CALCULATING BASIS IN STOCK AND DEBT OF AN S CORPORATION UNDER THE FINAL REGULATIONS

By Albert De Rosa, CPA, Charles Hecht & Company LLP

A taxpayer may invest in either the stock or debt obligations of an S corporation. Such an investment gives the taxpayer a basis in the stock or debt. In general, under the IRC the primary role of basis is to measure whether the final or intermediate liquidation of the taxpayer's investment in the corporation results in gain, loss, or the tax-free return of capital.

Under subchapter S, basis plays special roles. A shareholder's basis in stock and debt limits the amount of corporate losses and deductions that can pass through to that shareholder. Also, a shareholder's basis account generally ensures that a shareholder who has paid tax on corporate income can receive an equal amount of money or property without further tax. To achieve these results, subchapter S requires that corporate losses and income that pass through to a shareholder either decrease or increase the basis of the shareholder's investment in the corporation.

The basis rules of subchapter S offer an advantage over those of subchapter C. If an S corporation retains some of its earnings, the shareholder receives an increase in basis. That basis increase generally will reduce the taxes due on the sale or redemption of the stock. By contrast, the retained earnings of a C corporation do not increase the shareholders' stock basis.

In 1992, 10 years after the Subchapter S Revision Act of 1982, the IRS proposed regulations under IRC Sec. 1367. In 1993, the IRS, with some changes, adopted these as final regulations. These regulations apply to corporate taxable years starting after 1993. For prior taxable years, the taxpayer must apply the code and legislative history in a "reasonable manner." For this purpose, the regulations treat positions consistent with the final regulations as reasonable.

The IRC contains many rules that may affect the basis of stock or debt in the hands of a shareholder. In general, those rules apply to the stock or debt of an S corporation. In addition, subchapter S adds special rules.

Increases in Basis

Items of corporate income pass through to shareholders on a per-share per-day basis. This pass through occurs without regard to whether the income is or is not distributed. Appropriately, IRC Sec. 1367 provides for a basis increase equal to the income that passes through to a shareholder. Both separately and nonseparately computed income items increase basis. The increase generally affects the basis of stock but may restore the basis of debt under certain conditions as discussed below.

The following items also increase a shareholder's basis:

• An S corporation's tax-exempt income.
• The excess of depletion deductions over the basis of the property in question (non-oil and gas property only).

IRC Sec. 1367 provides a special rule that if an item is required to be reported on a return and included in gross income, that item increases basis only if the shareholder actually includes that item in gross income. This rule protects the IRS from taxpayers who fail to report income but wish to make the correct use of basis after the statute of limitations has run.

Restoration of Debt Basis

In general, IRC Sec. 1367(a)(1) allocates basis increases of the shareholder's stock. However, if pass-through (of losses, deductions, expenses, and depletion deductions) has eliminated the basis of stock and debt to a shareholder, a special rule provides that any "net increase" for a later year will first restore the basis of debts before affecting stock.

For this purpose, a "net increase" with respect to a shareholder means the amount by which the shareholder's pro rata share of income items and excess deductions for depletion exceed the items relating to losses, deductions, noncapital-nondeductible expenses, certain oil and gas depletion deductions, and nontaxable distributions for the taxable year.

Under the regulations, the restoration of basis applies only to debt held by a shareholder on the first day of the taxable year in which the increase occurs. In no event may the shareholder's basis of indebtedness be restored above the adjusted basis of the indebtedness under IRC Sec. 1016(a), excluding adjustments required by IRC Sec. 1367 for prior taxable years, determined as of the beginning of the taxable year in which the net increase arises.

On the first day of a corporation's taxable year, a shareholder may hold more than one debt. If so, a net increase first restores the basis of any debt repaid in whole or in part during the taxable year (to the extent necessary to offset gain that would be realized on repayment). Any remaining net increase applies first to other outstanding debt in proportion to the prior year basis reductions of each debt and then to stock. Shareholder advances not evidenced by separate written instruments (open account debt) are treated as a single indebtedness.

When Basis Adjustments Are Effective

The regulations provide that the adjustments to basis of a shareholder's stock are determined as of the close of the corporation's taxable year, and the adjustments generally are effective as of that date. However, if a shareholder disposes of stock during the corporation's taxable year, the adjustments with respect to that stock are effective immediately prior to the disposition. The regulations provide the similar rules for adjustments to basis of a shareholder's debt. Additionally, if a debt is disposed of or repaid in whole or in part before the close of the taxable year, the basis of a debt is restored before the disposition or the first repayment during the taxable year.

