 1.1368-1(f)(3)(ii). (14) Prop. Regs. Sec. 1.1368-2(b). (15) Prop. Regs. Sec. 1.1368-2(c). (16) Prop. Regs. Sec. 1.1368-2(d).
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Author:Tzinberg, Neil E.
Publication:The Tax Adviser
Date:Jun 1, 1993
Previous Article:Computing corporate estimated tax for the year following S status.
Next Article:Rev. Proc. 92-33 is applied to LLCs.

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