S Corporation Guidance Under AJCA of 2004 and GOZA of 2005, 47526-47531 [E8-18782]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 73, Number 158 (Thursday, August 14, 2008)]
[Rules and Regulations]
[Pages 47526-47531]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-18782]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9422]
RIN 1545-BE95


S Corporation Guidance Under AJCA of 2004 and GOZA of 2005

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations that provide guidance 
regarding certain changes made to the rules governing S corporations 
under the American Jobs Creation Act of 2004 and the Gulf Opportunity 
Zone Act of 2005. The final regulations replace obsolete references in 
the current regulations and allow taxpayers to make proper use of the 
provisions that made changes to prior law. The final regulations 
include guidance on the S corporation family shareholder rules, the 
definitions of ``powers of appointment'' and ``potential current 
beneficiaries'' (PCBs) with regard to electing small business trusts 
(ESBTs), the allowance of suspended losses to the spouse or former 
spouse of an S corporation shareholder, and relief for inadvertently 
terminated or invalid qualified subchapter S subsidiary (QSub) 
elections. The final regulations affect S corporations and their 
shareholders.

DATES: Effective Date: These regulations are effective on August 14, 
2008.
    Applicability Dates: For dates of applicability, see Sec. Sec.  
1.1361-4(a)(9)(ii), 1.1361-6, 1.1362-4(g) and 1.1366-5.

FOR FURTHER INFORMATION CONTACT: Charles J. Langley, Jr., (202) 622-
3060 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)) under control number 1545-2114.
    The collection of information is required by Sec.  1.1361-
1(m)(2)(ii)(A) of these final regulations. This information is required 
to enable the IRS to verify whether the corporation is an eligible S 
corporation.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number.
    Books or records relating to a collection of information must be 
retained as long as their contents might become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains amendments to the Income Tax Regulations (26 
CFR part 1) concerning S corporations under sections 1361, 1362, and 
1366 of the Internal Revenue Code (Code). These

[[Page 47527]]

sections were amended by sections 231, 232, 233, 234, 235, 236, 237, 
238, and 239 of the American Jobs Creation Act of 2004 (Pub. L. 108-
357, 118 Stat. 1418) (the 2004 Act) and sections 403 and 413 of the 
Gulf Opportunity Zone Act of 2005 (Pub. L. 109-135) (the 2005 Act). 
This document does not address other amendments made by the 2004 Act or 
the 2005 Act. In addition, this document contains additional amendments 
to the regulations under Code section 1362 necessary to conform the 
regulations to the changes made by section 1305(a) of the Small 
Business Job Protection Act of 1996 (Pub. L. 104-188, 110 Stat. 1755) 
(the 1996 Act).
    On September 28, 2007, a notice of proposed rulemaking and a notice 
of public hearing (REG-143326-05) were published in the Federal 
Register (72 FR 55132).
    No one requested to speak at the public hearing. Accordingly, the 
public hearing scheduled for January 16, 2008, was cancelled in a 
notice published in the Federal Register (73 FR 1131) on January 7, 
2008. No one submitted written or electronic comments, which were due 
by December 27, 2007. Thus, the proposed regulations are adopted as 
revised by this Treasury decision, which make only administrative or 
ministerial changes to the proposed regulations.
    The proposed regulations conformed references in the regulations to 
the specific numbers of S corporation shareholders permissible under 
section 1361. For purposes of determining the number of shareholders of 
an S corporation under Code section 1361(b)(1)(A), the proposed 
regulations provided rules relating to stock owned by family members.
    Pursuant to section 1361(c)(2)(A)(vi), the proposed regulations 
provided rules regarding limited instances in which individual 
retirement accounts (including Roth IRAs), qualify as eligible 
shareholders of banks or depository institution holding companies.
    The proposed regulations provided that a disposition of the S 
corporation stock by a QSST shall be treated as a disposition by the 
income beneficiary for purposes of applying sections 465 and 469 to the 
income beneficiary of a QSST.
    The proposed regulations described information that is required to 
be included in the ESBT election statement if the trust includes a 
power of appointment or other power to make distributions to certain 
organizations. The proposed regulations provided rules under which a 
person that may receive a distribution under a power of appointment 
will not be treated as a PCB. Also, the proposed regulations provided 
rules under which a class of organizations described in section 
1361(c)(6) will be treated as one PCB if the fiduciary has a power 
(other than a power of appointment) to make distributions to one or 
more members of the class. Also, the proposed regulations provided 
rules that any person who first met the definition of a PCB one year 
before the disposition by an ESBT of all of the stock of the S 
corporation will not be treated as a PCB or a shareholder of the S 
corporation.
    The proposed regulations provided that the Commissioner may provide 
relief for inadvertent invalid elections to be an S corporation or QSub 
or for inadvertent terminations of valid elections to be an S 
corporation or QSub and described the requirements to obtain that 
relief.
    Finally, with regard to a transfer of stock under Code section 
1041(a), between spouses or incident to a divorce, the proposed 
regulations provided for the treatment of losses or deductions with 
respect to the transferred shares that are subject to the basis 
limitation under Code section 1366(d)(1).