If a shareholder's interest in an S corporation terminates, the corporation may elect to close its books on the date of termination. Also, Reg. Sec. 1.1368-1(g)(2) allows a corporation to close its books in the case of a qualifying disposition (i.e., a disposition or redemption of 20% or more or the outstanding stock in a 30-day period and stock issuances equal to or greater than 25% of the outstanding stock in a 30-day period). In either case, the regulations require that stock basis be adjusted on an interim basis. A parallel rule applies with respect to debt held by a shareholder.

Decreases to Basis

Items of corporate loss and deductions pass through to shareholders on a per-share, per-day basis. IRC Sec. 1367(a)(2) requires a shareholder-level basis decrease equal to the losses and deductions that pass through. Both separately and nonseparately computed items of loss and deduction decrease basis. These items decrease basis even if a provision outside of subchapter S suspends any current deduction (e.g., capital loss or passive loss limitations).

A corporate expense that is not deductible nor properly chargeable to a capital account also reduces basis. This rule prevents a shareholder from having a deductible loss when selling the stock of a corporation that has expended its assets in nondeductible ways. Examples of noncapital, nondeductible expenses include political contributions, disallowed meals and entertainment, fines and penalties, illegal bribes and kickbacks, expenses relating to tax-exempt income, and losses disallowed under IRC Sec. 267.

IRC Sec. 1367(a)(2) allocates decreases in basis first to stock. However, stock basis cannot decline below zero. After stock basis has reached zero, IRC Sec. 1367(b)(2)(A) allocates any further decrease to the basis of debt owed by the corporation to the shareholder. The regulations indicate that a basis decrease generally occurs only for debt held by the shareholder at the close of the corporation's taxable year. Thus, generally, no basis reduction occurs for debt that is paid, disposed of, or cancelled during the taxable year. However, if a shareholder's interest in a corporation terminates, the basis reduction rules for debt apply just prior to the termination.

Allocation of Basis Increase and Decrease Among Multiple Shares

A shareholder may own shares of stock with different bases and holding periods. The final regulations apply increases and decreases separately to each share. Thus, shares that start a taxable year with different bases will receive separate adjustments. Under the regulations, the basis of a share generally decreases by the portion of losses, deductions, and expenses attributable to that share on a per-share, per-day basis. If the portion attributable to a share exceeds the share's basis, however, the excess shifts to, and reduces (but not below zero) the remaining bases of other shares owned by the shareholder. The shareholder allocates the excess in proportion to the remaining bases of each of those other shares.

Allocation of Decrease Among Multiple Debts

A shareholder may hold more than one corporate debt on the date a basis reduction occurs. In that case, the basis reduction applies to each debt in proportion to that debt's percentage of total basis for all debts (however, see debt aggregation rule above regarding open account debt). Like stock basis, debt basis cannot become negative. If a shareholder has no basis for either stock or debt obligations, IRC Sec. 1366(d)(1) suspends any further deduction and losses for the future benefits of that shareholder. Suspended losses and deductions should affect basis only when they become deductible in a later year, when basis is restored.

Prescribed and Elective Ordering Rules

IRC Sec. 1367(a) provides for increases and decreases in the basis of stock. The final regulations prescribe the order in which those changes occur as follows:

• Increases attributable to income items (taxable and exempt) and for the excess of depletion deductions over property basis.
• Decreases attributable to nondeductible, noncapital expenses and certain oil and gas depletion.
• Decreases attributable to corporate losses and deductions.
• Decreases attributable to tax-free distributions under IRC Sec. 1368.
• The final regulations added an elective ordering rule [Reg. Sec. 1.1367-1(f)]. It allows decreases to basis for items of loss or deductions to precede decreases for noncapital, nondeductible expenses, and oil and gas depletion deductions. The shareholder must agree that noncapital, nondeductible expenses in excess of basis and certain oil and gas depletion deductions will reduce basis in succeeding tax years. If the election is not made, noncapital, nondeductible items in excess of basis may not carry over and may disappear.

A shareholder makes the election by attaching a statement to the shareholder's timely filed original or amended return that states that the shareholder agrees to the carryover rule stated above. Once a shareholder makes an election to use the elective ordering rule, it must be used in all future years unless permission is received from the IRS to change. The election is made on a shareholder-by-shareholder basis.

The ordering rules impact the timing of deductible losses. Since, under the general rules losses are only deductible to the extent of basis, deductions are deferred to subsequent years when there is a basis limitation. Therefore, the elective ordering rule should normally be elected by taxpayers that have basis limitations and losses or deductions flowing from the S corporation. If an election is made, deductible items will take preference over the non- deductible items, and the nondeductible items in excess of basis will carry over to a year when the shareholder has sufficient basis to absorb them.

