Eligible Terminated S Corporations
| Citation | 85 FR 66471 |
| Published date | 20 October 2020 |
| Record Number | 2020-21144 |
| Section | Rules and Regulations |
| Court | Internal Revenue Service |
Federal Register, Volume 85 Issue 203 (Tuesday, October 20, 2020)
[Federal Register Volume 85, Number 203 (Tuesday, October 20, 2020)]
[Rules and Regulations]
[Pages 66471-66484]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-21144]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9914]
RIN 1545-BP20
Eligible Terminated S Corporations
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulation.
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SUMMARY: This document contains final regulations providing guidance on
the definition of an eligible terminated S corporation and rules
relating to distributions of money by such a corporation after the
post-termination transition period. This document also amends current
regulations to extend the treatment of distributions of money during
the post-termination transition period to all shareholders of the
corporation and clarifies the allocation of current earnings and
profits to distributions of money and other property. The final
regulations affect C corporations that were formerly S corporations and
the shareholders of such corporations.
DATES:
Effective Date: These regulations are effective October 20, 2020.
Applicability Dates: For dates of applicability, see Sec. Sec.
1.481-6(b), 1.1371-1(e), 1.1371-2(d), and 1.1377-3(c).
FOR FURTHER INFORMATION CONTACT: Concerning Sec. Sec. 1.481-5, 1.481-
6, 1.1362-2(a)(2)(iii), 1.1377-2, and 1.1377-3, Margaret Burow or
Michael Gould at (202) 317-5279; concerning Sec. Sec. 1.1371-1 and
1.1371-2, Aglaia Ovtchinnikova at (202) 317-6975 or Margaret Burow or
Michael Gould at (202) 317-5279; concerning Sec. 1.316-2, Aglaia
Ovtchinnikova at (202) 317-6975.
SUPPLEMENTARY INFORMATION:
Background
In the case of an S corporation, as defined in section 1361(a)(1)
of the Internal Revenue Code (Code), having accumulated earnings and
profits (as described in section 316(a)(1) of the Code (AE&P)) that
makes a distribution of property to which section 301 would otherwise
apply, section 1368(c)(1) of the Code generally treats the amount of
the distribution not in excess of the S corporation's accumulated
adjustments account (as defined in Sec. 1.1368-2(a)(1) (AAA)) or the
recipient shareholder's adjusted basis in such S corporation's stock as
excluded from the shareholder's gross income. Section 1368(c)(2)
provides that the remaining portion of the distribution is treated as a
dividend (as defined in section 316(a)) to the extent of the S
corporation's AE&P. Finally, section 1368(c)(3) provides that any
amount of the distribution in excess of the S corporation's AAA and
AE&P is applied against the shareholder's remaining adjusted basis in
the stock, with any amount exceeding that adjusted basis treated as
gain from the sale or exchange of property.
Generally, a distribution by a C corporation to its shareholders
with respect to their stock ownership is treated as a taxable dividend
to the extent of the corporation's earnings and profits. See sections
301(c) and 316(a). However, following the termination of a
corporation's S election made under section 1362 of the Code (S
election), section 1371(e) of the Code allows shareholders of the
resulting C corporation to benefit from the corporation's former status
as an S corporation with respect to distributions of money during the
corporation's post-termination transition period (PTTP), which is
generally the one-year period after the corporation terminates its S
election. Specifically, during the PTTP, a distribution of money by the
C corporation is characterized as a distribution from the corporation's
AAA. The receipt of such a distribution is tax-free to the extent of
the recipient shareholder's basis in its stock and the corporation's
AAA balance. If the distribution exceeds the recipient shareholder's
basis in its stock, but not the corporation's AAA, then the
distribution is tax-free to the extent of the recipient shareholder's
basis, with the remainder treated as gain from the sale of property. If
the distribution exceeds the corporation's AAA, then the excess is
taxed as a dividend from current earnings and profits (as described in
section 316(a)(2) (CE&P)) or any AE&P from the corporation's previous
existence as a corporation taxed under subchapter C. Without section
1371(e), shareholders of the former S corporation would be precluded
from receiving distributions allocable to AAA.
Section 13543(a) and (b) of Public Law 115-97, 131 Stat. 2054, 2155
(2017), commonly referred to as the Tax Cuts and Jobs Act (TJCA),
amended the Code by adding new sections 481(d) and 1371(f), effective
as of December 22, 2017, the date of enactment of the TCJA.
Section 481(d)(1) of the Code permits a corporation that qualifies
as an eligible terminated S corporation (ETSC) to take into account any
481 adjustments (as defined in part II.C of the Summary of Comments and
Explanation of Revisions) which are attributable to the revocation of
an S election over the section 481(d) inclusion period, which is the
six-taxable-year-period beginning with the year of change (as defined
in part II.C of the Summary of Comments and Explanation of Revisions).
Section 481(d)(2) defines an ETSC as a C corporation meeting the
following three requirements: (i) The corporation was an S corporation
on December 21, 2017; (ii) the S corporation revoked its election under
section 1362(a) to be an S corporation (that is, the S election) during
the two-year period beginning on December 22, 2017 (revocation
requirement); and (iii) the owners of the stock of the corporation,
determined on the date the corporation made a revocation of its S
election, are the same owners (and own identical proportions of the
corporation's stock) as on December 22, 2017 (shareholder identity
requirement).
Section 1371(f) extends the period during which shareholders of an
ETSC can benefit from its AAA generated during the corporation's former
status as an S corporation (ETSC period) by providing that, in the case
of distributions of money following the PTTP, (i) the distributing
ETSC's AAA is allocated to a distribution of money to which section 301
would otherwise apply (qualified distribution), and (ii) the qualified
distribution is chargeable to AE&P in the same ratio as the amount of
such AAA bears to the amount of such AE&P. In enacting section 1371(f),
Congress determined that ``it is important to provide rules to ease the
transition from S corporation to C corporation for the affected
taxpayers'' because, based on the TCJA's revisions to the Code,
``taxpayers that previously elected to be taxed as S corporations may
prefer instead to be taxed as C corporations.'' H. Rept. 115-409, 115th
Cong., 1st Sess., at 245 (Nov. 14, 2017) (House Report).
[[Page 66472]]
On November 7, 2019, the Department of the Treasury (Treasury
Department) and the IRS published a notice of proposed rulemaking (REG-
131071-18) in the Federal Register (84 FR 60011) containing proposed
regulations under section 1371 and proposed amendments to the Income
Tax Regulations (26 CFR part 1) under sections 481 and 1377 (proposed
regulations). The Treasury Department and the IRS received 16 written
or electronic comments responding to the proposed regulations. All
comments received on the proposed regulations are available at http://www.regulations.gov or upon request. As no request for a public hearing
was received, no hearing was held. After full consideration of the
comments received, this Treasury decision adopts generally the proposed
regulations with certain modifications in response to the comments
received, as described in the Summary of Comments and Explanation of
Revisions.
Summary of Comments and Explanation of Revisions
I. Overview
The final regulations retain the approach and structure of the
proposed regulations, with certain revisions. This Summary of Comments
and Explanation of Revisions discusses those revisions, as well as the
comments received in response to the proposed regulations.
II. Comments on Qualification as an Eligible Terminated S Corporation
A. Significance of Date of Revocation of S Election
To qualify as an ETSC under section 481(d)(2), a corporation must
satisfy the revocation requirement by making a revocation of its S
election during the two-year period beginning on December 22, 2017
(two-year period). See section 481(d)(2)(A)(ii) (setting forth the
revocation requirement); proposed Sec. 1.481-5(b)(2) (same). In
addition, the shareholder identity requirement must be satisfied by the
same shareholders owning identical proportions of the corporation's
stock on two dates: December 22, 2017, and the date on which the
corporation made a revocation of its S election. See section
481(d)(2)(B) (setting forth the shareholder identity requirement);
proposed Sec. 1.481-5(b)(3) (same). But see proposed Sec. 1.481-
5(c)(1) (identifying five categories of share transfers that do not
result in a change in shareholder ownership for purposes of section
481(d)(2)(B)). Consequently, the date on which a corporation makes a
revocation of its S election is critical for determining ETSC
qualification.
A corporation can allow the effective date of its S election
revocation to occur automatically by operation of section
1362(d)(1)(C), or it can specify an effective date under section
1362(d)(1)(D). For example, a revocation made before the 16th day of
the third month of an S corporation's taxable year generally is
effective retroactively on the first day of that taxable year. See
section 1362(d)(1)(C)(i); Sec. 1.1362-2(a)(2)(i). In contrast, a
revocation made after the 15th day of the third month of a
corporation's taxable year generally is effective prospectively on the
first day of the corporation's following taxable year. See section
1362(d)(1)(C)(ii); Sec. 1.1362-2(a)(2)(i). Alternatively, the
corporation may specify an immediate or prospective effective date for
a revocation by expressing a date (in terms of a stated day, month, and
year) that occurs on or after the date on which the revocation is made.
See section 1362(d)(1)(D); Sec. 1.1362-2(a)(2)(ii).
1. Retroactive Effective Date of the Revocation Determines ETSC Status
One commenter suggested that the final regulations revise proposed
Sec. 1.481-5(b)(2) to confirm that, in the case of a revocation with a
retroactive effective date pursuant to section 1362(d)(1)(C)(i), the
revocation may be treated as occurring on the retroactive effective
date for purposes of ETSC qualification. Based on the stated
congressional goal of facilitating the transition from S corporation
status to C corporation status, the commenter contended that taxpayers
reasonably could have interpreted the statute to indicate that
compliance with the shareholder identity requirement would be tested on
the retroactive revocation's effective date. In support of this
contention, the commenter correctly noted that, in the absence of such
an interpretation, a corporation would not satisfy the shareholder
identity requirement for qualifying as an ETSC in proposed Sec. 1.481-
5(b)(2) and (3) if the corporation (i) had the same shareholders (and
in identical proportions) on both December 22, 2017, and the
retroactive effective date of the revocation, but (ii) experienced a
change in shareholder ownership during the period between the
retroactive effective date of the revocation and the date on which the
revocation was made.
The Treasury Department and the IRS agree with the commenter's
interpretation. Proposed Sec. 1.481-5(b)(2) and (3) directly address
revocations with prospective effective dates, which can be specified
with significant flexibility in the revocation. A retroactive effective
date for a revocation results solely by operation of section
1362(d)(1)(C)(i) and Sec. 1.1362-2(a)(2)(i) and, in such instance, is
always effective on the first day of the corporation's taxable year. To
confirm the commenter's interpretation, Sec. 1.481-5(c)(2) of the
final regulations provides that, solely with regard to revocations with
retroactive effective dates, a revocation may be treated as having been
made on the effective date of such revocation. Accordingly, for
purposes of Sec. 1.481-5(b)(2) and (3), a corporation may test
compliance with the revocation requirement and the shareholder identity
requirement on either the date the revocation was made or, in the case
of a revocation with a retroactive effective date, the date the
revocation was effective.