Summary of Comments and Explanation of Revisions

    No comments were received. All revisions are administrative or 
ministerial and substantively conform to the proposed regulations.

Effect on Other Documents

    The following publication is obsoleted as of August 14, 2008:
    Notice 2005-91 (2005-2 CB 1164).

Effective Applicability Date

    These regulations are effective on August 14, 2008.

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 has also been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. Further, it has 
been determined that these regulations are not subject to the 
Regulatory Flexibility Act (5 U.S.C. chapter 6) because the collection 
of information required by these regulations is imposed on electing 
small business trusts and such entities are not ``small entities'' for 
purposes of the Regulatory Flexibility Act (5 U.S.C. chapter 6). 
Additionally, the information collection burden imposed on the electing 
small business trusts is minimal. Pursuant to section 7805(f) of the 
Internal Revenue Code, the notice of proposed rule making preceding 
this regulation was submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Drafting Information

    The principal author of these proposed regulations is Charles J. 
Langley, Jr. of the Office of Associate Chief Counsel (Passthroughs and 
Special Industries).

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are 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 1.1361-0 is amended by adding a new entry in the table 
of contents for Sec.  1.1361-1(e)(3) to read as follows:


Sec.  1.1361-0  Table of contents.

* * * * *


Sec.  1.1361-1  S Corporation defined.

* * * * *
    (e) * * *
    (3) Special rules relating to stock owned by members of a family.
* * * * *

0
Par. 3. Section 1.1361-1 is amended by:
0
1. Revising paragraphs (b)(1)(i) and (e)(1).
0
2. Adding paragraphs (e)(3), (h)(1)(vii), and (h)(3)(i)(G).
0
3. Adding a new sentence to the end of paragraphs (j)(8) and (k)(2)(i).
0
4. Revising paragraphs (m)(2)(ii)(A), (m)(4)(iii), and (m)(4)(vi).
0
5. Revising paragraphs (m)(8), Example 2 and Example 7.
0
6. Revising the seventh sentence of paragraph (m)(8), Example 5.
0
7. Adding paragraphs (m)(8), Example 8 and Example 9.
0
8. Adding a sentence to the end of paragraph (m)(9).
    The revisions and additions read as follows:

[[Page 47528]]

Sec.  1.1361-1  S Corporation defined.

