SERVICE ISSUES PROPOSED REGULATIONS RELATING TO DEFINITION OF 'SMALL SUBCHAPTER S CORPORATION' AND 'SUBCHAPTER S ITEM.'

However, special rules are now proposed to except small S corporations from such corporate-level proceedings. The regulations contained in T.D. 8122 define the limits of a "small" S corporation and define the term "subchapter S item" for purposes of treating certain small S corporation items at the corporate level rather than the shareholder-level. The regulations apply for any taxable year of a S corporation the due date of the return for which is on or after January 30, 1987. Written comments and requests for a public hearing should be sent by March 31, 1987. For further information on the proposed regulations, call Stuart G. Wessler at the IRS at (202) 566- 3297. (Doc 87-510)

LR-74-86

AGENCY: Internal Revenue Service, Treasury.

ACTION: Notice of proposed rulemaking by cross-reference to temporary regulations.

SUMMARY: In the Rules and Regulations portion of this issue of the Federal Register, the Internal Revenue Service is issuing temporary regulations relating to the small S corporation exception and the definition of subchapter S item. The text of the temporary regulations serves as the comment document for this notice of proposed rulemaking.

DATES: Written comments and requests for a public hearing must be delivered or mailed by March 31, 1987. Except as otherwise provided, the regulations are proposed to be effective with respect to taxable years beginning after December 31, 1982.

ADDRESS: Send comments and requests for a public hearing to: Commissioner of Internal Revenue, 1111 Constitution Avenue, N.W., Attention: CC:LR:T (LR-74-86), Washington, D.C. 20224.

FOR FURTHER INFORMATION CONTACT: Stuart G. Wessler of the Legislation and Regulations Division, Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224, (Attention: CC:LR:T LR-74-86). Telephone 202-566-3297 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

The temporary regulations in the Rules and Regulations portion of this issue of the Federal Register amend the Excise Tax Regulations Under The Crude Oil Windfall Profit Tax of 1980 (26 CFR Part 51) under section 6245 and the Regulations on Procedure and Administration (26 CFR Part 301) under sections 6241 and 6245 of the Internal Revenue Code of 1986, as added by section 4(a) of the Subchapter S Revision Act of 1982 (Pub. Law 97-354).

For the text of the temporary regulations, see T.D. 8122 published in the Rules and Regulations portion of this issue of the Federal Register. The preamble to the temporary regulations explains the addition to the regulations.

REGULATORY FLEXIBILITY ACT AND EXECUTIVE ORDER 12291

The Commissioner of Internal Revenue has determined that the proposed rule is not a major rule as defined in Executive Order 12291 and that a Regulatory Impact Analysis is therefore not required.

Although this document is a notice of proposed rulemaking that solicits public comment, it is hereby certified, pursuant to 5 U.S.C. 605(b), that the requirements of the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to this proposed regulation because it will not have a significant economic impact on a substantial number of small entities. The proposed regulations do not impose a significant economic burden on taxpayers; the regulations merely provide an exception to the unified corporation proceedings and define the items that are within the scope of the new rules for unified corporate proceedings.

COMMENTS AND REQUESTS FOR A PUBLIC HEARING

Before adopting these proposed regulations, consideration will be given to any written comments that are submitted (preferably eight copies) to the Commissioner of Internal Revenue. All comments will be available for public inspection and copying. A public hearing will be held upon written request of any person who has submitted written comments. If a public hearing is held, notice of the time and place will be published in the Federal Register.

The collection of information requirements contained in this notice of proposed rulemaking have been submitted to the Office of Management and Budget (OMB) for review under section 3504(h) of the Paperwork Reduction Act. Comments on these requirements should be sent to the Office of Information and Regulatory affairs of OMB, Attention: Desk Officer for Internal Revenue Service, New Executive Office Building, Washington, D.C. 20503. The Internal Revenue Service requests that persons submitting comments on these requirements to OMB also send copies of those comments to the Service.