2. Application of Section 7503 to a Revocation of an S Election
As discussed in part II.A of this Summary of Comments and
Explanation of Revisions, the revocation requirement of section
481(d)(2)(A)(ii) requires that a corporation must make a revocation
during the two-year period to qualify as an ETSC. Section 7503 provides
that, ``when the last day prescribed under authority of the internal
revenue laws for performing any act falls on Saturday, Sunday, or a
legal holiday, the performance of such act shall be considered timely
if it is performed on the next succeeding day which is not a Saturday,
Sunday, or a legal holiday.'' Because a revocation is an act made under
authority of the internal revenue laws (that is, section 1362 of the
Code), section 7503 applies for purposes of determining whether the
revocation was made within the required two-year period. As a result of
the application of section 7503 in conjunction with section 1362 and
Sec. 1.1362-2(a)(2), December 23, 2019 (a Monday), is the last day of
the two-year period. Therefore, a revocation made on that date would be
treated as made within the two-year period. Without the application of
section 7503, December 21, 2019 (a Saturday), would have been the last
day of the two-year period.
To avoid any doubt, these final regulations clarify the text of
Sec. 1.1362-2(a)(2) to provide explicitly that section 7503 applies
where the last day prescribed for making a revocation occurs on a
Saturday, Sunday, or legal holiday. Therefore, a revocation made on
December 23, 2019, will be treated as made during the two-year period.
B. Applicability of PTTP and ETSC Period to S Corporations With No AE&P
Following the termination of an S election, section 1371(e) permits
[[Page 66473]]
shareholders of the resulting C corporation to benefit from the
corporation's former status as an S corporation with respect to
distributions of money during the corporation's PTTP, which generally
is the one-year period after the corporation terminates its S election.
Specifically, during the PTTP, a distribution of money by the C
corporation is characterized as a distribution from the corporation's
AAA. The receipt of such a distribution is tax-free to the extent of
the recipient shareholder's basis in the stock with respect to which
the shareholder received the distribution, and is taxed as gain from
the sale of property to the extent the distribution exceeds the
shareholder's basis in that stock. See section 1371(e)(1). If the
corporation exhausts its AAA during the PTTP, subsequent distributions
are subject to treatment under section 301.
A commenter requested confirmation that the rules regarding
distributions made during the PTTP, including section 1371(e) and Sec.
1.1377-2, apply if the corporation did not have AE&P at the time that
it terminated its S election. Section 1371(e)(1) provides special
treatment to distributions made by a corporation during the PTTP if
such distributions (i) consist of money and (ii) are made with respect
to the corporation's stock. Those two conditions would be satisfied
regardless of whether the distributing corporation had AE&P. Therefore,
the Treasury Department and the IRS agree with the commenter's
interpretation of section 1371(e) and Sec. 1.1377-2, but have
determined that no clarifying revisions to the regulations are
necessary in this regard.
The commenter also requested confirmation that the rules regarding
distributions made during the ETSC period would apply if the
distributing corporation did not have AE&P as of the effective date of
the revocation. Example 1 of proposed Sec. 1.1371-1(d) illustrates
that, if an ETSC has no AE&P as of the beginning of the day on which
the revocation is effective, its historical AE&P is zero. Pursuant to
proposed Sec. 1.1371-1(a)(2)(ix) and (x), such a corporation would
enter its ETSC period with a AAA ratio of 1 and an AE&P ratio of zero.
Therefore, each qualified distribution would be characterized as a
distribution of AAA. Based on the guidance provided in Example 1, as
well as the definition of the ``AAA ratio'' set forth in proposed Sec.
1.1371-1(a)(ii), the Treasury Department and the IRS have determined
that no clarifying revisions to the regulations are necessary in this
regard.
C. Application of Section 481(d) to Qualified Subchapter S Subsidiaries
If an S corporation wholly owns the stock of a domestic C
corporation that is not an ineligible corporation described in section
1361(b)(2), the S corporation may elect under section 1361(b)(3)(B)(ii)
and Sec. 1.1361-3 to treat the C corporation as a qualified subchapter
S subsidiary (QSub) such that (i) the QSub will no longer be treated as
a separate corporation and (ii) all of the QSub's assets, liabilities,
and items of income, deduction, and credit will be treated as assets,
liabilities, and such items (as the case may be) of the S corporation
parent. If the requirements of section 1361(b)(3)(B) cease to be
satisfied with respect to a QSub, including by reason of the revocation
of the parent's S election, section 1361(b)(3)(C)(i) and Sec. 1.1361-
5(b)(1)(i) provide that the corporation's QSub election is terminated
such that the QSub is treated, for purposes of the Code, as (i) a newly
formed C corporation subsidiary separate from the parent and (ii)
acquiring all of its assets (and assuming all of its liabilities) from
the parent through an exchange to which section 351 of the Code applies
(deemed section 351 exchange).
If the taxable income of any taxpayer, including a corporation, for
the current year (year of change) is computed under a method of
accounting that is different from the method of accounting used by the
taxpayer in the preceding year (accounting method change), section 481
requires that the taxpayer must take into account those adjustments
that are determined to be necessary solely by reason of the accounting
method change to prevent items of income or expense from being
duplicated or omitted (481 adjustments). Section 481(a). The 481
adjustments are generally taken into account in computing the
taxpayer's taxable income in the year of change. However, section
481(c) permits a taxpayer, in such manner and subject to such
conditions prescribed in regulations by the Secretary of the Treasury
or his delegate (Secretary), to take 481 adjustments into account in
computing taxable income for the taxable year or years permitted under
such regulations. As noted earlier, section 481(d)(1) permits an ETSC
to take into account any 481 adjustments that are attributable to the
revocation of an S election over a six-taxable year period beginning
with the year of change (that is, the section 481(d) inclusion period).
Commenters have correctly observed that section 481(a) and (d) do
not apply to an ETSC's newly formed C corporation subsidiary (ETSC
corporate subsidiary) that operated as a QSub prior to the revocation
of its parent's S election. Upon such a revocation, the ETSC corporate
subsidiary is treated as acquiring all of its assets and assuming all
of its liabilities from the ETSC in a deemed section 351 exchange. See
section 1361(b)(3)(C)(i); Sec. 1.1361-5(b)(1)(i). A corporation formed
for a business purpose is a taxpayer separate from its shareholder(s).
See generally Moline Properties v. Commissioner, 319 U.S. 436 (1943).
As a result of the ETSC corporate subsidiary's status as a new C
corporation with no prior taxable year (rather than, for example, as a
successor under section 381(a) of the Code), commenters have noted that
the ETSC corporate subsidiary lacks any historical method of accounting
from which to change. Compare Sec. 1.446-1(e)(1) (providing that a
taxpayer filing its first return may adopt any permissible method of
accounting in computing taxable income for the taxable year covered by
such return) with section 381(c)(4) (providing that, in general, a
successor corporation must use the method of accounting used by the
predecessor corporation as of the date of the section 381(a)
transaction).
Notwithstanding those observations of the law, commenters have
requested that the final regulations extend the section 481(d)
inclusion period to an accrual method ETSC corporate subsidiary that
operated as a cash method QSub of a cash method S corporation prior to
the revocation of the parent's S election. These commenters highlighted
that, in the deemed section 351 exchange required by section
1361(b)(3)(C)(i) and Sec. 1.1361-5(b)(1)(i) that results from the
revocation of the parent's S election, the accounts receivable of a
former cash method QSub would be deemed transferred to the accrual
method ETSC corporate subsidiary with a zero basis. See generally Raich
v. Commissioner, 46 T.C. 604 (1966) (holding that trade accounts
receivable of a cash method transferor received by an accrual basis
transferee in a section 351 exchange had a zero basis). Therefore, the
ETSC corporate subsidiary would recognize income as it collects amounts
on the transferred receivables. In the case where the ETSC corporate
subsidiary collects the entire amount of the transferred receivables
during its first taxable year, commenters contended that the ETSC
corporate subsidiary's inability to include the amount received over
the six-year section 481(d) inclusion period would inappropriately
disadvantage the former QSub as
[[Page 66474]]
compared to its former S corporation parent.
The Treasury Department and the IRS understand the commenters'
concerns regarding the statutorily limited application of section
481(d) and observe that the commenters' request is not unique to the
application of section 481(d), but rather addresses the longstanding
treatment of former S corporations and QSubs under section 481 with
regard to a deemed section 351 exchange. Throughout the nearly 25-year
period since the 1996 enactment of the QSub provisions under section
1361, section 481(a)(2) and any inclusion period for a 481 adjustment
have not applied with respect to former QSubs. See section 1308 of the
Small Business Job Protection Act of 1996, Public Law 104-188, 110
Stat. 1755, 1782-3 (August 20, 1996). See also Rev. Proc. 97-27, 1997-1
C.B. 680, section 5.02(3)(a) (providing a four-year amortization period
solely to taxpayers that have a 481 adjustment); Rev. Proc. 2015-13,
2015-5 I.R.B. 419, section 7.03(1) (same). After considering the
commenters' analysis and the explicit reference in section 481(d) to
section 481(a)(2), the Treasury Department and the IRS have determined
that section 481(d) does not apply to ETSC corporate subsidiaries, but
rather maintains the longstanding application of section 481(a) solely
to taxpayers that make an accounting method change. Accordingly, there
is no authority under section 481(d) to extend the section 481(d)
inclusion period to ETSC corporate subsidiaries.
Commenters also contended that the Treasury Department and the IRS
could override the limited scope of section 481(d) through special QSub
regulations issued under the authority provided by section 481(c),
which, in the case of a taxpayer making an accounting method change,
authorizes regulations permitting a taxpayer to take any 481 adjustment
into account in computing taxable income for the taxable year or years
permitted under such regulations. For example, commenters suggested
that the final regulations permit an accrual method ETSC corporate
subsidiary to elect to treat the assets received (and liabilities
assumed) by the ETSC corporate subsidiary in the deemed section 351
exchange as though the subsidiary had owned such assets (and had such
liabilities) in a prior taxable year, thereby creating an accounting
method change upon the revocation. However, this approach contradicts
the explicit text of section 1362(b)(3)(C)(i), which provides that,
``[f]or purposes of this title'' (that is, for purposes of all of the
provisions of the Code), an ETSC corporate subsidiary ``shall be
treated as a new corporation.''
In the alternative, commenters suggested that the final regulations
could permit taxpayers to treat the assets received (and liabilities
assumed) by an ETSC corporate subsidiary as though still owned by the
former S corporation on the date on which the former S corporation
becomes an ETSC. Under this approach, the ETSC's 481 adjustment would
be computed as if the ETSC owned such assets and was subject to such
liabilities. For support, these commenters highlighted anti-abuse
regulations issued under section 263A of the Code (UNICAP anti-abuse
regulations) that utilized this alternative approach. See Sec. 1.263A-
7(c)(4)(ii) (providing an anti-abuse rule regarding the use of section
351 exchanges to avoid application of section 263A). However, the
UNICAP anti-abuse regulations were issued under the authority of
section 263A(h)(1) rather than the authority granted the Secretary
under section 481(c). See 52 FR 10052, 10059 (March 30, 1987). Section
263A(h)(1) requires the Secretary to ``prescribe rules to carry out the
purpose of section 263A, including regulations to prevent the use of
related parties, pass-thru entities, or intermediaries to avoid the
application of this section.'' Section 263A(j)(1).