* * * * *
    (b) * * *
    (1) * * *
    (i) More than the number of shareholders provided in section 
1361(b)(1)(A);
* * * * *
    (e) Number of shareholders--(1) General rule. A corporation does 
not qualify as a small business corporation if it has more than the 
number of shareholders provided in section 1361(b)(1)(A). Ordinarily, 
the person who would have to include in gross income dividends 
distributed with respect to the stock of the corporation (if the 
corporation were a C corporation) is considered to be the shareholder 
of the corporation. For example, if stock (owned other than by a 
husband and wife or members of a family described in section 
1361(c)(1)) is owned by tenants in common or joint tenants, each tenant 
in common or joint tenant is generally considered to be a shareholder 
of the corporation. (For special rules relating to stock owned by 
husband and wife or members of a family, see paragraphs (e)(2) and (3) 
of this section, respectively; for special rules relating to restricted 
stock, see paragraphs (b)(3) and (6) of this section.) The person for 
whom stock of a corporation is held by a nominee, guardian, custodian, 
or an agent is considered to be the shareholder of the corporation for 
purposes of this paragraph (e) and paragraphs (f) and (g) of this 
section. For example, a partnership may be a nominee of S corporation 
stock for a person who qualifies as a shareholder of an S corporation. 
However, if the partnership is the beneficial owner of the stock, then 
the partnership is the shareholder, and the corporation does not 
qualify as a small business corporation. In addition, in the case of 
stock held for a minor under a uniform transfers to minors act or 
similar statute, the minor and not the custodian is the shareholder. 
Except as otherwise provided in paragraphs (h) and (j) of this section, 
and for purposes of this paragraph (e) and paragraphs (f) and (g) of 
this section, if stock is held by a decedent's estate or a trust 
described in section 1361(c)(2)(A)(ii) or (iii), the estate or trust 
(and not the beneficiaries of the estate or trust) is considered to be 
the shareholder; however, if stock is held by a subpart E trust (which 
includes a voting trust) or an electing QSST described in section 
1361(d)(1), the deemed owner of the trust is considered to be the 
shareholder. If stock is held by an ESBT described in section 
1361(c)(2)(A)(v), each potential current beneficiary of the trust shall 
be treated as a shareholder, except that the trust shall be treated as 
the shareholder during any period in which there is no potential 
current beneficiary of the trust. If stock is held by a trust described 
in section 1361(c)(2)(A)(vi), the individual for whose benefit the 
trust was created shall be treated as the shareholder. See paragraph 
(h) of this section for special rules relating to trusts.
* * * * *
    (3) Special rules relating to stock owned by members of a family--
(i) In general. For purposes of paragraph (e)(1) of this section, stock 
owned by members of a family is treated as owned by one shareholder. 
Members of a family include a common ancestor, any lineal descendant of 
the common ancestor (without any generational limit), and any spouse 
(or former spouse) of the common ancestor or of any lineal descendants 
of the common ancestor. An individual shall not be considered to be a 
common ancestor if, on the applicable date, the individual is more than 
six generations removed from the youngest generation of shareholders 
who would be members of the family determined by deeming that 
individual as the common ancestor. For purposes of this six-generation 
test, a spouse (or former spouse) is treated as being of the same 
generation as the individual to whom the spouse is or was married. This 
test is applied on the latest of the date the election under section 
1362(a) is made for the corporation, the earliest date that a member of 
the family (determined by deeming that individual as the common 
ancestor) holds stock in the corporation, or October 22, 2004. For this 
purpose, the date the election under section 1362(a) is made for the 
corporation is the effective date of the election, not the date it is 
signed or received by any person. The test is only applied as of the 
applicable date, and lineal descendants (and spouses) more than six 
generations removed from the common ancestor will be treated as members 
of the family even if they acquire stock in the corporation after that 
date. The members of a family are treated as one shareholder under this 
paragraph (e)(3) solely for purposes of section 1361(b)(1)(A), and not 
for any other purpose, whether under section 1361 or any other 
provision. Specifically, each member of the family who owns or is 
deemed to own stock must meet the requirements of sections 
1361(b)(1)(B) and (C) (regarding permissible shareholders) and section 
1362(a)(2) (regarding shareholder consents to an S corporation 
election). Although a person may be a member of more than one family 
under this paragraph (e)(3), each family (not all of whose members are 
also members of the other family) will be treated as one shareholder. 
For purposes of this paragraph (e)(3), any legally adopted child of an 
individual, any child who is lawfully placed with an individual for 
legal adoption by that individual, and any eligible foster child of an 
individual (within the meaning of section 152(f)(1)(C)), shall be 
treated as a child of such individual by blood.
    (ii) Certain entities treated as members of a family. For purposes 
of this paragraph (e)(3), the estate or trust (described in section 
1361(c)(2)(A)(ii) or (iii)) of a deceased member of the family will be 
considered to be a member of the family during the period in which the 
estate or such trust (if the trust is described in section 
1361(c)(2)(A)(ii) or (iii)), holds stock in the S corporation. The 
members of the family also will include--
    (A) In the case of an ESBT, each potential current beneficiary who 
is a member of the family;
    (B) In the case of a QSST, the income beneficiary who makes the 
QSST election, if that income beneficiary is a member of the family;
    (C) In the case of a trust created primarily to exercise the voting 
power of stock transferred to it, each beneficiary who is a member of 
the family;
    (D) The individual for whose benefit a trust described in section 
1361(c)(2)(A)(vi) was created, if that individual is a member of the 
family;
    (E) The deemed owner of a trust described in section 
1361(c)(2)(A)(i) if that deemed owner is a member of the family; and
    (F) The owner of an entity disregarded as an entity separate from 
its owner under Sec.  301.7701-3 of this chapter, if that owner is a 
member of the family.
* * * * *
    (h) * * *
    (1) * * *
    (vii) Individual retirement accounts. In the case of a corporation 
which is a bank (as defined in section 581) or a depository institution 
holding company (as defined in section 3(w)(1) of the Federal Deposit 
Insurance Act (12 U.S.C. 1813(w)(1)), a trust which constitutes an 
individual retirement account under section 408(a), including one 
designated as a Roth IRA under section 408A, but only to the extent of 
the stock held by such trust in such bank or company as of October 22, 
2004. Individual retirement accounts