DRAFTING INFORMATION

The principal author of these proposed regulations is Stuart G. Wessler of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing these regulations both on matters of substance and style.

Lawrence B. Gibbs

DEFINITION OF SUBCHAPTER S ITEM AND SPECIAL RULE FOR CERTAIN SMALL S CORPORATIONS

AGENCY: Internal Revenue Service, Treasury.

ACTION: Temporary regulations.

SUMMARY: This document contains Temporary Regulations on Procedure and Administration relating to the definition of the term "subchapter S item" and the exception for small S corporations from the requirement of corporate-level determination of the tax treatment of "subchapter S items." This document also contains Temporary Regulations on the Crude Oil Windfall Profit Tax Act of 1980 relating to the definition of "subchapter S item" under the rules for tax treatment of subchapter S items. Changes to the applicable tax law were made by the Subchapter S Revision Act of 1982. These regulations provide guidance to S corporations, their shareholders, and Internal Revenue Service personnel for compliance with the tax law. The text of the temporary regulations set forth in this document also serves as the text of the proposed regulations cross-referenced in the notice of proposed rulemaking in the Proposed Rules section of this issue of the Federal Register.

DATE: Except as otherwise provided, the regulations contained in this document are effective for taxable years beginning after December 31, 1982.

FOR FURTHER INFORMATION CONTACT: Stuart G. Wessler of the Legislation and Regulations Division, Office of the Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C. 20224. (Attention CC:LR:T, LR-73-86) (202-566-3297, not a toll- free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

Prior to the enactment of the Subchapter S Revision Act of 1982 (96 Stat. 1691), there was only a limited mechanism for making corporate-level tax adjustments since the S corporation generally was not the taxable entity. A shareholder's tax liability was determined in proceedings between the shareholder and the Internal Revenue Service. Thus, issues involving the income or deductions of an S corporation were determined in separate administrative and judicial proceedings involving each shareholder whose tax liability was affected. Periods of limitations were also determined at the shareholder level, based on returns filed by the shareholders. The filing of the S corporation return did not affect the period of limitations applicable to the shareholders.

Section 4(a) of the Subchapter S Revision Act of 1982 added sections 6241-6245 to the Internal Revenue Code to provide for unified corporate-level administrative and judicial proceedings to determine the tax treatment of "subchapter S items" rather than separate shareholder-level proceedings. These provisions generally follow the provisions of subchapter C of chapter 63 of the Code relating to the tax treatment of "partnership items."

EXPLANATION OF PROVISIONS

TAX TREATMENT DETERMINED AT THE CORPORATE LEVEL

For taxable years beginning after December 31, 1982, section 6241 of the Code provides that, except as otherwise provided in regulations, the tax treatment of a subchapter S item shall be determined at the corporate level. The temporary regulations define the term "S corporation" to include any corporation required to file a return under section 6037(a) of the Code. However, the temporary regulations provide a small S corporation exception to the unified corporate-level proceedings similar to the exception provided by Congress under section 6231(a)(1)(B) for small partnerships. The regulations provide that for any taxable year of an S corporation the due date of the return for which (determined without regard to extensions) is on or after January 30, 1987, the unified corporate proceedings do not generally apply to small S corporations. A small S corporation is defined as an S corporation with 5 or fewer shareholders, each of whom is a natural person or an estate. An S corporation does not qualify for the exception if any of its shareholders is a pass-through shareholder (other than a shareholder's estate).

The regulations apply the "5 or fewer" limitation to the aggregate number of persons who are shareholders at any one time during the corporate taxable year. Thus, an S corporation that never has more than 5 shareholders at any one time during the taxable year would be treated as a small S corporation even if, because of transfers, 6 or more shareholders own stock in the S corporation during the course of the taxable year. For purposes of the small S corporation exception, a husband and wife will be treated as one shareholder.

An exempt small S corporation may elect to be subject to the new unified corporate procedures. The regulations provide procedural rules for making this election.

