Rev. Rul. 66-327

Advice has been requested whether the income of an electing small business corporation, X , which is required to be included in the gross income of one of its shareholders, A , is properly classified as income not derived from a trade or business for purposes of computing a net operating loss under section 172(c) of the Internal Revenue Code of 1954. In addition to owning X stock, A is also an employee of X corporation. A was paid a reasonable salary for the services which he rendered to X .

Section 172(d)(4) of the Code provides, in part, that for purposes of computing the net operating loss deduction, in the case of taxpayers other than a corporation, deductions which are not attributable to a taxpayer's trade or business are allowable only to the extent of their gross income not derived from a trade or business. Thus, for this purpose, it is important to know whether or not income is derived from a trade or business.

Section 1373 of the Code provides that the undistributed taxable income of an electing small business corporation shall be included in the gross income of the shareholders. The shareholder is required to include in his gross income the amount which he would have received as a dividend, if on the last day of the corporation's taxable year there had been distributed pro rata to its shareholders by the corporation an amount equal to the corporation's undistributed taxable income for that taxable year. This amount is treated as a dividend distributed on the last day of the taxable year of the corporation.

Under section 1373 of the Code and section 1.1373-1(d) of the Income Tax Regulations, actual distributions of money and property made with respect to its stock by an electing small business corporation will be included in the shareholder's income only if such distributions are dividends as defined in section 316(a) of the Code.

Therefore, the taxable income of X required to be included in the gross income of A is either dividend income or amounts required to be treated as dividends. Higgins v. Commissioner , 312 U.S. 212 (1941), Ct. D. 1486, C.B. 1941-1, 339 and Whipple v. Commissioner , 373 U.S. 193 (1963), Ct. D. 1882, C.B. 1963-2, 641 hold that dividend income is not income derived from a trade or business. Thus, the income from an electing small business corporation, which is dividend income as defined in section 316(a) of the Code or which is treated as dividend income under section 1373 of the Code, and which is required to be included in A's gross income as dividend income, is not income derived from a trade or business. Neither the election by a small business corporation, pursuant to section 1372 of the Code, nor a consent thereto by its shareholders, results in the consenting shareholders carrying on the corporation's trade or business. Rev. Rul. 59-221, C.B. 1959-1, 225. On the other hand A's salary is business income derived from a trade or business. Section 1.172-3(a)(3) of the regulations.

Accordingly, the taxable income of an electing small business corporation, which is required to be included in the gross income of one C.B. 1959-1, 225. On the other hand, not income derived from a trade or business for purposes of computing that shareholder's net operating loss under section 172(c) of the Code.