[[Page 47529]]

(including Roth IRAs) are not otherwise eligible S corporation 
shareholders.
* * * * *
    (3) * * *
    (i) * * *
    (G) If stock in an S corporation bank or depository institution 
holding company is held by an individual retirement account (including 
a Roth IRA) described in paragraph (h)(1)(vii) of this section, the 
individual for whose benefit the trust was created shall be treated as 
the shareholder.
* * * * *
    (j) * * *
    (8) * * * However, solely for purposes of applying sections 465 and 
469 to the income beneficiary, a disposition of S corporation stock by 
a QSST shall be treated as a disposition by the income beneficiary.
* * * * *
    (k) * * *
    (2) * * *
    (i) * * * Paragraphs (b)(1)(i), (e)(1), (e)(3), (h)(1)(vii), 
(h)(3)(i)(G), and the fifth sentence of paragraph (j)(8) are effective 
on August 14, 2008.
* * * * *
    (m) * * *
    (2) * * *
    (ii) * * *
    (A) The name, address, and taxpayer identification number of the 
trust, the potential current beneficiaries, and the S corporations in 
which the trust currently holds stock. If the trust includes a power 
described in paragraph (m)(4)(vi)(B) of this section, then the election 
statement must include a statement that such a power is included in the 
instrument, but does not need to include the name, address, or taxpayer 
identification number of any particular charity or any other 
information regarding the power.
* * * * *
    (4) * * *
    (iii) Special rule for dispositions of stock. Notwithstanding the 
provisions of paragraph (m)(4)(i) of this section, if a trust disposes 
of all of the stock which it holds in an S corporation, then, with 
respect to that corporation, any person who first met the definition of 
a potential current beneficiary during the 1-year period ending on the 
date of such disposition is not a potential current beneficiary and 
thus is not a shareholder of that corporation.
* * * * *
    (vi) Currently exercisable powers of appointment and other powers--
(A) Powers of appointment. A person to whom a distribution may be made 
during any period pursuant to a power of appointment (as described for 
transfer tax purposes in section 2041 and Sec.  20.2041-1(b) of this 
chapter and section 2514 and Sec.  25.2514-1(b) of this chapter) is not 
a potential current beneficiary unless the power is exercised in favor 
of that person during the period. It is immaterial for purposes of this 
paragraph (m)(4)(vi)(A) whether such power of appointment is a 
``general power of appointment'' for transfer tax purposes as described 
in Sec. Sec.  20.2041-1(c) and 25.2514-1(c) of this chapter. The mere 
existence of one or more powers of appointment during the lifetime of a 
power holder that would permit current distributions from the trust to 
be made to more than the number of persons described in section 
1361(b)(1)(A) or to a person described in section 1361(b)(1)(B) or (C) 
will not cause the S corporation election to terminate unless one or 
more of such powers are exercised, collectively, in favor of an 
excessive number of persons or in favor of a person who is ineligible 
to be an S corporation shareholder. For purposes of this paragraph 
(m)(4)(vi)(A), a ``power of appointment'' includes a power, regardless 
of by whom held, to add a beneficiary or class of beneficiaries to the 
class of potential current beneficiaries, but generally does not 
include a power held by a fiduciary who is not also a beneficiary of 
the trust to spray or sprinkle trust distributions among beneficiaries. 
Nothing in this paragraph (m)(4)(vi)(A) alters the definition of 
``power of appointment'' for purposes of any provision of the Internal 
Revenue Code or the regulations.
    (B) Powers to distribute to certain organizations not pursuant to 
powers of appointment. If a trustee or other fiduciary has a power 
(that does not constitute a power of appointment for transfer tax 
purposes as described in Sec. Sec.  20.2041-1(b) and 25.2514-1(b) of 
this chapter) to make distributions from the trust to one or more 
members of a class of organizations described in section 1361(c)(6), 
such organizations will be counted collectively as only one potential 
current beneficiary for purposes of this paragraph (m), except that 
each organization receiving a distribution also will be counted as a 
potential current beneficiary. This paragraph (m)(4)(vi)(B) shall not 
apply to a power to currently distribute to one or more particular 
charitable organizations described in section 1361(c)(6). Each of such 
organizations is a potential current beneficiary of the trust.
* * * * *
    (8) * * *