The Treasury Department and the IRS have considered the commenters'
suggested approaches for extending the section 481(d) inclusion period
to ETSC corporate subsidiaries but have determined that section 481(c)
would not support either approach. Section 481(c) and Sec. 1.481-
1(c)(2) provide the general rule that the 481 adjustment is taken into
account in computing taxable income in the year of change, unless the
Commissioner prescribes a different taxable year or years to take the
481 adjustment into account under Sec. Sec. 1.446-1(e)(3) and 1.481-4.
Any regulations issued under section 481(c) can apply only ``[i]n the
case of any change described in [section 481](a)'' with regard to
``adjustments required by [section 481](a)(2).'' As acknowledged by the
commenters, section 481(a) does not apply to an ETSC corporate
subsidiary because such entity is newly formed and therefore could not
have had a prior accounting method to potentially change.
Based on the foregoing, the final regulations do not adopt either
of the commenters' alternative suggestions or provide any inclusion
period for ETSC corporate subsidiaries under section 481. The Treasury
Department and the IRS, however, note that TCJA amendments to section
448(c) of the Code have significantly expanded the applicability of the
cash method to C corporations, including ETSC corporate subsidiaries.
As amended by section 13102(a) of the TCJA (131 Stat. 2054, 2102-3),
section 448(c) provides that a C corporation may use the cash method if
the corporation has average annual gross receipts not exceeding $25
million (adjusted for inflation) for its three prior taxable years.
Prior to the TCJA, the gross receipts threshold under section 448(c)
was $5 million. As a result, fewer ETSC corporate subsidiaries will be
required to adopt the accrual method as their permissible method of
accounting for their first tax return than if the section 448(c) gross
receipts threshold had not been increased from $5 million to $25
million.
III. Comments Regarding the Post-Termination Transition Period
The last sentence of Sec. 1.1377-2(b), as in effect prior to the
effective date of these final regulations (no-newcomer rule), limited
the special treatment provided under section 1371(e)(1) (with respect
to distributions of money during a corporation's PTTP) solely to those
shareholders who were shareholders of the corporation at the time that
it terminated or revoked its S election (collectively, legacy
shareholders). Because the rules pertaining to the PTTP and to the ETSC
period serve a similar objective of easing the transition from S
corporation to C corporation status, the Treasury Department and the
IRS determined that the rules regarding newcomers (that is, non-legacy
shareholders) should be consistent. See preamble to the proposed
regulations, Explanation of Provisions, part IV. Therefore, based on
the rationale for rejecting a no-newcomer rule with respect to the ETSC
period, as set forth in part II.A of the Explanation of Provisions of
the preamble to the proposed regulations, the Treasury Department and
the IRS determined that such a rule should also not apply with respect
to the PTTP and proposed the removal of the no-newcomer rule in Sec.
1.1377-2(b). See Id.
A. Reliance on the Sec. 1.1377-2(b) No-Newcomer Rule
One commenter expressed concern that elimination of the no-newcomer
rule in Sec. 1.1377-2(b) could alter bargained-for economic results if
a legacy shareholder had transferred less than all of its shares prior
to November 7, 2019 (that is, the publication date of the proposed
regulations) or after that date but pursuant to a binding agreement
entered into before that date. In particular, the commenter contended
[[Page 66475]]
that legacy shareholders who transferred less than all of their shares
would have expected that only legacy shareholders could receive
distributions of AAA during the PTTP, and perhaps even during the ETSC
period. According to the commenter, this expectation would have reduced
the bargained-for price for the transferred shares to reflect the tax
benefit of the future tax-free distributions.
The commenter provided an example in which a sole shareholder of an
ETSC sold 40 percent of its stock to a third-party. The sale price was
set prior to November 7, 2019, and the parties assumed that the no-
newcomer rule would limit distributions of AAA to the legacy
shareholder during the PTTP, and that a similar rule would apply during
the ETSC period. Under the proposed elimination of the no-newcomer rule
in Sec. 1.1377-2(b), however, the newcomer, and not the legacy
shareholder, would be eligible to receive 40 percent of any AAA
distributed during the PTTP or ETSC period. The commenter observed that
the newcomer's accession to a 40 percent interest in the corporation's
AAA during the PTTP and ETSC period amounts to a transfer of a tax
benefit from the legacy shareholder to the newcomer for no
consideration, contrary to the parties' expectations. Therefore, the
commenter recommended that the final regulations include an additional
transition rule. Under this rule, if shares of a former S corporation
were transferred to a newcomer pursuant to a binding agreement entered
into before the applicability date of the final regulations, then,
except upon unanimous agreement of current shareholders of a
corporation that are legacy shareholders, the no-newcomer rule would
apply during the PTTP, and a similar rule would apply during the ETSC
period.
The Treasury Department and the IRS understand the concern
underlying the commenter's recommendation. However, the Treasury
Department and the IRS intended the applicability date provisions in
the proposed regulations, and as adopted in these final regulations, to
afford corporations transition flexibility in applying Sec. 1.1377-
2(b) with regard to the PTTP. Section 1.1377-2(b), as revised by the
final regulations to eliminate the no-newcomer rule for special
treatment under section 1371(e)(1) of distributions of money by a
corporation with respect to its stock during the post-termination
transition period applies to a corporation's taxable years beginning
after the date of publication of the final regulations. In the case of
a corporation using the calendar year as its annual accounting period,
newcomers are not entitled to receive distributions of AAA before
January 1, 2021, unless the corporation chooses to apply Sec. 1.1377-
2(b) before January 1, 2021. Corporations to which the commenter's
transition rule would have applied generally will thus have completed
their PTTPs prior to the applicability of Sec. 1.1377-2(b).
Distributions of AAA during those PTTPs would have been limited to
legacy shareholders. Additionally, the commenter's proposed transition
rule would add complexity in administering these rules. Accordingly,
the Treasury Department and the IRS have determined that the
applicability date provisions, as set forth in the proposed regulations
and adopted in these final regulations, balance appropriately the
protection of legacy taxpayers' expectations with the goal of the
Treasury Department and the IRS to minimize complexity and
administrative difficulties for S corporations, their shareholders, and
the IRS.
With regard to the ETSC period, as discussed in part II.A of the
Explanation of Provisions of the preamble to the proposed regulations,
section 1371(f) does not contain a no-newcomer rule similar to Sec.
1.1377-2(b), and the Treasury Department and the IRS have concluded
that it is inappropriate to adopt one. Corporations may have applied a
similar analysis of section 1371(f) and made distributions of AAA to
newcomers during their respective ETSC periods. Providing an alternate
rule in these final regulations for the ETSC period could unexpectedly
alter taxpayers' bargained-for economic results. Therefore, the
Treasury Department and the IRS have determined that the best way to
address this situation is to allow but not require corporations to
apply the final regulations addressing distributions made during the
ETSC period to taxable years beginning on or before the date that these
final regulations are published in the Federal Register.
B. Consideration of Request for an Additional 120-Day PTTP
A commenter recommended that the final regulations provide a new
120-day PTTP that would begin on the applicability date of the final
regulations. The commenter noted that this new PTTP would create an
opportunity for any C corporation with undistributed AAA that expired
at the end of its PTTP to restore and distribute such AAA pursuant to
section 1371(e)(1) and Sec. 1.1377-2. The commenter contended that the
elimination of the no-newcomer rule only for terminations that occur
after the issuance of the proposed regulations disadvantages
corporations that terminated their S election more than one year prior
to issuance of the proposed regulations, as compared to corporations
that terminated their S election after the issuance of the proposed
regulations.
The Code sets forth a statutory definition of the PTTP that
includes detailed limits on its duration. Specifically, section
1377(b)(1)(A), (B), and (C) provide three separate durations for the
PTTP, the respective applicability of which depends upon particular
events. While the Treasury Department and the IRS acknowledge the
concerns raised by the commenter, the final regulations do not adopt
the commenter's recommendation because (i) section 1377(b) provides
specific, detailed, and unambiguous guidance on the duration of a PTTP,
and (ii) the recommended revision to Sec. 1.1377-2 exceeds the scope
of the authority granted to prescribe regulations under sections 1371
or 1377.
IV. Consideration of Comment Regarding Treatment of ETSC Status and AAA
as Section 381 Items
In the case of certain asset acquisitions, section 381(a) generally
requires the acquiring corporation to succeed to and take into account
the tax items described in section 381(c) of the distributor or
transferor corporation. See section 381(a) (describing distributions to
which section 332 of the Code applies and transfers to which section
361 of the Code applies that are carried out in connection with certain
reorganizations described in section 368(a)(1) of the Code); section
381(c) (enumerating tax items of the distributor or transferor
corporation that the acquiring corporation succeeds to and takes into
account under section 381(a)).
A commenter requested that the final regulations confirm that ETSC
status and AAA constitute tax items that an acquiring corporation would
succeed to or take into account under section 381(a). The Treasury
Department and the IRS have considered the issue raised by the
commenter but have determined that further study would be required to
promulgate the appropriate rule. In addition, the Treasury Department
and the IRS have concluded that this issue exceeds the scope of the
final regulations because whether AAA constitutes a tax item to which a
successor may succeed under section 381 is not limited to the ETSC
context.
[[Page 66476]]
Therefore, the final regulations do not address the commenter's
request.
Applicability Dates
These regulations generally apply to taxable years beginning after
October 20, 2020. See Sec. Sec. 1.481-6(b), 1.1371-1(e), 1.1371-2(d),
and 1.1377-3(c). However, a corporation may choose to apply the rules
set forth in Sec. Sec. 1.481-5, 1.1371-1, and 1.1371-2 in their
entirety to taxable years beginning on or before October 20, 2020. If a
corporation makes the choice described in the previous sentence, all
shareholders of the corporation must report consistently, and the
corporation must continue to apply the rules in Sec. Sec. 1.481-5,
1.1371-1, and 1.1371-2 in their entirety for the corporation's
subsequent taxable years.
In addition, a corporation generally may choose to not apply the
no-newcomer rule in Sec. 1.1377-2(b) to taxable years beginning on or
before October 20, 2020 and with respect to which the period described
in section 6501(a) as applied to that corporation has not expired. If a
corporation makes the choice described in the previous sentence, all
shareholders of the corporation must report consistently, and the
corporation must adopt Sec. Sec. 1.481-5, 1.1371-1, 1.1371-2 (if an
ETSC), and Sec. 1.1377-2(b) in their entirety and continue to apply
those rules in their entirety for the corporation's subsequent taxable
years.
Special Analyses
These final regulations are not subject to review under section
6(b) of Executive Order 12866 pursuant to the Memorandum of Agreement
(April 11, 2018) between the Treasury Department and the Office of
Management and Budget regarding review of tax regulations.
I. Regulatory Flexibility Act
Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it
is hereby certified that these final regulations will not have a
significant economic impact on a substantial number of small entities
within the meaning of section 601(6) of the Regulatory Flexibility Act.
Notwithstanding this certification, the Treasury Department and the IRS
provided such an analysis in the notice of proposed rulemaking
preceding these final regulations (see 84 FR 60011) and received no
comments on the impact that the proposed regulations would have on
small entities. This certification is based on the fact that the amount
of time necessary to report the required information will be minimal in
that it requires ETSCs to provide information already required to be
collected by previously existing statutory and regulatory requirements.
Accordingly, the Secretary certifies that these regulations will not
have a significant economic impact on a substantial number of small
entities.