DEFINITION OF SUBCHAPTER S ITEM

Under section 6245 of the Code, the term "subchapter S item" is defined to include any item of an S corporation to the extent regulations provide that the item is more appropriately determined at the corporate level than at the shareholder level. The temporary regulations list the items that the Internal Revenue Service considers to be more appropriately determined at the corporate level for income tax purposes.

Among the items listed are the "pro rata share" items that the corporation must allocate to the shareholders (including special purpose data such as that necessary to enable shareholders to compute depletion). Also included are corporate-level determinations that have a bearing on transactions affecting a shareholder, including contributions to the corporation and distributions to the shareholder. The temporary regulations provide illustrations of corporate-level determinations that have a bearing on contributions and distributions.

WINDFALL PROFIT TAX

Certain windfall profit tax items will be treated as subchapter S items so that the proper treatment of these items will be determined at the corporate level rather than at the shareholder level. A subchapter S item for purposes of the windfall profit tax is any item relating to the computation of the windfall profit tax on crude oil produced by the S corporation for which the Service determines that the tax treatment is more appropriately determined at the corporate level than at the shareholder level. The temporary regulations set forth items which will be treated as subchapter S items for purposes of the windfall profit tax.

OTHER ISSUES

Guidance on other issues raised by subchapter D of chapter 63 of the Code will be provided in later regulations or rulings under sections 6241-6245 of the Code.

SPECIAL ANALYSES

No general notice of proposed rulemaking is required by 5 U.S.C. 553(b) for temporary regulations. Accordingly, the Regulatory Flexibility Act does not apply and no Regulatory Flexibility Analysis is required for this rule. The Commissioner of Internal Revenue has determined that this temporary rule is not a major rule as defined in Executive Order 12291 and that a Regulatory Impact Analysis therefore is not required.

PAPERWORK REDUCTION ACT

The collection of information requirements contained in these temporary regulations have been submitted to the Office of Management and Budget (OMB) in accordance with the Paperwork Reduction Act of 1980. These requirements have been approved by OMB under control number 1545-0130.

DRAFTING INFORMATION

The principal author of these temporary regulations is Stuart G. Wessler of the Legislation and Regulations Division of the Office of Chief Counsel, Internal Revenue Service. However, personnel from other offices of the Internal Revenue Service and Treasury Department participated in developing the regulations, both on matters of substance and style.

LIST OF SUBJECTS IN 26 CFR Part 51

Excise taxes, Petroleum, Crude oil.

LIST OF SUBJECTS IN 26 CFR Part 301

Administrative practice and procedure, Bankruptcy, Courts, Crime, Employment taxes, Excise taxes, Gift taxes, Income taxes, Investigations, Law enforcement, Penalties, Pensions, Statistics, Taxes, Disclosure of information, Filing requirements.

LIST OF SUBJECTS IN 26 CFR Part 301

Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR Parts 51, 301, and 602 are amended as follows:

EXCISE TAX REGULATIONS UNDER THE CRUDE OIL WINDFALL PROFIT TAX OF 1980 (26 CFR Part 51)

Paragraph 1. The authority for 26 CFR Part 51 is amended by adding the following citation:

Authority: 26 U.S.C. 7805 * * * Section 51.6245-1T is also issued under 26 U.S.C. 6245.

Par. 2. New section 51.6245-1T is added in the appropriate place to read as follows:

Section 51.6245-1T Subchapter S items.

(a) IN GENERAL. For purposes of section 6245 and the regulations thereunder, the term "subchapter S item" means any item relating to the determination of the tax imposed by chapter 45 to the extent that such item is more appropriately determined at the corporate level than at the shareholder level.