    Example 2. (i) Invalid potential current beneficiary. Effective 
January 1, 2005, Trust makes a valid ESBT election. On January 1, 
2006, A, a nonresident alien, becomes a potential current 
beneficiary of Trust. Trust does not dispose of all of its S 
corporation stock within one year after January 1, 2006. As of 
January 1, 2006, A is the potential current beneficiary of Trust and 
therefore is treated as a shareholder of the S corporation. Because 
A is not an eligible shareholder of an S corporation under section 
1361(b)(1), the S corporation election of any corporation in which 
Trust holds stock terminates effective January 1, 2006. Relief may 
be available under section 1362(f).
    (ii) Invalid potential current beneficiary and disposition of S 
stock. Assume the same facts as in Example 2 (i) except that within 
one year after January 1, 2006, trustee of Trust disposes of all 
Trust's S corporation stock. A is not considered a potential current 
beneficiary of Trust and therefore is not treated as a shareholder 
of any S corporation in which Trust previously held stock.
* * * * *
    Example 5. * * * Trust-2 itself will not be counted toward the 
shareholder limit of section 1361(b)(1)(A). * * *
* * * * *
    Example 7. Potential current beneficiaries and powers of 
appointment. M creates Trust from which A has a right to all net 
income and funds it with S corporation stock. A also has a currently 
exercisable power to appoint income or principal to anyone except A, 
A's creditors, A's estate, and the creditors of A's estate. The 
potential current beneficiaries of Trust for any period will be A 
and each person who receives a distribution from Trust pursuant to 
A's exercise of A's power of appointment during that period.
    Example 8. Power to distribute to an unlimited class of 
charitable organizations not pursuant to a power of appointment. M 
creates Trust from which A has a right to all net income and funds 
it with S corporation stock. In addition, the trustee of Trust, who 
is not A or a descendant of M, has the power to make discretionary 
distributions of principal to the living descendants of M and to any 
organizations described in section 1361(c)(6). The potential current 
beneficiaries of Trust for any period will be A, each then-living 
descendant of M, and each exempt organization described in section 
1361(c)(6) that receives a distribution during that period. In 
addition, the class of exempt organizations will be counted as one 
potential current beneficiary.
    Example 9. Power to distribute to a class of named charitable 
organizations not pursuant to a power of appointment. M creates 
Trust from which A has a right to all net income and funds it with S 
corporation stock. In addition, the trustee of Trust, who is not A 
or a descendant of M, has the power to make discretionary 
distributions of principal to the living descendants of M and to X, 
Y, and Z, each of which is an organization described in section 
1361(c)(6). The potential current beneficiaries of Trust for any 
period will be A, X, Y, Z, and each living descendant of M.