Pursuant to section 7805(f), the notice of proposed rulemaking
preceding this regulation was submitted to the Chief Counsel for the
Office of Advocacy of the Small Business Administration for comment on
its impact on small businesses. No comments were received from the
Chief Counsel for the Office of Advocacy of the Small Business
Administration.
II. Paperwork Reduction Act
These final regulations do not require collection of any new or
additional information pursuant to the Paperwork Reduction Act (44
U.S.C. 3501 et seq.). Nevertheless, the Treasury Department and the IRS
provided such an analysis in the notice of proposed rulemaking
preceding these final regulations. See 84 FR 60011.
III. Unfunded Mandates Reform Act
Section 202 of the Unfunded Mandates Reform Act of 1995 requires
that agencies assess anticipated costs and benefits and take certain
other actions before issuing a final rule that includes any Federal
mandate that may result in expenditures in any one year by a state,
local, or tribal government, in the aggregate, or by the private
sector, of $100 million in 1995 dollars, updated annually for
inflation. In 2020, that threshold is approximately $156 million. This
final rule does not include any mandate that may result in expenditures
by state, local, or tribal governments, or by the private sector in
excess of that threshold.
IV. Executive Order 13132: Federalism
Executive Order 13132 (entitled ``Federalism'') prohibits an agency
from publishing any rule that has federalism implications if the rule
either imposes substantial, direct compliance costs on state and local
governments, and is not required by statute, or preempts state law,
unless the agency meets the consultation and funding requirements of
section 6 of the Executive Order. This final rule does not have
federalism implications and does not impose substantial, direct
compliance costs on state and local governments or preempt state law
within the meaning of the Executive Order.
Drafting Information
The principal authors of these final regulations are Margaret Burow
and Michael Gould of the Office of Associate Chief Counsel
(Passthroughs and Special Industries) and Aglaia Ovtchinnikova of the
Office of Associate Chief Counsel (Corporate). However, other personnel
from the Treasury Department and the IRS participated in the
development of the final regulations.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 is amended by adding an
entry in numerical order for Sec. 1.481-6 to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
* * * * *
Section 1.481-6 is also issued under 26 U.S.C. 481.
* * * * *
Sec. 1.316-2 [Amended]
0
Par. 2. Section 1.316-2 is amended by removing ``consist only of money
and'' from the second sentence of paragraph (b).
Sec. 1.481-5 [Redesignated as Sec. 1.481-6]
0
Par. 3. Section 1.481-5 is redesignated as Sec. 1.481-6.
0
Par. 4. New Sec. 1.481-5 is added to read as follows:
Sec. 1.481-5 Eligible terminated S corporation.
(a) Scope. Section 481(d)(2) of the Internal Revenue Code (Code)
and this section provide rules relating to the qualification of a
corporation as an eligible terminated S corporation (ETSC). Paragraph
(b) of this section sets forth the requirements a corporation must meet
to qualify as an ETSC. Paragraph (c) of this section describes certain
transfers and other events that are disregarded for purposes of
determining whether a corporation qualifies as an ETSC, as well as the
treatment of revocations for which the effective date is the first day
of the taxable year during which the revocation is made. Paragraph (d)
of this section contains examples illustrating the rules of this
section.
(b) ETSC qualification. For a C corporation to qualify as an ETSC,
it must satisfy the following requirements:
(1) The corporation must have been an S corporation on December 21,
2017;
(2) During the 2-year period beginning on December 22, 2017, the
corporation
[[Page 66477]]
must have made a valid revocation of its S election under section
1362(d)(1) and the regulatory provisions in this part under section
1362 of the Code (revocation); and
(3) Except as provided in paragraph (c) of this section, the owners
of the shares of stock of the corporation must be the same (and in
identical proportions) on both:
(i) December 22, 2017; and
(ii) The day on which the revocation is made.
(c) Special rules--(1) Certain disregarded events. The following
events are disregarded for purposes of determining whether the
requirement in paragraph (b)(3) of this section is satisfied:
(i) Transfers of stock between a shareholder and that shareholder's
trust treated as wholly owned by that shareholder under subpart E of
subchapter J of chapter 1 of the Code;
(ii) Transfers of stock between a shareholder and an entity owned
by that shareholder that is disregarded as separate from its owner
under Sec. 301.7701-2(c)(2)(i) of the Procedure and Administration
Regulations;
(iii) An election by a shareholder trust to be treated as part of a
decedent's estate under section 645 of the Code or the termination of
an election under that section;
(iv) A change in the status of a shareholder trust from one type of
eligible S corporation shareholder trust described in section
1361(c)(2)(A) of the Code to another type of eligible S corporation
shareholder trust; for example, a trust to which the shares of stock
were transferred pursuant to the terms of a will (testamentary trust)
described in section 1361(c)(2)(A)(iii) that elects to become an
electing small business trust described in section 1361(c)(2)(A)(v) and
(e); and
(v) A transaction that includes more than one of the events
described in this paragraph (c)(1).
(2) Certain revocations. For purposes of paragraphs (b)(2) and
(b)(3)(ii) of this section, a revocation with an effective date that is
the first day of the taxable year during which the revocation is made
pursuant to section 1362(d)(1)(C)(i) may be treated as having been made
on the day the revocation was made or on the effective date of the
revocation.
(d) Examples. Paragraphs (d)(1) through (3) of this section
(Examples 1 through 3) illustrate the rules of this section. For
purposes of paragraphs (d)(1) through (3) of this section (Examples 1
through 3), as of December 1, 2017, X is a calendar year S corporation
with 100 shares of stock outstanding that is owned equally by unrelated
individuals A and B. Pursuant to section 1362(d)(1) and Sec. Sec.
1.1362-2 and 1.1362-6, X made a valid revocation of its S election on
March 15, 2019, effective on January 1, 2019. X treats the revocation
as having been made on March 15, 2019, for purposes of paragraphs
(b)(2) and (b)(3)(ii). At all times, X has a single class of stock
outstanding. Paragraphs (d)(1) through (3) of this section (Examples 1
through 3) describe all relevant transactions involving the X stock
from December 1, 2017, until March 15, 2019.
(1) Example 1--(i) Facts. On June 5, 2018, A contributed 20 of its
shares of X stock to Y, a wholly owned limited liability company that
is disregarded as an entity separate from A pursuant to Sec. 301.7701-
2(c)(2)(i). On June 14, 2018, A contributed all of its interest in Y to
Trust, which was a revocable trust treated as a wholly owned grantor
trust of A pursuant to sections 671 and 676 of the Code. On December
27, 2018, B sold 10 shares of its X stock to C, an unrelated person.
(ii) Analysis. X is an ETSC if it satisfies the requirements of
paragraph (b) of this section.
(A) S corporation. X was an S corporation on December 21, 2017.
Therefore, X satisfies the requirement of paragraph (b)(1) of this
section.
(B) Date of revocation. X made a valid revocation of its S election
pursuant to section 1362(d)(1) on March 15, 2019, which is during the
two-year period specified in paragraph (b)(2) of this section.
Therefore, X satisfies the requirement of paragraph (b)(2) of this
section.
(C) Ownership. For purposes of the requirement in paragraph (b)(3)
of this section, the relevant dates are: December 22, 2017, and March
15, 2019 (the date X made a revocation of its S corporation status).
(1) A's ownership interest. As of December 22, 2017, A owned 50
shares of the outstanding shares of X stock. On June 5, 2018, A
contributed 20 of its shares of X stock to Y (Transfer). On June 14,
2018, A contributed all of its interest in Y to Trust (Contribution).
Both the Transfer and the Contribution are disregarded for purposes of
determining whether the requirement of paragraph (b)(3) of this section
is satisfied. See paragraphs (c)(2) and (1) of this section,
respectively. Therefore, A owns 50 shares of the outstanding stock of X
on March 15, 2019.
(2) B's ownership interest. As of December 22, 2017, B owned 50
shares of the outstanding shares of X stock. On December 27, 2018, B
sold 10 shares to C. Therefore, B owns 40 shares of the outstanding
stock of X on March 15, 2019.
(3) C's ownership interest. As of December 22, 2017, C owned no
shares of X stock. On December 27, 2018, C purchased 10 shares from B.
Therefore, C owns 10 shares of the outstanding stock of X on March 15,
2019.
(4) Failure to satisfy the requirement in paragraph (b)(3) of this
section. As described in paragraphs (d)(1)(ii)(C)(2) and (3) of this
section, B's and C's interest in X were not in the same proportions on
December 22, 2017, and March 15, 2019. Therefore, X does not satisfy
the requirement of paragraph (b)(3) of this section and does not
qualify as an ETSC.
(iii) Restoration of interests prior to end of PTTP. If C
transferred its shares of X stock back to B on February 1, 2019, then
on December 22, 2017, and March 15, 2019, A and B will have owned 50
shares of the outstanding stock of X. Under these facts, X satisfies
the requirement of paragraph (b)(3) of this section and qualifies as an
ETSC.
(2) Example 2--(i) Facts. The facts are the same as in paragraph
(d)(1)(i) of this section, except that B sold 10 shares of its X stock
to C on December 18, 2017, in addition to the sale of 10 shares of X
stock on December 27, 2018.
(ii) Analysis. The analysis in paragraph (d)(1)(ii)(A) and (B) of
this section remains the same regarding the requirements of paragraph
(b)(1) and (2) of this section. With respect to the requirement of
paragraph (b)(3) of this section, on December 22, 2017, A owned 50%, B
owned 40%, and C owned 10% of the outstanding stock of X. As in
paragraph (d)(1)(ii)(C)(1) of this section, the Transfer and the
Contribution are disregarded for purposes of determining whether the
requirement of paragraph (b)(3) of this section is satisfied.
Therefore, on March 15, 2019, A owned 50% (50 shares), B owned 30% (30
shares), and C owned 20% (20 shares) of the outstanding shares of X.
Even though A, B, and C owned shares of X on December 22, 2017, B's and
C's proportionate ownership interest of X stock was not the same on
December 22, 2017, and March 15, 2019. Therefore, X does not satisfy
the requirement of paragraph (b)(3) of this section and does not
qualify as an ETSC.
(3) Example 3--(i) Facts. The facts are the same as in paragraph
(d)(1)(i) of this section, except that X made a valid revocation of its
S election on November 1, 2019, effective on January 1, 2020.
(ii) Analysis. The analysis in paragraph (d)(1)(ii)(A) through (C)
of this section remains the same regarding the requirements of
paragraph (b)(1)
[[Page 66478]]
through (3) of this section, except that the relevant dates are:
December 22, 2017, and November 1, 2019 (the date X made a revocation
of its S corporation status). Although the effective date of X's
revocation of its S election (January 1, 2020) occurs after the
conclusion of the two-year period specified in paragraph (b)(2) of this
section, it is irrelevant for purposes of determining whether the
requirements of paragraph (b)(2) and (3) of this section are satisfied.
0
Par. 5. Newly redesignated Sec. 1.481-6 is revised to read as follows:
Sec. 1.481-6 Effective dates; applicability dates.
(a) Sections 1.481-1, 1.481-2, 1.481-3, and 1.481-4 are effective
for Consent Agreements signed on or after December 27, 1994. For
Consent Agreements signed before December 27, 1994, see Sec. Sec.
