Adjustment To Net Unrealized Built-in Gain, 8727-8729 [05-3462]

Download as PDF Federal Register / Vol. 70, No. 35 / Wednesday, February 23, 2005 / Rules and Regulations verification or copying of any such required record, is a prohibited act under section 301 of the act. * * * * * n 9. In § 1.368, revise paragraph (a) to read as follows: § 1.368 What are the compliance dates for this subpart? * * * * * (a) The compliance date for the requirements in this subpart is June 9,2006, for small businesses employing fewer that 500, but more than 10 fulltime equivalent employees. * * * * * Dated: February 16, 2005. Jeffrey Shuren, Assistant Commissioner for Policy. [FR Doc. 05–3424 Filed 2–22–05; 8:45 am] BILLING CODE 4160–01–S DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1 [TD 9180] RIN 1545–BC29 Adjustment To Net Unrealized Built-in Gain AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. SUMMARY: This document contains final regulations under section 1374 that provide for an adjustment to the amount that may be subject to tax under section 1374 in certain cases in which an S corporation acquires assets from a C corporation in an acquisition to which section 1374(d)(8) applies. These final regulations provide guidance to certain S corporations that acquire assets from a C corporation in a carryover basis transaction. DATES: Effective Date: These regulations are effective February 23, 2005. Applicability Dates: For dates of applicability, see § 1.1374–10. FOR FURTHER INFORMATION CONTACT: Jennifer D. Sledge, (202) 622–7750 (not a toll-free number). SUPPLEMENTARY INFORMATION: Background and Explanation of Provisions This document contains amendments to Income Tax Regulations (26 CFR part 1) under section 1374 of the Internal Revenue Code (Code), relating to the tax imposed on certain recognized built-in VerDate jul<14>2003 16:23 Feb 22, 2005 Jkt 205001 gains of S corporations. Section 1374 imposes a tax on an S corporation’s net recognized built-in gain attributable to assets that it held on the date it converted from a C corporation to an S corporation for the 10-year period beginning on the first day the corporation is an S corporation and assets that it acquired from a C corporation in a carryover basis transaction for the 10-year period beginning on the day of the acquisition. A separate determination of the amount subject to tax under section 1374 is required for those assets the S corporation held on the date it converted to C status and each pool of assets the S corporation acquired in a carryover basis transaction from a C corporation. The total amount subject to tax under section 1374 for each pool of assets is limited to that pool’s net unrealized built-in gain (NUBIG) on the date of the conversion or acquisition. Under the current rules, if X, a C corporation, elects to be an S corporation when it owns some or all of the stock of Y, a C corporation, and Y subsequently transfers its assets to X in a liquidation to which sections 332 and 337(a) apply or in a reorganization described in section 368(a), the built-in gain or built-in loss in Y’s assets may be wholly or partially reflected twice: once in the NUBIG attributable to the assets X owned on the date of its conversion (including the Y stock) and a second time in the NUBIG attributable to Y’s former assets acquired by X in the liquidation of Y. The IRS and Treasury Department recognize that continuing to reflect the built-in gain or the built-in loss in the Y stock at the time of X’s conversion after the liquidation or reorganization is inconsistent with the fact that such liquidation or reorganization has the effect of eliminating that built-in gain or built-in loss. Therefore, on June 25, 2004, the IRS and Treasury Department published in the Federal Register (69 FR 35544) a notice of proposed rulemaking (REG– 131486–03) that includes regulations proposing an adjustment to the NUBIG in these cases. In particular, the proposed regulations generally provide that, if an S corporation acquires assets of a C corporation in a carryover basis transaction, some or all of the stock of the C corporation from which such assets were acquired was taken into account in the computation of NUBIG for a pool of assets of the S corporation, and some or all of such stock is redeemed or canceled in such transaction, then, subject to certain limitations, such NUBIG is adjusted to eliminate any effect any built-in gain or PO 00000 Frm 00019 Fmt 4700 Sfmt 4700 8727 built-in loss in the redeemed or canceled stock had on the initial computation of NUBIG for that pool of assets. These regulations are proposed to apply for taxable years beginning after the date they are published as final regulations in the Federal Register. No public hearing was requested or held regarding the proposed regulations. One written comment, however, was received. That comment requested that the proposed regulations be made effective as soon as possible. These final regulations adopt the proposed regulations without substantive change as final regulations. However, the final regulations do modify the proposed effective date of the regulations. The final regulations apply to section 1374(d)(8) transactions that occur in taxable years beginning after February 23, 2005. The final regulations also provide that an S corporation may apply the regulations to section 1374(d)(8) transactions that occur in taxable years beginning on or before February 23, 2005, if the S corporation (and any