    (9) Effective/applicability date. * * * Paragraphs (m)(2)(ii)(A), 
(m)(4)(iii) and

[[Page 47530]]

(vi), and (m)(8), Example 2, Example 5, Example 7, Example 8, and 
Example 9 of this section are effective on August 14, 2008.

0
Par. 4. Section 1.1361-4 is amended by revising paragraph (a)(1) and 
adding new paragraph (a)(9) to read as follows:


Sec.  1.1361-4  Effect of QSub election.

    (a) Separate existence ignored--(1) In general. Except as otherwise 
provided in paragraphs (a)(3), (a)(6), (a)(7), (a)(8), and (a)(9) of 
this section, for Federal tax purposes--
    (i) A corporation that is a QSub shall not be treated as a separate 
corporation; and
    (ii) All assets, liabilities, and items of income, deduction, and 
credit of a QSub shall be treated as assets, liabilities, and items of 
income, deduction, and credit of the S corporation.
* * * * *
    (9) Information returns--(i) In general. Except to the extent 
provided by the Secretary or Commissioner in guidance (including forms 
or instructions), paragraph (a)(1) of this section shall not apply to 
part III of subchapter A of chapter 61, relating to information 
returns.
    (ii) Effective/applicability date. This paragraph (a)(9) is 
effective on August 14, 2008.
* * * * *

0
Par. 5. Section 1.1361-6 is amended by revising the first sentence to 
read as follows:


Sec.  1.1361-6  Effective date.

    Except as provided in Sec. Sec.  1.1361-4(a)(3)(iii), 1.1361-
4(a)(5)(i), 1.1361-4(a)(6)(iii), 1.1361-4(a)(7)(ii), 1.1361-
4(a)(8)(ii), 1.1361-4(a)(9), and 1.1361-5(c)(2), the provisions of 
Sec. Sec.  1.1361-2 through 1.1361-5 apply to taxable years beginning 
on or after January 20, 2000; however, taxpayers may elect to apply the 
regulations in whole, but not in part (aside from those sections with 
special dates of applicability), for taxable years beginning on or 
after January 1, 2000, provided all affected taxpayers apply the 
regulations in a consistent manner. * * *
0
Par. 6. Section 1.1362-0 is amended by revising the heading of the 
table of contents for Sec.  1.1362-4 and adding a new entry in the 
table of contents for Sec.  1.1362-4(g) to read as follows:


Sec.  1.1362-0  Table of contents.

* * * * *


Sec.  1.1362-4  Inadvertent terminations and inadvertently invalid 
elections.

* * * * *
    (g) Effective/applicability date.
* * * * *

0
Par. 7. Section 1.1362-4 is amended by:
0
1. Revising the section heading and paragraphs (a), (b), (c), (d), and 
(f).
0
2. Adding paragraph (g).
    The addition and revisions read as follows:


Sec.  1.1362-4  Inadvertent terminations and inadvertently invalid 
elections.