1.481-1, 1.481-2, 1.481-3, 1.481-4, and 1.481-5 as contained in 26 CFR
part 1, revised as of April 1, 1995.
(b) Section 1.481-5 applies to taxable years beginning October 20,
2020. However, a corporation may choose to apply the rules in
Sec. Sec. 1.481-5, 1.1371-1, and 1.1371-2 in their entirety to taxable
years beginning on or before October 20, 2020. If a corporation makes
the choice described in the previous sentence, the corporation must
continue to apply the rules in Sec. Sec. 1.481-5, 1.1371-1, and
1.1371-2 in their entirety for the corporation's subsequent taxable
years.
0
Par. 6. Section 1.1362-2 is amended by adding paragraph (a)(2)(iii) to
read as follows:
Sec. 1.1362-2 Termination of election.
(a) * * *
(2) * * *
(iii) Applicability of section 7503. With respect to a revocation
made under paragraph (a)(2) of this section, see section 7503
(addressing time for performance of acts where the last day occurs on a
Saturday, Sunday, or legal holiday). This paragraph (a)(2)(iii) applies
to revocations made under paragraph (a)(2) of this section effective
after October 20, 2020. A corporation may apply this paragraph
(a)(2)(iii) retroactively to a revocation made by the corporation under
paragraph (a)(2) of this section effective on or before October 20,
2020.
* * * * *
0
Par. 6. Sections 1.1371-1 and 1.1371-2 are added to read as follows:
Sec. 1.1371-1 Distributions of money by an eligible terminated S
corporation.
(a) Scope and definitions--(1) Scope. This section provides rules
relating to qualified distributions and distributions to which section
301 of the Internal Revenue Code (Code) applies during each taxable
year of the ETSC period, including the taxable year in which the ETSC
period ends. If an ETSC does not make any qualified distributions
during a taxable year, then no distribution by the ETSC is governed by
section 1371(f) of the Code or this section. Paragraph (a)(2) of this
section contains definitions that apply for purposes of this section.
Paragraph (b) of this section contains rules regarding the
characterization of a qualified distribution. Paragraph (c) of this
section contains rules regarding the characterization of any excess
qualified distribution and non-qualified distribution during each
taxable year of the ETSC period, including the taxable year in which
the ETSC period ends. Paragraph (d) of this section contains examples
illustrating the rules of this section. Paragraph (e) of this section
contains the applicability date of this section.
(2) Definitions. The following definitions apply for purposes of
this section--
(i) AAA. The term AAA means the accumulated adjustments account,
within the meaning of section 1368(e)(1)(A) of the Code and Sec.
1.1368-2(a)(1).
(ii) AAA ratio. Except as provided in this paragraph or paragraph
(b)(3)(iv) of this section, the term AAA ratio means the fraction of
which the numerator is historical AAA and the denominator is the sum of
historical AAA and historical AE&P. Notwithstanding the preceding
sentence, if the AE&P of the ETSC is less than or equal to zero as of
the beginning of a taxable year, then the AAA ratio is one for such
year and for all subsequent taxable years of the ETSC period.
(iii) AE&P. The term AE&P means earnings and profits described in
section 316(a)(1) of the Code.
(iv) AE&P ratio. Except as provided in this paragraph or paragraph
(b)(3)(iv) of this section, the term AE&P ratio means the fraction of
which the numerator is historical AE&P, and the denominator is the sum
of historical AAA and historical AE&P. Notwithstanding the preceding
sentence, if the AE&P of the ETSC is less than or equal to zero as of
the beginning of a taxable year, then the AE&P ratio is zero for such
year and all subsequent taxable years of the ETSC period.
(v) CE&P. The term CE&P means earnings and profits that are
described in section 316(a)(2).
(vi) ETSC. The term ETSC means an eligible terminated S
corporation, within the meaning of section 481(d) of the Code and Sec.
1.481-5.
(vii) ETSC period. In general, the term ETSC period means any
taxable year, or portion thereof, of an ETSC beginning on the first day
after the post-termination period within the meaning of section
1377(b)(1)(A) of the Code and ending on the date on which the ETSC's
AAA balance is zero. Additionally, an ETSC does not have an ETSC period
if the ETSC's AAA balance is not greater than zero at the end of its
post-termination transition period. See Sec. 1.1371-2 for rules
governing the impact of a post-termination period, within the meaning
of section 1377(b)(1)(B), on the ETSC period.
(viii) Excess qualified distribution. The term excess qualified
distribution means the portion of a qualified distribution that is not
characterized pursuant to paragraph (b)(2) or (3) of this section.
(ix) Historical AAA. The term historical AAA means the AAA of the
ETSC as of the beginning of the day on which the revocation of an
election under section 1362(a) of the Code is effective pursuant to
section 1362(d)(1).
(x) Historical AE&P. The term historical AE&P means the AE&P of the
ETSC as of the beginning of the day on which the revocation of an
election under section 1362(a) is effective pursuant to section
1362(d)(1). For purposes of the preceding sentence, if the ETSC's
historical AE&P is less than zero, then the historical AE&P is treated
as zero.
(xi) Non-qualified distribution. The term non-qualified
distribution means a distribution that is not a qualified distribution
and to which section 301 applies.
(xii) Qualified distribution. The term qualified distribution means
a distribution of money by an ETSC during the ETSC period to which,
absent the application of section 1371(f) and this section, section 301
would apply. However, if paragraph (d)(2)(i) of this section applies to
the ETSC, then a qualified distribution to a non-legacy shareholder is
treated as a non-qualified distribution.
(b) Characterization of qualified distribution--(1) In general.
Paragraph (b)(2) of this section provides rules regarding the
determination of the amount of a qualified distribution that is sourced
from AAA and the corollary effects of such a characterization.
Paragraph (b)(3) of this section provides rules regarding the
determination of the amount of a qualified distribution that is sourced
from AE&P and the corollary
[[Page 66479]]
effects of such a characterization. Paragraph (b)(4) of this section
provides rules regarding the characterization of an excess qualified
distribution as a separate qualified distribution. The rules in
paragraphs (b)(2) through (4) of this section are applied before the
application of paragraph (c) of this section.
(2) Distribution of AAA--(i) Amount. The portion of a qualified
distribution that is sourced from an ETSC's AAA is equal to the lesser
of:
(A) The product of the qualified distribution and the AAA ratio;
and
(B) The ETSC's AAA immediately before the qualified distribution.
(ii) Reduction or elimination of ETSC's AAA. The ETSC's AAA is
reduced by the amount of the distribution described in paragraph
(b)(2)(i) of this section. If, with respect to a qualified
distribution, the amount described in paragraph (b)(2)(i)(A) of this
section equals or exceeds the amount described in paragraph
(b)(2)(i)(B) of this section, then the rules in this paragraph (b) do
not apply to any subsequent distributions by the ETSC. Instead, the
subsequent distributions are treated in the manner provided in
paragraph (c) of this section.
(iii) Effect on the shareholder. The amount described in paragraph
(b)(2)(i) of this section is applied against and reduces the
shareholder's adjusted basis of the shares of stock with respect to
which the distribution is made under the principles of section
301(c)(2). If the application of the amount described in paragraph
(b)(2)(i) of this section would result in a reduction of basis that
exceeds the shareholder's adjusted basis of any share of stock with
respect to which the distribution is made, such excess is treated as
gain from the sale or exchange of property. The reduction of the
shareholder's basis described in this paragraph with respect to a
qualified distribution occurs prior to the application of paragraph (c)
of this section to the excess qualified distribution, if any, with
respect to such qualified distribution.
(3) Distribution of AE&P--(i) Amount. This paragraph (b)(3) applies
if an ETSC's AE&P ratio is greater than zero. If this paragraph (b)(3)
applies, the portion of a qualified distribution that is sourced from
the ETSC's AE&P is equal to the lesser of:
(A) The product of the qualified distribution and the AE&P ratio;
and
(B) The ETSC's AE&P immediately before the qualified distribution.
For purposes of the preceding sentence, if the ETSC's AE&P immediately
before the qualified distribution is less than zero, then the ETSC's
AE&P is treated as zero.
(ii) Effect on ETSC's AE&P. The ETSC's AE&P is reduced, as
described in section 312(a)(1), by the amount of the distribution
described in paragraph (b)(3)(i) of this section. The AE&P reduction
described in this paragraph occurs prior to the application of
paragraph (c) of this section, even if a distribution to which
paragraph (c) of this section applies (regarding excess qualified
distributions and non-qualified distributions) occurs earlier in time
than the qualified distribution to which this paragraph applies.
(iii) Effect on the shareholder. The amount of the qualified
distribution that is sourced from the ETSC's AE&P described in
paragraph (b)(3)(i) of this section is included in the gross income of
the shareholder as a dividend under section 301(c)(1).
(iv) Adjustment to the AAA ratio and the AE&P ratio. After the
application of paragraph (b)(3)(ii) of this section, if the ETSC's AE&P
is zero and the ETSC's AAA is greater than zero, then the ETSC's AAA
ratio is one and the ETSC's AE&P ratio is zero for all subsequent
qualified distributions during:
(A) That taxable year; and
(B) All subsequent taxable years of the ETSC period.
(4) Excess qualified distribution treated as a separate qualified
distribution--(i) In general. After the application of paragraph
(b)(2)(ii) of this section with respect to a qualified distribution, if
the ETSC has any remaining AAA, then any amount of excess qualified
distribution, with respect to such qualified distribution, is treated
as a separate qualified distribution and is analyzed pursuant to
paragraph (b) of this section.
(ii) No change in characterization of previously characterized
portion of qualified distribution. Paragraph (b)(4)(i) will not change
the characterization of any portion of a qualified distribution that
was previously characterized pursuant to paragraphs (b)(2) and (3) of
this section and will reflect the application of paragraphs (b)(2) and
(3) of this section to the portion of the qualified distribution
previously characterized.
(c) Characterization of excess qualified distribution and non-
qualified distributions. After the application of paragraph (b), the
excess qualified distributions, if any, and non-qualified
distributions, if any, are treated in the manner provided in sections
301(c) and 316.
(d) Examples. Paragraphs (d)(1) through (5) of this section
(Examples 1 through 5) illustrate the rules of this section. For
purposes of paragraphs (d)(1) through (5) of this section (Examples 1
through 5), X is a calendar year S corporation with a single share of
stock outstanding. A, an individual, purchased its share of X stock
prior to December 22, 2017, and, except as otherwise indicated, never
contributed any amounts to X's capital. A remained the sole shareholder
of X when X made a valid revocation on March 15, 2018, pursuant to
section 1362(d)(1) and Sec. Sec. 1.1362-2 and 1.1362-6, of its S
election and when that revocation became effective on January 1, 2018.
X qualified as an ETSC pursuant to Sec. 1.481-5(b) and its ETSC period
began on January 1, 2019. Additionally, X did not make any
distributions during its post-termination transition period, within the
meaning of section 1377(b)(1)(A). Furthermore, A remains the sole
shareholder of X at the time of the distribution(s) described.