(b) SUBCHAPTER S ITEMS. The following items with respect to oil removed from any property in which the S corporation holds an interest are more appropriately determined at the corporate level than at the shareholder level and, therefore, are subchapter S items:

(1) The tier or tiers of the crude oil (including the category of the crude oil to the extent determinable at the corporate level);

(2) The quantity of crude oil in each tier;

(3) The adjusted base price and removal price;

(4) The severance tax adjustment;

(5) The determination of whether the oil qualifies as exempt Alaskan oil;

(6) The determination of when removal from the premises occurs and what constitutes the property;

(7) The percentage interest of each shareholder in the oil removed;

(8) The amount of (and each shareholder's share of) the windfall profit tax withheld from, or paid by, the S corporation for S corporation oil removed during the taxable period;

(9) The windfall profit tax liability of each shareholder for that shareholder's share of the S corporation oil removed during the taxable period (computed without regard to the net income limitation and on the assumption that information furnished to the S corporation by the shareholder with respect to the shareholder's status as an independent producer or exempt status is correct); and

(10) The net income limitation to the extent the limitation can be computed at the corporate level.

(c) EFFECTIVE DATE. The provisions of this section are applicable to taxable periods beginning after December 31, 1982.

PROCEDURE AND ADMINISTRATION (26 CFR Part 301)

Par. 3. The authority for 26 CFR Part 301 is amended by adding the following citations:

Authority: 26 U.S.C. 7805. * * * Section 301.6241-1T also issued under 26 U.S.C. 6241. Section 301.6245-1T also issued under 26 U.S.C. 6245.

Par. 4. New sections 301.6241-1T and 301.6245-1T are added in the appropriate places to read as follows:

Section 301.6241-1T Tax treatment determined at corporate level.

(a) IN GENERAL. For a taxable year of an S corporation beginning after December 31, 1982, a shareholder's treatment of a subchapter S item (as defined in section 301.6245-1T) on the shareholder's return may not be changed except as provided in sections 6241-6245 of the Code and the regulations thereunder. Thus, for example, if a shareholder treats an item on the shareholder's return consistently with the treatment of that item on the S corporation return, the Internal Revenue Service generally cannot adjust the treatment of that item on the shareholder's return except through a corporate-level proceeding. Similarly, the shareholder may not put a subchapter S item in issue in a proceeding relating to nonsubchapter S items. For example, the shareholder may not offset a potential increase in taxable income based on changes in nonsubchapter S items by a potential decrease based on subchapter S items.

(b) RESTRICTIONS INAPPLICABLE AFTER ITEMS BECOME NONSUBCHAPTER S ITEMS. Section 6241 and paragraph (a) of this section cease to apply to items arising from an S corporation with respect to a shareholder when those items cease to be subchapter S items with respect to that shareholder under section 6231(b)(1) (as extended to and made applicable to subchapter S items under section 6244).

(c) S CORPORATION--(1) IN GENERAL. For purposes of subchapter D of chapter 63 of the Code, except as provided in paragraph (c)(2) of this section, the term "S corporation" means any corporation required to file a return under section 6037(a).

(2) EXCEPTION FOR SMALL S CORPORATIONS--(i) EFFECTIVE DATE. This paragraph (c)(2) shall apply to any taxable year of an S corporation the due date of the return for which (determined without regard to extensions) is on or after January 30, 1987.

(ii) FIVE OR FEWER SHAREHOLDERS. For purposes of this paragraph (c), an S corporation shall not include a small S corporation. A small S corporation is defined as an S corporation with 5 or fewer shareholders, each of whom is a natural person or an estate. For purposes of this paragraph (c)(2), a husband and wife (and their estates) are treated as one shareholder. If stock (owned other than by a husband and wife) is owned by tenants in common or joint tenants, each tenant in common or joint tenant is considered to be a shareholder of the corporation. The limitation is applied to the number of natural persons and estates that were shareholders at any one time during the taxable year of the corporation. Thus, for example, an S corporation that at no time during the taxable year had more than 5 shareholders may be treated as a small S corporation even if, because of transfers of interests in the corporation, 6 or more natural persons or estates owned stock in the corporation for some portion of the taxable year.