There are examples in the regulations that illustrate the rules discussed above.*

FINAL REGULATIONS RENDER REV. RUL. 92-84 OBSOLETE

By Juda Coard, CPA, Yohalem & Gilman

Rev. Rul. 92-84, 1992-2 C.D. 216, holds that if a Qualified Subchapter 8 Trust (QSST) sells its stock, the current income beneficiary and not the trust must recognize any gain or loss. On July 20, 1996, the IRS issued final regulations (T.D. 8600) on the definition of an S corporation under IRC Sec. 1361. As a result of the newly issued regulations, Rev. Rul. 92-84 has been rendered obsolete.

Under the final regulations, the current income beneficiary of a QSST will not be treated as the owner of the S corporation stock in determining and attributing the Federal income tax consequences of a disposition of the stock by the QSST. Instead, any consideration received for such dispositions will be treated as received by the trust in its status as a separate taxpayer under IRC Sec. 641.

Background

Only certain types of trusts are eligible to hold S corporation stock for a period longer than 60 days. Generally, a trust that is treated as owned by an individual who is a citizen or resident of the U.S. under the grantor trust provisions of IRC (Secs. 671-679 of Subpart E trusts) may qualify as a permitted S corporation shareholder.

A QSST will be a permitted a shareholder if the current income beneficiary makes an election, and if the trust satisfies certain requirements. Generally, the requirements will be satisfied if under the terms of the trust 1) there can be only one income beneficiary of the trust during the current income beneficiary's lifetime; 2) corpus distributed during the lifetime of the current income beneficiary may be distributed only to such beneficiary; 3) the income interest of the current income beneficiary terminates on the earlier of the beneficiary's death or the trust's termination; 4) upon the termination of the trust during the life of the current income beneficiary the trust shall distribute all of its assets to such beneficiary; and 6) all of the income of the trust is, or is required to be distributed currently to the income beneficiary who is a citizen or resident of the U.S.

Under IRC Sec. 678, a person other than the grantor of a trust can be treated as the owner of the trust for tax purposes. In the case of a QSST with respect to which an income beneficiary makes an election, IRC Sec. 1361(d) provides that the income beneficiary of the trust, will be treated as the owner (for purposes of IRC Sec. 678) of that portion of the trust which consists of stock in an S corporation.

Rev. Rul 92-84--Phantom Incomes And Possible Disposition Under 489B

Rev. Rul. 92-84, 1992-2 C.B. 216 holds that if a QSST sells its S corporation stock, the current income beneficiary and not the trust must recognize any gain or loss. As a result, the current income beneficiary was required to pay tax on gain, which under local law would generally be considered corpus of the trust. Unless there was a provision under the trust that would allow a distribution of corpus to the current income beneficiary, the current income beneficiary would have phantom income.

In addition to the phantom income issue, some practitioners following the reasoning in Rev. Rul 92-84, questioned whether the trust could effectively use the installment method under IRC Sec. 453 to report gain realized on the sale of the stock.

Rev. Rul 92-84 stated that the income beneficiary is treated as the owner of the stock sold. As a corollary, the income beneficiary would also be treated as the owner of an installment obligation received in exchange for the sale of the stock. Since the QSST ceases to be a QSST as to the S corporation stock sold, it was possible that the IRS would view the income beneficiary as no longer being the owner of the installment obligation held by the trust. As a result, there could be a disposition of the installment obligation under IRC Sec. 453B(a).

How the Final Regulations Change the Result of Rev. Rul. 92-84

The IRS along with the Treasury Department reexamined the revenue ruling. Under Reg. Sec. 1-1361-1(j)(8) an income beneficiary who is a deemed IRC Sec. 676 owner only by reason of IRC Sec. 1361(d)(1) will not be treated as the owner of the S corporation stock in determining and attributing the Federal income tax consequences of a disposition of the stock by the QSST. Thus, for example any gain recognized on a sale of the S corporation stock is the gross income of the trust. Similarly, the trust must report any gain realized upon the sale under IRC Sec. 453 if the sale otherwise qualifies as an installment sale. The IRS has stated that this provision
of the final regulations reflects an interpretation of IRC Sec. 1361(d)(1) and
has no bearing upon the operation or affect of the principles of IRC Secs.
671 through 679 beyond the context
of a QSST.

Effective Date of New Regulations

Reg Sec.1.1341-1(k)(2)(ii) provides that if a QSST has sold or otherwise disposed of all or a portion of its S corporation stock in a tax year that is open under the statutes for both the QSST and the income beneficiary on or before July 21, 1995, the QSST and the income beneficiary may trust the transaction under Rev. Rul. 92-84 or under the final regulations. However, the QSST and the income beneficiary must take consistent reporting positions. The final regulations require that the QSST and the income beneficiary must state on their respective returns (or amended returns) that they are taking consistent reporting
positions.

Editor:
Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editors:
Richard M. Barth, CPA

Stephen P. Valenti, CPA