(1) Example 1: Historical AE&P is zero--(i) Facts. At the beginning
of January 1, 2018, X had AAA of $100 and AE&P of $0. During 2018, X
had $300 of CE&P and made no distributions. At the beginning of January
1, 2019, X has AAA of $100 and AE&P of $300, and A's adjusted basis in
its share of X stock is $460. During 2019, the only distribution that X
makes is a $60 distribution of money to A on December 27. X's CE&P
during 2019 is $150, without diminution by reason of any distributions
made during the taxable year.
(ii) Analysis--(A) Calculation of AAA ratio and AE&P ratio.
Pursuant to paragraphs (a)(2)(ix) and (x) of this section,
respectively, X's historical AAA and X's historical AE&P are determined
as of the beginning of January 1, 2018, the beginning of the day on
which the revocation of X's election under section 1362(a) is effective
pursuant to section 1362(d)(1). Accordingly, X's historical AAA is $100
and X's historical AE&P is $0. Therefore, X's AAA ratio is 1 ($100/
($100 + $0)), and X's AE&P ratio is zero ($0/($100 + $0)).
(B) Characterization of distribution. Pursuant to paragraph
(a)(2)(xii) of this section, the $60 distribution on December 27, 2019,
is a qualified distribution because it is a distribution of money by an
ETSC during the ETSC period to which section 301 would apply absent the
application of section 1371(f) and this section.
(C) Analysis of qualified distribution--(1) Distribution of AAA.
Pursuant to paragraph (b)(2)(i) of this section, the portion of the
qualified distribution that is sourced from AAA is equal to the lesser
of: The product of the qualified distribution and the AAA ratio
[[Page 66480]]
($60 x 1, or $60), and X's AAA immediately before the qualified
distribution ($100). Therefore, $60 is sourced from AAA. Pursuant to
paragraph (b)(2)(ii) of this section, after the distribution, X's AAA
is reduced by $60 to $40. Pursuant to paragraph (b)(2)(iii) of this
section, A's basis in its X stock is reduced by $60 to $400.
(2) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this
section, the portion of the distribution that is sourced from AE&P is
equal to the lesser of: The product of the qualified distribution and
the AE&P ratio ($60 x 0, or $0), and X's AE&P immediately before the
qualified distribution ($300). Therefore, $0 is sourced from AE&P.
(2) Example 2: Qualified distributions with both historical AAA and
historical AE&P--(i) Facts. At the beginning of January 1, 2018, X had
AAA of $200 and AE&P of $100. During 2018, X had $0 of CE&P and made no
distributions. At the beginning of January 1, 2019, X has AAA of $200
and AE&P of $100, and A's adjusted basis in its share of X stock is
$500. During 2019, X makes a $90 distribution of money on February 9
and a $150 distribution of money on June 5. X's CE&P during 2019 is
$500, without diminution by reason of any distributions made during the
taxable year.
(ii) Analysis--(A) Calculation of AAA ratio and AE&P ratio.
Pursuant to paragraphs (a)(2)(ix) and (x) of this section,
respectively, X's historical AAA and X's historical AE&P are determined
as of the beginning of January 1, 2018, the beginning of the day on
which the revocation of X's election under section 1362(a) is effective
pursuant to section 1362(d)(1). Accordingly, X's historical AAA is $200
and X's historical AE&P is $100. Therefore, X's AAA ratio is 0.67
($200/($200 + $100)), and X's AE&P ratio is 0.33 ($100/($200 + $100)).
(B) Characterization of distributions. Pursuant to paragraph
(a)(2)(xii) of this section, the $90 distribution on February 9, 2019,
and the $150 distribution on June 5, 2019, are both qualified
distributions because they are distributions of money by an ETSC during
the ETSC period to which section 301 would apply absent the application
of section 1371(f) and this section.
(C) Analysis of qualified distributions--(1) February 9, 2019
distribution--(i) Distribution of AAA. Pursuant to paragraph (b)(2)(i)
of this section, the portion of the qualified distribution that is
sourced from AAA is equal to the lesser of: The product of the
qualified distribution and the AAA ratio ($90 x 0.67, or $60), and X's
AAA immediately before the qualified distribution ($200). Therefore,
$60 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this
section, after the distribution, X's AAA is reduced by $60 to $140.
Pursuant to paragraph (b)(2)(iii) of this section, A's basis in its X
stock is reduced by $60 to $440.
(ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this
section, the portion of the distribution that is sourced from AE&P is
equal to the lesser of: the product of the qualified distribution and
the AE&P ratio ($90 x 0.33, or $30), and X's AE&P immediately before
the qualified distribution ($100). Therefore, $30 is sourced from AE&P.
Pursuant to paragraph (b)(3)(ii) of this section, after the
distribution, X's AE&P is reduced by $30 to $70. Pursuant to paragraph
(b)(3)(iii) of this section, the $30 distribution is characterized as a
dividend.
(2) June 5, 2019 distribution--(i) Distribution of AAA. Pursuant to
paragraph (b)(2)(i) of this section, the portion of the qualified
distribution that is sourced from AAA is equal to the lesser of: The
product of the qualified distribution and the AAA ratio ($150 x 0.67,
or $100), and X's AAA immediately before the qualified distribution
($140). Therefore, $100 is sourced from AAA. Pursuant to paragraph
(b)(2)(ii) of this section, after the distribution, X's AAA is reduced
by $100 to $40. Pursuant to paragraph (b)(2)(iii) of this section, A's
basis in its X stock is reduced by $100 to $340.
(ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this
section, the portion of the distribution that is sourced from AE&P is
equal to the lesser of: The product of the qualified distribution and
the AE&P ratio ($150 x 0.33, or $50), and X's AE&P immediately before
the qualified distribution ($70). Therefore, $50 is sourced from AE&P.
Pursuant to paragraph (b)(3)(ii) of this section, after the
distribution, X's AE&P is reduced by $50 to $20. Pursuant to paragraph
(b)(3)(iii) of this section, the $50 distribution is characterized as a
dividend.
(3) Example 3: Limitation on amount characterized as AAA--(i)
Facts. At the beginning of January 1, 2018, X had AAA of $100 and AE&P
of $300. During 2018, X had $280 of CE&P and made no distributions. At
the beginning of January 1, 2019, X has AAA of $100 and AE&P of $580,
and A's adjusted basis in its share of X stock is $450. During 2019,
the only distribution that X makes is a $500 distribution of money to A
on October 5. X's CE&P during 2019 is $150, without diminution by
reason of any distributions made during the taxable year.
(ii) Analysis--(A) Calculation of AAA ratio and AE&P ratio.
Pursuant to paragraphs (a)(2)(ix) and (x) of this section,
respectively, X's historical AAA and X's historical AE&P are determined
as of the beginning of January 1, 2018, the beginning of the day on
which the revocation of X's election under section 1362(a) is effective
pursuant to section 1362(d)(1). Accordingly, X's historical AAA is $100
and X's historical AE&P is $300. Therefore, X's AAA ratio is 0.25
($100/($100 + $300)), and X's AE&P ratio is 0.75 ($300/($100 + $300)).
(B) Characterization of distribution. Pursuant to paragraph
(a)(2)(xii) of this section, the $500 distribution on October 5, 2019,
is a qualified distribution because it is a distribution of money by an
ETSC during the ETSC period to which section 301 would apply absent the
application of section 1371(f) and this section.
(C) Analysis of qualified distribution--(1) Distribution of AAA.
Pursuant to paragraph (b)(2)(i) of this section, the portion of the
qualified distribution that is sourced from AAA is equal to the lesser
of: The product of the qualified distribution and the AAA ratio ($500 x
0.25, or $125), and X's AAA immediately before the qualified
distribution ($100). Therefore, $100 is sourced from AAA. Pursuant to
paragraph (b)(2)(ii) of this section, after the distribution, X's AAA
is reduced by $100 to $0. Pursuant to paragraph (b)(2)(iii) of this
section, A's basis in its X stock is reduced by $100 to $350.
(2) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this
section, the portion of the distribution that is sourced from AE&P is
equal to the lesser of: the product of the qualified distribution and
the AE&P ratio ($500 x 0.75, or $375), and X's AE&P immediately before
the qualified distribution ($580). Therefore, $375 is sourced from
AE&P. Pursuant to paragraph (b)(3)(ii) of this section, after the
distribution, X's AE&P is reduced by $375 to $205. Pursuant to
paragraph (b)(3)(iii) of this section, the $375 distribution is
characterized as a dividend.
(D) Effect of qualified distribution on ETSC period. Pursuant to
paragraph (a)(2)(vii) of this section, X's ETSC period ends because X's
AAA balance is zero following the October 5, 2019 distribution.
(E) Analysis of excess qualified distribution--(1) Amount of excess
qualified distribution. Pursuant to paragraph (a)(2)(viii) of this
section, the amount of the excess qualified distribution is $25, the
portion of the
[[Page 66481]]
qualified distribution ($500) not characterized pursuant to paragraph
(b)(2) or (3) of this section ($100 AAA distribution + $375 AE&P
distribution).
(2) Characterization of excess qualified distribution. Paragraph
(b)(4) of this section does not apply to the excess qualified
distribution because X's AAA balance is zero after the application of
paragraph (b)(2)(ii) of this section (see paragraph (d)(3)(ii)(C)(1) of
this section). Pursuant to paragraph (c) of this section, section
301(c) applies to the excess qualified distribution. Pursuant to
sections 301(c)(1) and 316, the $25 excess qualified distribution is
sourced from CE&P.
(iii) Subsequent contribution. The facts are the same as paragraph
(d)(3)(i) of this section, except that at the time of the October 5,
2019 distribution, A's adjusted basis in its X stock is $90. Further,
on December 27, 2019, A contributes $100 to X in a transaction
described in section 351(a). The analysis in paragraph (d)(3)(ii) of
this section remains the same, except that, unlike the second to last
sentence of paragraph (d)(3)(ii)(C)(1) of this section, A's basis in
its X stock is reduced by $90 to $0 and pursuant to paragraph
(b)(2)(iii) of this section, $10 is treated as gain from the sale or
exchange of property. Additionally, as a result of the December 27,
2019 contribution of $100, A's basis in its X stock is increased by
$100, so that at the end of 2019, A's basis in its X stock is $100.
(4) Example 4: Limitation on the amount characterized as AE&P--(i)
Facts. At the beginning of January 1, 2018, X had AAA of $100 and AE&P
of $100. During 2018, X had CE&P of $(75) and made no distributions. At
the beginning of January 1, 2019, X has AAA of $100 and AE&P of $25,
and A's adjusted basis in its share of X stock is $500. During 2019,
the only distributions that X makes are a $100 distribution of money to
A on July 9 and a $40 distribution of money to A on September 27. X's
CE&P during 2019 is $20, without diminution by reason of any
distributions made during the taxable year.
(ii) Analysis--(A) Calculation of AAA ratio and AE&P ratio.
Pursuant to paragraphs (a)(2)(ix) and (x) of this section,
respectively, X's historical AAA and X's historical AE&P are determined
as of the beginning of January 1, 2018, the beginning of the day on
which the revocation of X's election under section 1362(a) is effective
pursuant to section 1362(d)(1). Accordingly, X's historical AAA is $100
and X's historical AE&P is $100. Therefore, X's AAA ratio is 0.5 ($100/
($100 + $100)), and X's AE&P ratio is 0.5 ($100/($100 + $100)).