(iii) SPECIAL RULE. The exception provided in paragraph (c)(2)(ii) of this section does not apply to an S corporation for a taxable year if any shareholder in the corporation during that taxable year is a pass-through shareholder. For purposes of this paragraph (c)(2)(iii), a pass-through shareholder is--

(A) A trust;

(B) A nominee; or

(C) Other similar pass-through persons through whom other persons have an ownership interest in the stock of the S corporation.

For purposes of the preceding sentence, a shareholder's estate shall not be treated as a pass-through shareholder.

(iv) DETERMINATION MADE ANNUALLY. The determination of whether an S corporation meets the requirements for the exception under paragraph (c)(2)(ii) of this section shall be made for each taxable year of the corporation. Thus, an S corporation which does not qualify as a small S corporation in one taxable year may qualify as a small S corporation in another taxable year if the requirements for the exception under paragraph (c)(2)(ii) of this section are met with respect to that other taxable year.

(v) ELECTION TO HAVE SUBCHAPTER D OF CHAPTER 63 APPLY--(A) IN GENERAL. Notwithstanding paragraph (c)(2)(ii) of this section, a small S corporation may elect to have the provisions of subchapter D of chapter 63 of the Code apply with respect to that corporation.

(B) METHOD OF ELECTION. A small S corporation shall make the election described in paragraph (c)(2)(v)(A) of this section for a taxable year of the corporation by attaching a statement to the corporate return for the first taxable year for which the election is to be effective. The statement shall be identified as an election under section 301.6241-1T(c)(2)(v)(A), shall be signed by all persons who were shareholders of that corporation at any time during the corporate taxable year to which the return relates, and shall be filed at the time (determined with regard to any extensions of time for filing) and place prescribed for filing the corporate return.

(C) YEARS COVERED BY ELECTION. The election shall be effective for the taxable year of the corporation to which the return relates and all subsequent taxable years of the corporation unless revoked with the consent of the Commissioner.

Section 301.6245-1T Subchapter S items.

(a) IN GENERAL. For purposes of subtitle F of the Internal Revenue Code of 1986, the following items which are required to be taken into account for the taxable year of an S corporation under subtitle A of the Code are more appropriately determined at the corporate level than at the shareholder level and, therefore, are subchapter S items:

(1) The S corporation aggregate and each shareholder's share of, and any factor necessary to determine, each of the following:

(i) Items of income, gain, loss, deduction, or credit of the corporation;

(ii) Expenditures by the corporation not deductible in computing its taxable income (for example, charitable contributions);

(iii) Items of the corporation that may be tax preference items under section 57(a) for any shareholder;

(iv) Items of income of the corporation that are exempt from tax;

(v) Corporate liabilities (including determinations of the amount of the liability, whether the corporate liability is to a shareholder of the corporation, and changes from the preceding year); and

(vi) Other amounts determinable at the corporate level with respect to corporate assets, investments, transactions, and operations necessary to enable the S corporation or the shareholders to determine--

(A) The general business credit provided by section 38;

(B) Recapture under section 47 of the credit provided by section 38;

(C) Amounts at risk in any activity to which section 465 applies;

(D) The depletion allowance under section 613A with respect to oil and gas wells;

(E) Amortization of reforestation expenses under section 194;

(F) The credit provided by section 34 for certain uses of gasoline and special fuels; and

(G) The taxes imposed at the corporate level, such as the taxes imposed under section 56, 1374, or 1375;

(2) Any factor necessary to determine whether the entity is an S corporation under section 1361, such as the number, eligibility, and consent of shareholders and the classes of stock;

(3) Any factor necessary to determine whether the entity has properly elected to be an S corporation under section 1362 for the taxable year;

(4) Any factor necessary to determine whether and when the S corporation election of the entity has been revoked or terminated under section 1362 for the taxable year (for example, the existence and amount of subchapter C earnings and profits, and passive investment income); and

(5) Items relating to the following transactions, to the extent that a determination of such items can be made from determinations that the corporation is required to make with respect to an amount, the character of an amount, or the percentage of stock ownership of a shareholder in the corporation, for purposes of the corporation's books and records or for purposes of furnishing information to a shareholder:

(i) Contributions to the corporation; and

(ii) Distributions from the corporation.