predecessors or successors) and all affected shareholders file original or amended returns that are consistent with the regulations for taxable years of the S corporation during the recognition period of the pool of assets the NUBIG of which would be adjusted pursuant to the regulations that are not closed as of the first date after February 23, 2005, that the S corporation files an original or amended return. Special Analyses It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations and, because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Code, this regulation was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business. Drafting Information The principal author of these regulations is Jennifer D. Sledge of the Office of Associate Chief Counsel (Corporate). Other personnel from Treasury and the IRS participated in their development. E:\FR\FM\23FER1.SGM 23FER1 8728 Federal Register / Vol. 70, No. 35 / Wednesday, February 23, 2005 / Rules and Regulations List of Subjects in 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. Proposed Amendments to the Regulations Accordingly, 26 CFR part 1 is amended as follows: n PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 continues to read, in part, as follows: n Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.1374–3 is amended by: n 1. Revising paragraph (b). n 2. Adding paragraph (c). The revision and addition read as follows: n § 1.1374–3 Net unrealized built-in gain. * * * * (b) Adjustment to net unrealized builtin gain—(1) In general. If section 1374(d)(8) applies to an S corporation’s acquisition of assets, some or all of the stock of the corporation from which such assets were acquired was taken into account in the computation of the net unrealized built-in gain for a pool of assets of the S corporation, and some or all of such stock is redeemed or canceled in such transaction, then, subject to the limitations of paragraph (b)(2) of this section, such net unrealized built-in gain is adjusted to eliminate any effect that any built-in gain or built-in loss in the redeemed or canceled stock (other than stock with respect to which a loss under section 165 is claimed) had on the initial computation of net unrealized built-in gain for that pool of assets. For purposes of this paragraph, stock described in section 1374(d)(6) shall be treated as taken into account in the computation of the net unrealized built-in gain for a pool of assets of the S corporation. (2) Limitations on adjustment—(i) Recognized built-in gain or loss. Net unrealized built-in gain for a pool of assets of the S corporation is only adjusted under paragraph (b)(1) of this section to reflect built-in gain or builtin loss in the redeemed or canceled stock that has not resulted in recognized built-in gain or recognized built-in loss during the recognition period. (ii) Anti-duplication rule. Paragraph (b)(1) of this section shall not be applied to duplicate an adjustment to the net unrealized built-in gain for a pool of assets made pursuant to paragraph (b)(1) of this section. (3) Effect of adjustment. Any adjustment to the net unrealized built- in gain made pursuant to this paragraph (b) only affects computations of the amount subject to tax under section 1374 for taxable years that end on or after the date of the acquisition to which section 1374(d)(8) applies. (4) Pool of assets. For purposes of this section, a pool of assets means— (i) The assets held by the corporation on the first day it became an S corporation, if the corporation was previously a C corporation; or (ii) The assets the S corporation acquired from a C corporation in a section 1374(d)(8) transaction. (c) Examples. The following examples illustrate the rules of this section: Example 1. Computation of net unrealized built-in gain. (i)(A) X, a calendar year C corporation using the cash method, elects to become an S corporation on January 1, 1996. On December 31, 1995, X has assets and liabilities as follows: * VerDate jul<14>2003 16:23 Feb 22, 2005 Jkt 205001 Assets FMV Basis Factory .................... Accounts Receivable ..................... Goodwill .................. $500,000 $900,000 300,000 250,000 0 0 Total .................... 1,050,000 900,000 Liabilities Amount Mortgage ....................................... Accounts Payable ......................... $200,000 100,000 Total .......................................... 300,000 (B) Further, X must include a total of $60,000 in taxable income in 1996, 1997, and 1998 under section 481(a). (ii) If, on December 31, 1995, X sold all its assets to a third party that assumed all its liabilities, X’s amount realized would be $1,050,000 ($750,000 cash received + $300,000 liabilities assumed = $1,050,000). Thus, X’s net unrealized built-in gain is determined as follows: Amount realized ...................... Deduction allowed (A/P) ......... Basis of X’s assets ................. Section 481 adjustments ........ Net unrealized built-in gain ..... $1,050,000 (100,000) (900,000) 60,000 110,000 Example 2. Adjustment to net unrealized built-in gain for built-in gain in eliminated C corporation stock. (i) X, a calendar year C corporation, elects to become an S corporation effective January 1, 2005. On that date, X’s assets (the first pool of assets) have a net unrealized built-in gain of $15,000. Among the assets in the first pool of assets is all of the outstanding stock of Y, a C corporation, with a fair market value of $33,000 and an adjusted basis of $18,000. On March 1, 2009, X sells an asset that it owned on January 1, 2005, and as a result has $10,000 of recognized built-in gain. X has had no other recognized built-in gain or built-in loss. X’s taxable income limitation for 2009 is $50,000. Effective June 1, 2009, PO 00000 Frm 00020 Fmt 4700 Sfmt 4700 X elects under section 1361 to treat Y as a qualified subchapter S subsidiary (QSub). The election is treated as a transfer of Y’s assets to X in a liquidation to which sections 332 and 337(a) apply. (ii) Under paragraph (b) of this section, the net unrealized built in-gain of the first pool of assets is adjusted to account for the elimination of the Y stock in the liquidation. The net unrealized built-in gain of the first pool of assets, therefore, is decreased by $15,000, the amount by which the fair market value of the Y stock exceeded its adjusted basis as of January 1, 2005. Accordingly, for taxable years ending after June 1, 2009, the net unrealized built-in gain of the first pool of assets is $0. (iii) Under § 1.1374–2(a), X’s net recognized built-in gain for any taxable year equals the least of X’s pre-limitation amount, taxable income limitation, and net unrealized built-in gain limitation. In 2009, X’s prelimitation amount is $10,000, X’s taxable income limitation is $50,000, and X’s net unrealized built-in gain limitation is $0. Because the net unrealized built-in gain of the first pool of assets has been adjusted to $0, despite the $10,000 of recognized builtin gain in 2009, X has $0 net recognized built-in gain for the taxable year ending on December 31, 2009. Example 3. Adjustment to net unrealized built-in gain for built-in loss in eliminated C corporation stock. (i) X, a calendar year C corporation, elects to become an S corporation effective January 1, 2005. On that date, X’s assets (the first pool of assets) have a net unrealized built-in gain of negative $5,000. Among the assets in the first pool of assets is 10 percent of the outstanding stock of Y, a C corporation, with a fair market value of $18,000 and an adjusted basis of $33,000. On March 1, 2009, X sells an asset that it owned on January 1, 2005, resulting in $8,000 of recognized built-in gain. X has had no other recognized built-in gains or built-in losses. X’s taxable income limitation for 2009 is $50,000. On June 1, 2009, Y transfers its assets to X in a reorganization under section 368(a)(1)(C). (ii) Under paragraph (b) of this section, the net unrealized built in-gain of the first pool of assets is adjusted to account for the elimination of the Y stock in the reorganization. The net unrealized built-in gain of the first pool of assets, therefore, is increased by $15,000, the amount by which the adjusted basis of the Y stock exceeded its fair market value as of January 1, 2005. Accordingly, for taxable years ending after June 1, 2009, the net unrealized built-in gain of the first pool of assets is $10,000. (iii) Under § 1.1374–2(a), X’s net recognized built-in gain for any taxable year equals the least of X’s pre-limitation amount, taxable income limitation, and net unrealized built-in gain limitation. In 2009, X’s prelimitation amount is $8,000 and X’s taxable income limitation is $50,000. The net unrealized built-in gain of the first pool of assets has been adjusted to $10,000, so X’s net unrealized built-in gain limitation is $10,000. X, therefore, has $8,000 net recognized built-in gain for the taxable year ending on December 31, 2009. X’s net unrealized built-in gain limitation for 2010 is $2,000. E:\FR\FM\23FER1.SGM 23FER1 Federal Register / Vol. 70, No. 35 / Wednesday, February 23, 2005 / Rules and Regulations Example 4. Adjustment to net unrealized built-in gain in case of prior gain recognition. (i) X, a calendar year C corporation, elects to become an S corporation effective January 1, 2005. On that date, X’s assets (the first pool of assets) have a net unrealized built-in gain of $30,000. Among the assets in the first pool of assets is all of the outstanding stock of Y, a C corporation, with a fair market value of $45,000 and an adjusted basis of $10,000. Y has no current or accumulated earnings and profits. On April 1, 2007, Y distributes $18,000 to X, $8,000 of which is treated as gain to X from the sale or exchange of property under section 301(c)(3). That $8,000 is recognized built-in gain to X under section 1374(d)(3), and results in $8,000 of net recognized built-in gain to X for 2007. X’s net unrealized built-in gain limitation for 2008 is $22,000. On June 1, 2009, Y transfers its assets to X in a liquidation to which sections 332 and 337(a) apply. (ii) Under paragraph (b) of this section, the net unrealized built in-gain of the first pool of assets is adjusted to account for the elimination of the Y stock in the liquidation. The net unrealized built-in gain of that pool of assets, however, can only be adjusted to reflect the amount of built-in gain that was inherent in the Y stock on January 1, 2005 that has not resulted in recognized built-in gain during the recognition period. In this case, therefore, the net unrealized built-in gain of the first pool of assets cannot be reduced by more than $27,000 ($35,000, the amount by which the fair market value of the Y stock exceeded its adjusted basis as of January 1, 2005, minus $8,000, the recognized built-in gain with respect to the stock during the recognition period). Accordingly, for taxable years ending after June 1, 2009, the net unrealized built-in