    (a) In general. A corporation is treated as continuing to be an S 
corporation or a QSub (or, an invalid election to be either an S 
corporation or a QSub is treated as valid) during the period specified 
by the Commissioner if--
    (1) The corporation made a valid election under section 1362(a) or 
section 1361(b)(3) and the election terminated or the corporation made 
an election under section 1362(a) or section 1361(b)(3) that was 
invalid;
    (2) The Commissioner determines that the termination or invalidity 
was inadvertent;
    (3) Within a reasonable period of time after discovery of the 
terminating event or invalid election, steps were taken so that the 
corporation for which the election was made or the termination occurred 
is a small business corporation or a QSub, as the case may be, or to 
acquire the required shareholder consents; and
    (4) The corporation and shareholders agree to adjustments that the 
Commissioner may require for the period.
    (b) Inadvertent termination or inadvertently invalid election. For 
purposes of paragraph (a) of this section, the determination of whether 
a termination or invalid election was inadvertent is made by the 
Commissioner. The corporation has the burden of establishing that under 
the relevant facts and circumstances the Commissioner should determine 
that the termination or invalid election was inadvertent. The fact that 
the terminating event or invalidity of the election was not reasonably 
within the control of the corporation and, in the case of a 
termination, was not part of a plan to terminate the election, or the 
fact that the terminating event or circumstance took place without the 
knowledge of the corporation, notwithstanding its due diligence to 
safeguard itself against such an event or circumstance, tends to 
establish that the termination or invalidity of the election was 
inadvertent.
    (c) Corporation's request for determination of an inadvertent 
termination or invalid election. A corporation that believes that the 
termination or invalidity of its election was inadvertent may request a 
determination from the Commissioner that the termination or invalidity 
of its election was inadvertent. The request is made in the form of a 
ruling request and should set forth all relevant facts pertaining to 
the event or circumstance including, but not limited to, the facts 
described in paragraph (b) of this section, the date of the 
corporation's election (or intended election) under section 1362(a) or 
1361(b)(3), a detailed explanation of the event or circumstance causing 
the termination or invalidity, when and how the event or circumstance 
was discovered, and the steps taken under paragraph (a)(3) of this 
section.
    (d) Adjustments. The Commissioner may require any adjustments that 
are appropriate. In general, the adjustments required should be 
consistent with the treatment of the corporation as an S corporation or 
QSub during the period specified by the Commissioner. In the case of 
stock held by an ineligible shareholder that causes an inadvertent 
termination or invalid election for an S corporation under section 
1362(f), the Commissioner may require the ineligible shareholder to be 
treated as a shareholder of the S corporation during the period the 
ineligible shareholder actually held stock in the corporation. 
Moreover, the Commissioner may require protective adjustments that 
prevent the loss of any revenue due to the holding of stock by an 
ineligible shareholder (for example, a nonresident alien).
* * * * *
    (f) Status of corporation. The status of the corporation after the 
terminating event or invalid election and before the determination of 
inadvertence is determined by the Commissioner. Inadvertent termination 
or inadvertent invalid election relief may be granted retroactively for 
all years for which the terminating event or circumstance giving rise 
to invalidity is effective, in which case the corporation is treated as 
if its election was valid or had not terminated. Alternatively, relief 
may be granted only for the period in which the corporation became 
eligible for subchapter S or QSub treatment, in which case the 
corporation is treated as a C corporation or, in the case of a QSub 
with an inadvertently terminated or invalid election, as a separate C 
corporation, during the period for which the corporation was not 
eligible for its intended status.
    (g) Effective/applicability date. Paragraphs (a), (b), (c), (d), 
and (f) of this section are effective on August 14, 2008.

0
Par. 8. Section 1.1366-0 is amended by adding new entries in the table 
of

[[Page 47531]]

contents for Sec.  1.1366-2(a)(5)(i), (a)(5)(ii) and (a)(5)(iii) to 
read as follows:


Sec.  1.1366-0  Table of contents.

* * * * *


Sec.  1.1366-2  Limitations on deduction of passthrough items of an S 
corporation to its shareholders.

    (a) * * *
    (5) * * *
    (i) In general.
    (ii) Exceptions for transfers of stock under section 1041(a).
    (iii) Examples.

0
Par. 9. Section 1.1366-2(a)(5) is amended by:
0
1. Redesignating paragraph (a)(5) as (a)(5)(i).
0
2. Adding a heading and revising the first sentence of paragraph 
(a)(5)(i).
0
3. Adding paragraphs (a)(5)(ii) and (a)(5)(iii).
    The revisions and additions read as follows:


Sec.  1.1366-2  Limitations on deduction of passthrough items of an S 
corporation to its shareholders.