(b) FACTORS THAT AFFECT THE DETERMINATION OF SUBCHAPTER S ITEMS. The term "subchapter S item" includes the accounting practices and the legal and factual determinations that underlie the determination of the existence, amount, timing, and characterization of items of income, credit, gain, loss, deduction, etc. Examples of these determinations are: The S corporation's method of accounting, taxable year, and inventory method; whether an election was made by the corporation; whether corporate property is a capital asset, section 1231 property, or inventory; whether an item is currently deductible or must be capitalized; whether corporate activities had been engaged in with the intent to make a profit for purposes of section 183; whether the corporation qualified for the credit for increasing research activities under section 41; and whether the corporation qualified for the credit for clinical testing expenses for a rare disease or condition under section 28.

(c) ILLUSTRATIONS--(1) IN GENERAL. This paragraph (c) illustrates the provisions of paragraph (a)(5) of this section. The determinations illustrated in this paragraph (c) that the corporation is required to make are not exhaustive; there may be additional determinations that the corporation is required to make which relate to a determination listed in paragraph (a)(5) of this section. The critical element is that the corporation is required to make a determination with respect to a matter for the purposes stated; failure by the corporation actually to make a determination (for example, because it does not maintain proper books and records) does not prevent an item from being a subchapter S item.

(2) CONTRIBUTIONS. For purposes of its books and records, or for purposes of furnishing information to a shareholder, the S corporation must determine:

(i) The character of the amount received by the corporation (for example, whether it is a contribution, loan, or repayment of a loan);

(ii) The amount of money received by the corporation; and

(iii) The basis to the corporation of contributed property (including necessary preliminary determinations, such as the shareholder's basis in the contributed property).

To the extent that a determination of an item relating to a contribution can be made from these and similar determinations that the corporation is required to make, that item is a subchapter S item. To the extent that the determination requires other information, however, that item is not a subchapter S item. Such other information would include those factors used in determining whether there is recapture under section 47 by the contributing shareholder of the general business credit because of the contribution of property in circumstances in which that determination is irrelevant to the corporation.

(3) DISTRIBUTIONS. For purposes of its books and records, or for purposes of furnishing information to a shareholder, the S corporation must determine:

(i) The character of the amount transferred to a shareholder (for example, whether it is a dividend, compensation, loan, or repayment of a loan);

(ii) The amount of money distributed to a shareholder;

(iii) The fair market value of property distributed to a shareholder;

(iv) The adjusted basis to the corporation of distributed property; and

(v) The character of corporation property (for example, whether an item is inventory or a capital asset).

To the extent that a determination of an item relating to a distribution can be made from these and similar determinations that the corporation is required to make, that item is a subchapter S item. To the extent that the determination requires other information, however, that item is not a subchapter S item. Such other information would include the determination of a shareholder's basis in the shareholder's stock or in the indebtedness of the S corporation to the shareholder.

(d) CROSS REFERENCE. For the definition of subchapter S item for purposes of the windfall profit tax, see section 51.6245-1T.

(e) EFFECTIVE DATE. This section shall apply to taxable years beginning after December 31, 1982.

OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT (26 CFR Part 602)

Par. 5. The authority for 26 CFR Part 602 continues to read as following:

Authority: 26 U.S.C. 7805.

Par. 6. Section 602.101(c) is amended by inserting the following item in the appropriate place in the table:

Section 301.6241-1T . . . . 1545-0130.

* * * * *

There is need for immediate guidance with respect to the provisions contained in this Treasury decision. For this reason it is found impracticable to issue it with notice and public procedure under subsection (b) of section 553 of Title 5 of the United States Code or subject to the effective date limitation of subsection (d) of that section.

Lawrence B. Gibbs