gain of the first pool of assets is $3,000. The net unrealized built-in gain limitation for 2009 is $0. Par. 3. Paragraph (a) of § 1.1374–10 is revised to read as follows: n § 1.1374–10 rules. Effective date and additional (a) In general. Sections 1.1374–1 through 1.1374–9, other than § 1.1374– 3(b) and (c) Examples 2 through 4, apply for taxable years ending on or after December 27, 1994, but only in cases where the S corporation’s return for the taxable year is filed pursuant to an S election or a section 1374(d)(8) transaction occurring on or after December 27, 1994. Section 1.1374–3(b) and (c) Examples 2 through 4 apply to section 1374(d)(8) transactions that occur in taxable years beginning after February 23, 2005. In addition, an S corporation may apply § 1.1374–3(b) and (c) Examples 2 through 4 to section 1374(d)(8) transactions that occur in taxable years beginning on or before February 23, 2005, if the S corporation (and any predecessors or successors) and all affected shareholders file original or amended returns that are consistent with these provisions for VerDate jul<14>2003 16:23 Feb 22, 2005 Jkt 205001 taxable years of the S corporation during the recognition period of the pool of assets the net unrealized built-in gain of which would be adjusted pursuant to those provisions that are not closed as of the first date after February 23, 2005, that the S corporation files an original or amended return. For purposes of this section, affected shareholders means all shareholders who received distributive shares of S corporation items in such taxable years. However, the Commissioner may, in appropriate circumstances, permit taxpayers to apply these provisions even if all affected shareholders cannot file consistent returns. In addition, for this purpose, a predecessor of an S corporation is a corporation that transfers its assets to the S corporation in a transaction to which section 381 applies. A successor of an S corporation is a corporation to which the S corporation transfers its assets in a transaction to which section 381 applies. * * * * * Mark E. Matthews, Deputy Commissioner for Services and Enforcement. Approved: February 14, 2005. Eric Solomon, Acting Deputy Assistant Secretary of the Treasury. FR Doc. 05–3462 Filed 2–22–05; 8:45 am] BILLING CODE 4830–01–P DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1 [TD 9179] RIN 1545–BB62 Uniform Capitalization of Interest Expense in Safe Harbor Sale and Leaseback Transactions AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. SUMMARY: This document contains amendments to regulations relating to the capitalization of interest expense incurred in sale and leaseback transactions under the Economic Recovery Tax Act of 1981 (ERTA) safe harbor leasing provisions. The regulations affect taxpayers that provide purchase money obligations in connection with these transactions. DATES: Effective Date: These regulations are effective February 23, 2005. Applicability Dates: For dates of applicability, see § 1.263A–15(a)(3). PO 00000 Frm 00021 Fmt 4700 Sfmt 4700 8729 FOR FURTHER INFORMATION CONTACT: Christian Wood, 202–622–4930 (not a toll-free number). SUPPLEMENTARY INFORMATION: Background This document contains amendments to 26 CFR part 1. On May 20, 2004, the IRS and Treasury Department published in the Federal Register a notice of proposed rulemaking (REG–148399–02; 69 FR 29113) by cross reference to temporary regulations (TD 9129; 69 FR 29066) under section 263A(f) of the Internal Revenue Code (Code). These amendments pertain to the treatment of certain interest expense incurred by the lessor in a sale and leaseback transaction under the ERTA safe harbor leasing provisions (former section 168(f)(8), as enacted by section 201(a) of ERTA, Public Law 97–34, 95 Stat. 214). No comments in response to the proposed regulations or requests to speak at a public hearing were received, and no hearing was held. The proposed regulations under section 263A(f) are adopted by this Treasury decision. Effective Date These final regulations generally apply to interest incurred in taxable years beginning on or after May 20, 2004. In the case of property that is inventory in the hands of the taxpayer, these regulations apply to taxable years beginning on or after May 20, 2004. Taxpayers may elect to apply these regulations to interest incurred in taxable years beginning on or after January 1, 1995, or, in the case of property that is inventory in the hands of the taxpayer, to taxable years beginning on or after January 1, 1995 (the general effective date of the interest capitalization regulations). In addition, for purposes of § 1.263A– 15(a)(2), the exclusion of purchase money obligations given by the lessor to the lessee (or a party related to the lessee) in a sale and leaseback transaction under former section 168(f)(8) as enacted by ERTA will be considered to be a reasonable position for the application of section 263A(f) in taxable years beginning before January 1, 1995. Consequently, a taxpayer changing a method of accounting for property that is not inventory in the hands of the taxpayer to conform to these regulations may elect to include interest incurred after December 31, 1986, in taxable years beginning on or after December 31, 1986 (the general effective date of section 263A), and before January 1, 1995, in the determination of its adjustment under section 481(a). A taxpayer changing a method of accounting for property that E:\FR\FM\23FER1.SGM 23FER1