(B) Analysis of July 9, 2019 distribution--(1) Characterization of
distribution. Pursuant to paragraph (a)(2)(xii) of this section, the
$100 distribution on July 9, 2019, is a qualified distribution because
it is a distribution of money by an ETSC during the ETSC period to
which section 301 would apply absent the application of section 1371(f)
and this section.
(2) Analysis of qualified distribution--(i) Distribution of AAA.
Pursuant to paragraph (b)(2)(i) of this section, the portion of the
distribution that is sourced from AAA is equal to the lesser of: The
product of the qualified distribution and the AAA ratio ($100 x 0.5, or
$50), and X's AAA immediately before the qualified distribution ($100).
Therefore, $50 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of
this section, after the distribution, X's AAA is reduced by $50 to $50.
Pursuant to paragraph (b)(2)(iii) of this section, A's basis in its X
stock is reduced by $50 to $450.
(ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this
section, the portion of the distribution that is sourced from AE&P is
equal to the lesser of: The product of the qualified distribution and
the AE&P ratio ($100 x 0.5, or $50), and X's AE&P immediately before
the qualified distribution ($25). Therefore, $25 is sourced from AE&P.
Pursuant to paragraph (b)(3)(ii) of this section, after the
distribution, X's AE&P is reduced by $25 to $0. Pursuant to paragraph
(b)(3)(iii) of this section, $25 of the distribution is characterized
as a dividend.
(3) Recalculation of AAA and AE&P ratios. Pursuant to paragraph
(b)(3)(iv) of this section, because the July 9, 2019 distribution
caused X's AE&P to be reduced to zero, the AAA ratio is one and the
AE&P ratio is zero for all subsequent qualified distributions during
the 2019 taxable year and subsequent taxable years of the ETSC period.
(4) Excess qualified distribution--(i) Amount of excess qualified
distribution. Pursuant to paragraph (a)(2)(viii) of this section, the
amount of the excess qualified distribution is $25, the amount of the
qualified distribution ($100) not characterized pursuant to paragraph
(b)(2) or (3) of this section ($50 AAA distribution + $25 AE&P
distribution).
(ii) Characterization of excess qualified distribution as a
separate qualified distribution. Pursuant to paragraph (b)(4) of this
section, because X has AAA remaining after characterizing the qualified
distribution (see paragraph (d)(4)(ii)(B)(2)(i) of this section), the
$25 excess qualified distribution is treated as a separate qualified
distribution and is analyzed pursuant to paragraph (b) of this section.
(iii) Analysis of excess qualified distribution that is treated as
a separate qualified distribution. Pursuant to paragraph (b)(2)(i) of
this section, the portion of the distribution that is sourced from AAA
is equal to the lesser of: The product of the excess qualified
distribution and the AAA ratio ($25 x 1, or $25), and X's AAA
immediately before the excess qualified distribution ($50). Therefore,
$25 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this
section, after the distribution, X's AAA is reduced by $25 to $25.
Pursuant to paragraph (b)(2)(iii) of this section, A's basis in its X
stock is reduced by $25 to $425. Pursuant to paragraph (b)(3)(i) of
this section, because X's AE&P ratio is zero, paragraph (b)(3) of this
section does not apply.
(C) Analysis of September 27, 2019 distribution--(1)
Characterization of the distribution. Pursuant to paragraph (a)(2)(xii)
of this section, the $40 distribution on September 27, 2019, is a
qualified distribution because it is a distribution of money by an ETSC
during the ETSC period to which section 301 would apply absent the
application of section 1371(f) and this section.
(2) Analysis of qualified distribution--(i) Distribution of AAA.
Pursuant to paragraph (b)(2)(i) of this section, the portion of the
distribution that is sourced from AAA is equal to the lesser of: The
product of the qualified distribution and the AAA ratio ($40 x 1, or
$40), and X's AAA immediately before the qualified distribution ($25)
(see paragraph (d)(4)(ii)(B)(4)(iii) of this section). Therefore, $25
is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section,
after the distribution, X's AAA is reduced by $25 to $0. Pursuant to
paragraph (b)(2)(iii) of this section, A's basis in its X stock is
reduced by $25 to $400.
(ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this
section, because X's AE&P ratio is zero, paragraph (b)(3) of this
section does not apply.
(3) Excess qualified distribution--(i) Amount of excess qualified
distribution. Pursuant to paragraph (a)(2)(viii) of this section, the
amount of the excess qualified distribution is $15, the portion of the
qualified distribution ($40) not characterized pursuant to paragraph
(b)(2) or (3) of this section ($25 AAA distribution + $0 AE&P
distribution).
(ii) Excess qualified distribution not characterized as a separate
qualified distribution. Pursuant to paragraph (b)(4) of this section,
because X has
[[Page 66482]]
AAA of $0 after characterizing the qualified distribution (see
paragraph (d)(4)(ii)(C)(2)(i) of this section), the $15 excess
qualified distribution is not treated as a separate qualified
distribution.
(iii) Analysis of excess qualified distribution that is not treated
as a separate qualified distribution. Pursuant to paragraph (c) of this
section, section 301(c) applies to the excess qualified distribution.
Pursuant to sections 301(c)(1) and 316, the $15 excess qualified
distribution is sourced from CE&P.
(5) Example 5: Distributions include non-qualified distributions--
(i) Facts. At the beginning of January 1, 2018, X had AAA of $100 and
AE&P of $100. During 2018, X had $0 of CE&P and made no distributions.
At the beginning of January 1, 2019, X has AAA of $100 and AE&P of
$100, and A's adjusted basis in its X stock is $200. During 2019, X
makes a $100 distribution of money on June 14; a $300 distribution of
property on November 9; and a $200 distribution of money on December
18. X's CE&P during 2019 is $160, without diminution by reason of any
distributions made during the taxable year.
(ii) Analysis--(A) Calculation of AAA ratio and AE&P ratio.
Pursuant to paragraphs (a)(2)(ix) and (x) of this section,
respectively, X's historical AAA is $100 and X's historical AE&P is
$100. Therefore, X's AAA ratio is 0.5 ($100/($100 + $100)), and X's
AE&P ratio is 0.5 ($100/($100 + $100)).
(B) Characterization of distributions. Pursuant to paragraph
(a)(2)(xii) of this section, the $100 distribution on June 14, 2019,
and the $200 distribution on December 18, 2019, are both qualified
distributions because they are distributions of money by an ETSC during
the ETSC period to which section 301 would apply absent the application
of section 1371(f) and this section. Pursuant to paragraph (a)(2)(xi)
of this section, the $300 distribution of property on November 9, 2019,
is a non-qualified distribution. Pursuant to paragraph (b)(1) of this
section, the rules of paragraph (b)(2) through (b)(4) of this section
apply to the qualified distributions before the rules of paragraph (c)
of this section apply to the non-qualified distribution and any excess
qualified distributions.
(C) Analysis of qualified distributions--(1) June 14, 2019
distribution--(i) Distribution of AAA. Pursuant to paragraph (b)(2)(i)
of this section, the portion of the distribution that is sourced from
AAA is equal to the lesser of: The product of the qualified
distribution and the AAA ratio ($100 x 0.5, or $50), and X's AAA
immediately before the qualified distribution ($100). Therefore, $50 is
sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section,
after the distribution, X's AAA is reduced by $50 to $50. Pursuant to
paragraph (b)(2)(iii) of this section, on June 14, 2019, A's basis in
its X stock is reduced by $50 to $150.
(ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this
section, the portion of the distribution that is sourced from AE&P is
equal to the lesser of: The product of the qualified distribution and
the AE&P ratio ($100 x 0.5, or $50), and X's AE&P immediately before
the qualified distribution ($100). Therefore, $50 is sourced from AE&P.
Pursuant to paragraph (b)(3)(ii) of this section, after the
distribution, X's AE&P is reduced by $50 to $50. Pursuant to paragraph
(b)(3)(iii) of this section, the $50 distribution is characterized as a
dividend.
(iii) Amount of excess qualified distribution. The amount of the
excess qualified distribution is $0, the amount of the qualified
distribution ($100) not characterized pursuant to paragraph (b)(2) or
(3) of this section ($50 AAA distribution + $50 AE&P distribution).
(2) December 18, 2019 distribution--(i) Distribution of AAA.
Pursuant to paragraph (b)(2)(i) of this section, the portion of the
distribution that is sourced from AAA is equal to the lesser of: The
product of the qualified distribution and the AAA ratio ($200 x 0.5, or
$100), and X's AAA immediately before the qualified distribution ($50).
Therefore, $50 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of
this section, after the distribution, X's AAA is reduced by $50 to $0.
Pursuant to paragraph (b)(2)(iii) of this section, A must determine its
basis as of December 18, 2019, in order to determine the consequences
of receiving the $50 AAA distribution. Because the non-qualified
distribution on November 9, 2019, which precedes the December 18, 2019
qualified distribution, could have the effect of reducing A's basis,
any effect on A's basis from that non-qualified distribution must be
analyzed prior to determining the effect of the December 18, 2019
distribution of AAA on A's basis. See paragraphs (d)(5)(ii)(D)(3) and
(4) of this section. Pursuant to paragraph (a)(2)(vii) of this section,
X's ETSC period ends because X's AAA balance is zero following the
December 18, 2019 distribution.
(ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this
section, the portion of the distribution that is sourced from AE&P is
equal to the lesser of: The product of the qualified distribution and
the AE&P ratio ($200 x 0.5, or $100), and X's AE&P immediately before
the qualified distribution ($50). Therefore, $50 is sourced from AE&P.
Pursuant to paragraph (b)(3)(ii) of this section, after the
distribution, X's AE&P is reduced by $50 to $0. Pursuant to paragraph
(b)(3)(iii) of this section, the $50 distribution is characterized as a
dividend.
(iii) Amount of excess qualified distribution. The amount of the
excess qualified distribution is $100, the amount of the qualified
distribution ($200) not characterized pursuant to paragraph (b)(2) or
(3) of this section ($50 AAA distribution + $50 AE&P distribution).
(D) Analysis of non-qualified and excess qualified distributions--
(1) In general. The $300 non-qualified distribution on November 9,
2019, and the $100 excess qualified distribution on December 18, 2019,
are treated in the manner provided in section 301(c).
(2) Allocation of CE&P. Pursuant to section 316 and Sec. 1.316-2,
X's CE&P is allocated proportionately among the excess qualified and
the non-qualified distributions. Therefore, the portion of X's CE&P
that is allocated to the November 9, 2019 distribution and the December
18, 2019 distribution is $120 ($160 CE&P x ($300 distribution/$400
total excess qualified and non-qualified distributions during 2019) and
$40 ($160 CE&P x ($100 distribution/$400 total excess qualified and
non-qualified distributions during 2019), respectively.
(3) November 9, 2019 distribution. Pursuant to paragraph
(d)(5)(ii)(D)(2) of this section, $120 of the $300 distribution is
characterized as a distribution of CE&P. Pursuant to paragraph
(d)(5)(ii)(C)(2)(ii) of this section, the amount of X's AE&P available
to allocate the November 9, 2019 distribution is $0. Therefore, the
remaining $180 is characterized pursuant to section 301(c)(2) and (3).
Pursuant to paragraph (d)(5)(ii)(C)(1)(i) of this section, A's basis in
its X stock prior to the November 9, 2019 distribution is $150.