    (a) In general. * * *
    (5) Nontransferability of losses and deductions--(i) In general. 
Except as provided in paragraph (a)(5)(ii) of this section, any loss or 
deduction disallowed under paragraph (a)(1) of this section is personal 
to the shareholder and cannot in any manner be transferred to another 
person. * * *
    (ii) Exceptions for transfers of stock under section 1041(a). If a 
shareholder transfers stock of an S corporation after December 31, 
2004, in a transfer described in section 1041(a), any loss or deduction 
with respect to the transferred stock that is disallowed to the 
transferring shareholder under paragraph (a)(1) of this section shall 
be treated as incurred by the corporation in the following taxable year 
with respect to the transferee spouse or former spouse. The amount of 
any loss or deduction with respect to the stock transferred shall be 
determined by prorating any losses or deductions disallowed under 
paragraph (a)(1) of this section for the year of the transfer between 
the transferor and the spouse or former spouse based on the stock 
ownership at the beginning of the following taxable year. If a 
transferor claims a deduction for losses in the taxable year of 
transfer, then under paragraph (a)(4) of this section, if the 
transferor's pro rata share of the losses and deductions in the year of 
transfer exceeds the transferor's basis in stock and the indebtedness 
of the corporation to the transferor, then the limitation must be 
allocated among the transferor spouse's pro rata share of each loss or 
deduction, including disallowed losses and deductions carried over from 
the prior year.
    (iii) Examples. The following examples illustrates the provisions 
of paragraph (a)(5)(ii) of this section:

    Example 1. A owns all 100 shares in X, a calendar year S 
corporation. For X's taxable year ending December 31, 2006, A has 
zero basis in the shares and X does not have any indebtedness to A. 
For the 2006 taxable year, X had $100 in losses that A cannot use 
because of the basis limitation in section 1366(d)(1) and that are 
treated as incurred by the corporation with respect to A in the 
following taxable year. Halfway through the 2007 taxable year, A 
transfers 50 shares to B, A's former spouse in a transfer to which 
section 1041(a) applies. In the 2007 taxable year, X has $80 in 
losses. On A's 2007 individual income tax return, A may use the 
entire $100 carryover loss from 2006, as well as A's share of the 
$80 2007 loss determined under section 1377(a) ($60), assuming A 
acquires sufficient basis in the X stock. On B's 2007 individual 
income tax return, B may use B's share of the $80 2007 loss 
determined under section 1377(a) ($20), assuming B has sufficient 
basis in the X stock. If any disallowed 2006 loss is disallowed to A 
under section 1366(d)(1) in 2007, that loss is prorated between A 
and B based on their stock ownership at the beginning of 2008. On 
B's 2008 individual income tax return, B may use that loss, assuming 
B acquires sufficient basis in the X stock. If neither A nor B 
acquires any basis during the 2007 taxable year, then as of the 
beginning of 2008, the corporation will be treated as incurring $50 
of loss with respect to A and $50 of loss with respect to B for the 
$100 of disallowed 2006 loss, and the corporation will be treated as 
incurring $60 of loss with respect to A and $20 with respect to B 
for the $80 of disallowed 2007 loss.
    Example 2. Assume the same facts as Example 1, except that 
during the 2007 taxable year, A acquires $10 of basis in A's shares 
in X. For the 2007 taxable year, A may claim a $10 loss deduction, 
which represents $6.25 of the disallowed 2006 loss of $100 and $3.75 
of A's 2007 loss of $60. The disallowed 2006 loss is reduced to 
$93.75. As of the beginning of 2008, the corporation will be treated 
as incurring half of the remaining $93.75 of loss with respect to A 
and half of that loss with respect to B for the remaining $93.75 of 
disallowed 2006 loss, and if B does not acquire any basis during 
2007, the corporation will be treated as incurring $56.25 of loss 
with respect to A and $20 with respect to B for the remaining 
disallowed 2007 loss.
* * * * *

0
Par. 10. Section 1.1366-5 is amended by adding a new sentence at the 
end to read as follows:


Sec.  1.1366-5  Effective/applicability date.

    * * * Sections 1.1366-2(a)(5)(i), (ii) and (iii) are effective on 
August 14, 2008.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

0
Par. 11. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.


0
Par. 12. Section 602.101, paragraph (b) is amended by adding the entry 
in numerical order to the table to read as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       control No.
------------------------------------------------------------------------
 
                                * * * * *
1.1361-1................................................       1545-2114
 
                                * * * * *
------------------------------------------------------------------------


Sherri L. Brown,
Acting Deputy Commissioner for Services and Enforcement.
    Approved: August 5, 2008.
Eric Solomon,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E8-18782 Filed 8-13-08; 8:45 am]
BILLING CODE 4830-01-P