Agencies

[Federal Register Volume 70, Number 35 (Wednesday, February 23, 2005)]
[Rules and Regulations]
[Pages 8727-8729]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-3462]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9180]
RIN 1545-BC29


Adjustment To Net Unrealized Built-in Gain

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final regulations under section 1374 
that provide for an adjustment to the amount that may be subject to tax 
under section 1374 in certain cases in which an S corporation acquires 
assets from a C corporation in an acquisition to which section 
1374(d)(8) applies. These final regulations provide guidance to certain 
S corporations that acquire assets from a C corporation in a carryover 
basis transaction.

DATES: Effective Date: These regulations are effective February 23, 
2005.
    Applicability Dates: For dates of applicability, see Sec.  1.1374-
10.

FOR FURTHER INFORMATION CONTACT: Jennifer D. Sledge, (202) 622-7750 
(not a toll-free number).

SUPPLEMENTARY INFORMATION: 

Background and Explanation of Provisions

    This document contains amendments to Income Tax Regulations (26 CFR 
part 1) under section 1374 of the Internal Revenue Code (Code), 
relating to the tax imposed on certain recognized built-in gains of S 
corporations. Section 1374 imposes a tax on an S corporation's net 
recognized built-in gain attributable to assets that it held on the 
date it converted from a C corporation to an S corporation for the 10-
year period beginning on the first day the corporation is an S 
corporation and assets that it acquired from a C corporation in a 
carryover basis transaction for the 10-year period beginning on the day 
of the acquisition. A separate determination of the amount subject to 
tax under section 1374 is required for those assets the S corporation 
held on the date it converted to C status and each pool of assets the S 
corporation acquired in a carryover basis transaction from a C 
corporation. The total amount subject to tax under section 1374 for 
each pool of assets is limited to that pool's net unrealized built-in 
gain (NUBIG) on the date of the conversion or acquisition.
    Under the current rules, if X, a C corporation, elects to be an S 
corporation when it owns some or all of the stock of Y, a C 
corporation, and Y subsequently transfers its assets to X in a 
liquidation to which sections 332 and 337(a) apply or in a 
reorganization described in section 368(a), the built-in gain or built-
in loss in Y's assets may be wholly or partially reflected twice: once 
in the NUBIG attributable to the assets X owned on the date of its 
conversion (including the Y stock) and a second time in the NUBIG 
attributable to Y's former assets acquired by X in the liquidation of 
Y. The IRS and Treasury Department recognize that continuing to reflect 
the built-in gain or the built-in loss in the Y stock at the time of 
X's conversion after the liquidation or reorganization is inconsistent 
with the fact that such liquidation or reorganization has the effect of 
eliminating that built-in gain or built-in loss. Therefore, on June 25, 
2004, the IRS and Treasury Department published in the Federal Register 
(69 FR 35544) a notice of proposed rulemaking (REG-131486-03) that 
includes regulations proposing an adjustment to the NUBIG in these 
cases. In particular, the proposed regulations generally provide that, 
if an S corporation acquires assets of a C corporation in a carryover 
basis transaction, some or all of the stock of the C corporation from 
which such assets were acquired was taken into account in the 
computation of NUBIG for a pool of assets of the S corporation, and 
some or all of such stock is redeemed or canceled in such transaction, 
then, subject to certain limitations, such NUBIG is adjusted to 
eliminate any effect any built-in gain or built-in loss in the redeemed 
or canceled stock had on the initial computation of NUBIG for that pool 
of assets. These regulations are proposed to apply for taxable years 
beginning after the date they are published as final regulations in the 
Federal Register.
    No public hearing was requested or held regarding the proposed 
regulations. One written comment, however, was received. That comment 
requested that the proposed regulations be made effective as soon as 
possible.
    These final regulations adopt the proposed regulations without 
substantive change as final regulations. However, the final regulations 
do modify the proposed effective date of the regulations. The final 
regulations apply to section 1374(d)(8) transactions that occur in 
taxable years beginning after February 23, 2005. The final regulations 
also provide that an S corporation may apply the regulations to section 
1374(d)(8) transactions that occur in taxable years beginning on or 
before February 23, 2005, if the S corporation (and any predecessors or 
successors) and all affected shareholders file original or amended 
returns that are consistent with the regulations for taxable years of 
the S corporation during the recognition period of the pool of assets 
the NUBIG of which would be adjusted pursuant to the regulations that 
are not closed as of the first date after February 23, 2005, that the S 
corporation files an original or amended return.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations and, because the 
regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Therefore, a Regulatory Flexibility Analysis is not required. 
Pursuant to section 7805(f) of the Code, this regulation was submitted 
to the Chief Counsel for Advocacy of the Small Business Administration 
for comment on their impact on small business.