Therefore, $150 is applied against basis pursuant to section 301(c)(2)
(reducing A's basis to $0) and $30 is treated as gain from the sale or
exchange of property pursuant to section 301(c)(3).
(4) December 18, 2019 distribution--(i) Consequences of AAA
distribution. As of December 18, 2019, A's basis in its X stock is $0.
See paragraph (d)(5)(ii)(D)(3) of this section. Pursuant to paragraph
(d)(5)(ii)(C)(2)(i) of this section, $50 of the distribution is
characterized as a distribution of AAA. Because the amount of the
distribution of AAA ($50) exceeds A's basis in its X
[[Page 66483]]
stock ($0), pursuant to paragraph (b)(2)(iii) of this section, on
December 18, 2019, $50 is treated as gain from the sale or exchange of
property.
(ii) Characterization of excess qualified distribution. Pursuant to
paragraph (d)(5)(ii)(C)(2)(iii) of this section, $100 of the December
18, 2019 distribution is an excess qualified distribution. Paragraph
(b)(4) of this section does not apply to the excess qualified
distribution because X's AAA balance is zero after the application of
paragraph (b)(2)(ii) of this section (see paragraph (d)(5)(ii)(C)(2)(i)
of this section. Pursuant to paragraph (c) of this section, section
301(c) applies to the excess qualified distribution. Pursuant to
paragraph (d)(5)(ii)(D)(2) of this section, $40 of the $100 excess
qualified distribution is characterized as a distribution of CE&P.
Pursuant to paragraph (d)(5)(ii)(D)(3) of this section, X's AE&P as the
time of the December 18, 2019 distribution is $0. Therefore, the
remaining $60 is characterized pursuant to section 301(c)(2) and (3).
Pursuant to paragraph (d)(5)(ii)(D)(4)(i) of this section, A's basis in
its X stock prior to characterization of the excess qualified
distribution is $0. Therefore, $60 is treated as gain from the sale or
exchange of property pursuant to section 301(c)(3).
(e) Applicability date. This section applies to taxable years
beginning after October 20, 2020. However, a corporation may choose to
apply the rules in Sec. Sec. 1.481-5, 1.1371-1, and 1.1371-2 in their
entirety to taxable years beginning on or before October 20, 2020. If a
corporation makes the choice described in the previous sentence, all
shareholders of the corporation must report consistently, and the
corporation must continue to apply the rules in Sec. Sec. 1.481-5,
1.1371-1, and 1.1371-2 in their entirety for the corporation's
subsequent taxable years.
Sec. 1.1371-2 Impact of Audit PTTP on ETSC Period.
(a) Definitions. For purposes of this section, the definitions used
in Sec. 1.1371-1(a)(2) are applicable. Additionally, the following
definitions apply for purposes of this section--
(1) Audit PTTP. The term audit PTTP means a post-termination
transition period described in section 1377(b)(1)(B) of the Internal
Revenue Code (Code).
(2) Initial PTTP. The term initial PTTP means a post-termination
transition period described in section 1377(b)(1)(A).
(3) Intervening audit PTTP. The term intervening audit PTTP means
an audit PTTP arising during the ETSC period.
(b) In general. If an intervening audit PTTP arises, the ETSC
period immediately stops. Immediately following the end of the
intervening audit PTTP, the ETSC period resumes if the ETSC's AAA
balance is greater than zero. Otherwise, any subsequent distributions
by the ETSC are treated in the manner provided in section 301(c) of the
Code.
(c) Examples. Paragraphs (c)(1) and (2) of this section (Examples 1
and 2) illustrate the rules of this section. For purposes of paragraphs
(c)(1) and (2) of this section (Examples 1 and 2), X is a calendar year
S corporation. A, an individual, purchased all of the outstanding
shares of X in a single transaction at the same price per share prior
to December 22, 2017, and was the sole shareholder of X at all times.
Pursuant to section 1362(d)(1) of the Code and Sec. Sec. 1.1362-2 and
1.1362-6, X made a valid revocation of its S election on March 15,
2019, that became effective on January 1, 2019. No amount distributed
by X is an extraordinary dividend within the meaning of section 1059.
(1) Example 1: No ETSC period following initial PTTP--(i) Facts. At
the beginning of January 1, 2019, X had AAA of $49,000 and AE&P of
$2,000, and A's adjusted basis in its shares of X stock was $50,000.
During 2019, the only distribution that X made was a $49,000
distribution of money to A on March 13, 2019. X's CE&P during 2019 was
$0, without regard to any diminution by reason of any distributions
made during the taxable year.
(ii) Analysis--(A) Distribution during initial PTTP. Pursuant to
sections 1371(e) and 1377(b)(1)(A), the $49,000 distribution of money
on March 13, 2019, is characterized as a distribution of AAA because it
was made during the initial PTTP.
(B) Effect on corporation. Pursuant to Sec. 1.1368-2(a)(3)(iii),
X's AAA is reduced by $49,000 to $0. Following the initial PTTP, even
if X satisfies the requirements of section 481(d)(2) of the Code and
Sec. 1.481-5(b) to be an ETSC, X does not have an ETSC period because
its AAA balance is zero at the end of its initial PTTP. Therefore,
section 1371(f) of the Code and Sec. 1.1371-1 will not apply to any
subsequent distributions by X.
(C) Effect on shareholder. Pursuant to section 1371(e)(1), A
reduces its basis in its X stock by $49,000 to $1,000.
(2) Example 2: Intervening audit PTTP--(i) Facts. The facts are the
same as the facts in paragraph (c)(1) of this section. On May 20, 2020,
which is after X's initial PTTP, the IRS begins an audit of X's 2018
return. During the audit it is agreed that X overstated its advertising
expense deduction by $10,000. On July 6, 2020, A signs a closing
agreement whereby X's overstatement results in an additional tax on A's
2018 individual return. As a result, at the beginning of January 1,
2019, X had AAA of $59,000 ($49,000 + $10,000) and AE&P of $2,000.
Additionally, at the beginning of January 1, 2019, A's adjusted basis
in its shares of X stock was $60,000 ($50,000 + $10,000). During 2020,
the only distribution X makes is a $6,000 distribution of money to A on
September 1, 2020. X's CE&P during 2020 was $0, without regard to any
diminution by reason of any distributions made during the taxable year.
(ii) Analysis--(A) Analysis of March 13, 2019 distribution. The
treatment of the March 13, 2019, distribution is the same as described
in paragraph (c)(1)(ii)(A) of this section, because the amount of the
distribution ($49,000) does not exceed X's AAA balance at the beginning
of January 1, 2019 ($59,000), and so the entirety of the $49,000
distribution is properly characterized as a distribution of AAA.
(1) Effect on corporation. As described in paragraph (c)(1)(ii)(B)
of this section, X's AAA ($59,000 at the beginning of January 1, 2019)
is reduced by $49,000 to $10,000. At the conclusion of X's initial PTTP
(ending on December 31, 2019), X's AAA balance is $10,000. Pursuant to
Sec. 1.1371-1(a)(2)(vii), X has an ETSC period. Therefore, section
1371(f) and Sec. 1.1371-1 will apply to any subsequent qualified
distributions by X.
(2) Effect on shareholder. As described in paragraph (c)(1)(ii)(C)
of this section, A reduces its basis in its X stock ($60,000 at the
beginning of January 1, 2019) by $49,000 to $11,000.
(B) Intervening audit PTTP. Pursuant to section 1377(b)(1)(B), X
enters an intervening audit PTTP that begins on July 6, 2020, and ends
on November 2, 2020. The application of section 1371(f) and Sec.
1.1371-1 to distributions during the intervening audit PTTP is stopped.
Instead, sections 1371(e) and 1377(b)(1)(B) and Sec. Sec. 1.1371-2 and
1.1377-2 apply for the duration of the intervening audit PTTP. During
the intervening audit PTTP, the only distribution X made is a $6,000
distribution of money to A on September 1, 2020. Pursuant to sections
1371(e) and 1377(b)(1)(B), the $6,000 distribution is characterized as
a distribution of AAA because it was made during the intervening audit
PTTP.
[[Page 66484]]
(1) Effect on corporation. Pursuant to Sec. 1.1368-2(a)(3)(iii),
X's AAA is reduced by $6,000 to $4,000. Beginning on November 3, 2020,
pursuant to Sec. 1.1371-1(a)(2)(vii), X's ETSC period resumes (after
the intervening audit PTTP's conclusion) because its AAA balance is
greater than zero.
(2) Effect on shareholder. Pursuant to section 1371(e)(1), A
reduces its basis in its X stock by $6,000 to $5,000.
(C) ETSC period. Beginning on November 3, 2020, X's ETSC period
resumes, and distributions of money are subject to section 1371(f) and
Sec. 1.1371-1 until X's AAA balance is zero. For purposes of
calculating each of X's AAA and AE&P ratios, X's historical AAA is
$59,000 (at the beginning of January 1, 2019, which includes the
$10,000 increase as a result of the July 6, 2020, closing agreement).
(d) Applicability date. This section applies to taxable years
beginning after October 20, 2020. However, a corporation may choose to
apply the rules in Sec. Sec. 1.481-5, 1.1371-1, and 1.1371-2 in their
entirety to taxable years that began on or before October 20, 2020. If
a corporation makes the choice described in the previous sentence, all
shareholders of the corporation must report consistently, and the
corporation must continue to apply the rules in Sec. Sec. 1.481-5,
1.1371-1, and 1.1371-2 in their entirety for the corporation's
subsequent taxable years.
Sec. 1.1377-2 [Amended]
0
Par. 7. Section 1.1377-2 is amended by removing the last sentence of
paragraph (b).
0
Par. 8. Section 1.1377-3 is revised to read as follows:
Sec. 1.1377-3 Applicability dates.
(a) In general. Except as otherwise provided in this section,
Sec. Sec. 1.1377-1 and 1.1377-2 apply to taxable years of an S
corporation beginning after December 31, 1996.
(b) Certain conversions. Section 1.1377-1(a)(2)(iii) and (c)(3)
(Example 3) are applicable for taxable years beginning on and after May
14, 2002.
(c) Special treatment of distributions of money during post-
termination transition period--(1) In general. Except as provided in
paragraph (c)(2) of this section, Sec. 1.1377-2(b) applies to taxable
years beginning after October 20, 2020. For taxable years beginning on
or before October 20, 2020, see Sec. 1.1377-2(b) as contained in 26
CFR part 1, revised April 1, 2020.
(2) Taxable years beginning on or before October 20, 2020. A
corporation may choose to apply Sec. 1.1377-2(b) to taxable years
beginning on or before October 20, 2020 and with respect to which the
period described in section 6501(a) has not expired. If a corporation
makes the choice described in the previous sentence, all shareholders
of the corporation must report consistently, and the corporation must
adopt Sec. Sec. 1.481-5, 1.1371-1, 1.1371-2, if an ETSC, and 1.1377-
2(b) in their entity and continue to apply those rules in their
entirety for the corporation's subsequent taxable years.
Sunita Lough,
Deputy Commissioner for Services and Enforcement.
Approved: September 9, 2020.
David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2020-21144 Filed 10-19-20; 8:45 am]
BILLING CODE 4830-01-P