Drafting Information

    The principal author of these regulations is Jennifer D. Sledge of 
the Office of Associate Chief Counsel (Corporate). Other personnel from 
Treasury and the IRS participated in their development.

[[Page 8728]]

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read, in 
part, as follows:

    Authority: 26 U.S.C. 7805 * * *


0
Par. 2. Section 1.1374-3 is amended by:
0
1. Revising paragraph (b).
0
2. Adding paragraph (c).
    The revision and addition read as follows:


Sec.  1.1374-3  Net unrealized built-in gain.

* * * * *
    (b) Adjustment to net unrealized built-in gain--(1) In general. If 
section 1374(d)(8) applies to an S corporation's acquisition of assets, 
some or all of the stock of the corporation from which such assets were 
acquired was taken into account in the computation of the net 
unrealized built-in gain for a pool of assets of the S corporation, and 
some or all of such stock is redeemed or canceled in such transaction, 
then, subject to the limitations of paragraph (b)(2) of this section, 
such net unrealized built-in gain is adjusted to eliminate any effect 
that any built-in gain or built-in loss in the redeemed or canceled 
stock (other than stock with respect to which a loss under section 165 
is claimed) had on the initial computation of net unrealized built-in 
gain for that pool of assets. For purposes of this paragraph, stock 
described in section 1374(d)(6) shall be treated as taken into account 
in the computation of the net unrealized built-in gain for a pool of 
assets of the S corporation.
    (2) Limitations on adjustment--(i) Recognized built-in gain or 
loss. Net unrealized built-in gain for a pool of assets of the S 
corporation is only adjusted under paragraph (b)(1) of this section to 
reflect built-in gain or built-in loss in the redeemed or canceled 
stock that has not resulted in recognized built-in gain or recognized 
built-in loss during the recognition period.
    (ii) Anti-duplication rule. Paragraph (b)(1) of this section shall 
not be applied to duplicate an adjustment to the net unrealized built-
in gain for a pool of assets made pursuant to paragraph (b)(1) of this 
section.
    (3) Effect of adjustment. Any adjustment to the net unrealized 
built-in gain made pursuant to this paragraph (b) only affects 
computations of the amount subject to tax under section 1374 for 
taxable years that end on or after the date of the acquisition to which 
section 1374(d)(8) applies.
    (4) Pool of assets. For purposes of this section, a pool of assets 
means--
    (i) The assets held by the corporation on the first day it became 
an S corporation, if the corporation was previously a C corporation; or
    (ii) The assets the S corporation acquired from a C corporation in 
a section 1374(d)(8) transaction.
    (c) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Computation of net unrealized built-in gain. (i)(A) 
X, a calendar year C corporation using the cash method, elects to 
become an S corporation on January 1, 1996. On December 31, 1995, X 
has assets and liabilities as follows:

------------------------------------------------------------------------
                      Assets                           FMV       Basis
------------------------------------------------------------------------
Factory..........................................    $500,000   $900,000
Accounts Receivable..............................     300,000          0
Goodwill.........................................     250,000          0
                                                  -------------
  Total..........................................   1,050,000    900,000
------------------------------------------------------------------------


 
                         Liabilities                             Amount
------------------------------------------------------------------------
Mortgage.....................................................   $200,000
Accounts Payable.............................................    100,000
                                                              ----------
  Total......................................................    300,000
------------------------------------------------------------------------

    (B) Further, X must include a total of $60,000 in taxable income 
in 1996, 1997, and 1998 under section 481(a).
    (ii) If, on December 31, 1995, X sold all its assets to a third 
party that assumed all its liabilities, X's amount realized would be 
$1,050,000 ($750,000 cash received + $300,000 liabilities assumed = 
$1,050,000). Thus, X's net unrealized built-in gain is determined as 
follows:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Amount realized...........................................    $1,050,000
Deduction allowed (A/P)...................................     (100,000)
Basis of X's assets.......................................     (900,000)
Section 481 adjustments...................................        60,000
Net unrealized built-in gain..............................       110,000
------------------------------------------------------------------------

    Example 2. Adjustment to net unrealized built-in gain for built-
in gain in eliminated C corporation stock. (i) X, a calendar year C 
corporation, elects to become an S corporation effective January 1, 
2005. On that date, X's assets (the first pool of assets) have a net 
unrealized built-in gain of $15,000. Among the assets in the first 
pool of assets is all of the outstanding stock of Y, a C 
corporation, with a fair market value of $33,000 and an adjusted 
basis of $18,000. On March 1, 2009, X sells an asset that it owned 
on January 1, 2005, and as a result has $10,000 of recognized built-
in gain. X has had no other recognized built-in gain or built-in 
loss. X's taxable income limitation for 2009 is $50,000. Effective 
June 1, 2009, X elects under section 1361 to treat Y as a qualified 
subchapter S subsidiary (QSub). The election is treated as a 
transfer of Y's assets to X in a liquidation to which sections 332 
and 337(a) apply.
    (ii) Under paragraph (b) of this section, the net unrealized 
built in-gain of the first pool of assets is adjusted to account for 
the elimination of the Y stock in the liquidation. The net 
unrealized built-in gain of the first pool of assets, therefore, is 
decreased by $15,000, the amount by which the fair market value of 
the Y stock exceeded its adjusted basis as of January 1, 2005. 
Accordingly, for taxable years ending after June 1, 2009, the net 
unrealized built-in gain of the first pool of assets is $0.
    (iii) Under Sec.  1.1374-2(a), X's net recognized built-in gain 
for any taxable year equals the least of X's pre-limitation amount, 
taxable income limitation, and net unrealized built-in gain 
limitation. In 2009, X's pre-limitation amount is $10,000, X's 
taxable income limitation is $50,000, and X's net unrealized built-
in gain limitation is $0. Because the net unrealized built-in gain 
of the first pool of assets has been adjusted to $0, despite the 
$10,000 of recognized built-in gain in 2009, X has $0 net recognized 
built-in gain for the taxable year ending on December 31, 2009.
    Example 3. Adjustment to net unrealized built-in gain for built-
in loss in eliminated C corporation stock. (i) X, a calendar year C 
corporation, elects to become an S corporation effective January 1, 
2005. On that date, X's assets (the first pool of assets) have a net 
unrealized built-in gain of negative $5,000. Among the assets in the 
first pool of assets is 10 percent of the outstanding stock of Y, a 
C corporation, with a fair market value of $18,000 and an adjusted 
basis of $33,000. On March 1, 2009, X sells an asset that it owned 
on January 1, 2005, resulting in $8,000 of recognized built-in gain. 
X has had no other recognized built-in gains or built-in losses. X's 
taxable income limitation for 2009 is $50,000. On June 1, 2009, Y 
transfers its assets to X in a reorganization under section 
368(a)(1)(C).
    (ii) Under paragraph (b) of this section, the net unrealized 
built in-gain of the first pool of assets is adjusted to account for 
the elimination of the Y stock in the reorganization. The net 
unrealized built-in gain of the first pool of assets, therefore, is 
increased by $15,000, the amount by which the adjusted basis of the 
Y stock exceeded its fair market value as of January 1, 2005. 
Accordingly, for taxable years ending after June 1, 2009, the net 
unrealized built-in gain of the first pool of assets is $10,000.
    (iii) Under Sec.  1.1374-2(a), X's net recognized built-in gain 
for any taxable year equals the least of X's pre-limitation amount, 
taxable income limitation, and net unrealized built-in gain 
limitation. In 2009, X's pre-limitation amount is $8,000 and X's 
taxable income limitation is $50,000. The net unrealized built-in 
gain of the first pool of assets has been adjusted to $10,000, so 
X's net unrealized built-in gain limitation is $10,000. X, 
therefore, has $8,000 net recognized built-in gain for the taxable 
year ending on December 31, 2009. X's net unrealized built-in gain 
limitation for 2010 is $2,000.

[[Page 8729]]

    Example 4. Adjustment to net unrealized built-in gain in case of 
prior gain recognition. (i) X, a calendar year C corporation, elects 
to become an S corporation effective January 1, 2005. On that date, 
X's assets (the first pool of assets) have a net unrealized built-in 
gain of $30,000. Among the assets in the first pool of assets is all 
of the outstanding stock of Y, a C corporation, with a fair market 
value of $45,000 and an adjusted basis of $10,000. Y has no current 
or accumulated earnings and profits. On April 1, 2007, Y distributes 
$18,000 to X, $8,000 of which is treated as gain to X from the sale 
or exchange of property under section 301(c)(3). That $8,000 is 
recognized built-in gain to X under section 1374(d)(3), and results 
in $8,000 of net recognized built-in gain to X for 2007. X's net 
unrealized built-in gain limitation for 2008 is $22,000. On June 1, 
2009, Y transfers its assets to X in a liquidation to which sections 
332 and 337(a) apply.
    (ii) Under paragraph (b) of this section, the net unrealized 
built in-gain of the first pool of assets is adjusted to account for 
the elimination of the Y stock in the liquidation. The net 
unrealized built-in gain of that pool of assets, however, can only 
be adjusted to reflect the amount of built-in gain that was inherent 
in the Y stock on January 1, 2005 that has not resulted in 
recognized built-in gain during the recognition period. In this 
case, therefore, the net unrealized built-in gain of the first pool 
of assets cannot be reduced by more than $27,000 ($35,000, the 
amount by which the fair market value of the Y stock exceeded its 
adjusted basis as of January 1, 2005, minus $8,000, the recognized 
built-in gain with respect to the stock during the recognition 
period). Accordingly, for taxable years ending after June 1, 2009, 
the net unrealized built-in gain of the first pool of assets is 
$3,000. The net unrealized built-in gain limitation for 2009 is $0.


0
Par. 3. Paragraph (a) of Sec.  1.1374-10 is revised to read as follows:


Sec.  1.1374-10  Effective date and additional rules.

    (a) In general. Sections 1.1374-1 through 1.1374-9, other than 
Sec.  1.1374-3(b) and (c) Examples 2 through 4, apply for taxable years 
ending on or after December 27, 1994, but only in cases where the S 
corporation's return for the taxable year is filed pursuant to an S 
election or a section 1374(d)(8) transaction occurring on or after 
December 27, 1994. Section 1.1374-3(b) and (c) Examples 2 through 4 
apply to section 1374(d)(8) transactions that occur in taxable years 
beginning after February 23, 2005. In addition, an S corporation may 
apply Sec.  1.1374-3(b) and (c) Examples 2 through 4 to section 
1374(d)(8) transactions that occur in taxable years beginning on or 
before February 23, 2005, if the S corporation (and any predecessors or 
successors) and all affected shareholders file original or amended 
returns that are consistent with these provisions for taxable years of 
the S corporation during the recognition period of the pool of assets 
the net unrealized built-in gain of which would be adjusted pursuant to 
those provisions that are not closed as of the first date after 
February 23, 2005, that the S corporation files an original or amended 
return. For purposes of this section, affected shareholders means all 
shareholders who received distributive shares of S corporation items in 
such taxable years. However, the Commissioner may, in appropriate 
circumstances, permit taxpayers to apply these provisions even if all 
affected shareholders cannot file consistent returns. In addition, for 
this purpose, a predecessor of an S corporation is a corporation that 
transfers its assets to the S corporation in a transaction to which 
section 381 applies. A successor of an S corporation is a corporation 
to which the S corporation transfers its assets in a transaction to 
which section 381 applies.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: February 14, 2005.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.
FR Doc. 05-3462 Filed 2-22-05; 8:45 am]
BILLING CODE 4830-01-P