Eligible Terminated S Corporations, 66471-66484 [2020-21144]

Download as PDF Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations European Union Aviation Safety Agency) (EASA) AD No. 2018–0205, dated September 14, 2018. You may view the EASA AD on the internet at https://www.regulations.gov in Docket No. FAA–2019–1003. (i) Subject Joint Aircraft Service Component (JASC) Code: 6220, Main Rotor Head. Issued on October 8, 2020. Gaetano A. Sciortino, Deputy Director for Strategic Initiatives, Compliance & Airworthiness Division, Aircraft Certification Service. [FR Doc. 2020–23019 Filed 10–19–20; 8:45 am] BILLING CODE 4910–13–P DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1 [TD 9914] RIN 1545–BP20 Eligible Terminated S Corporations Internal Revenue Service (IRS), Treasury. ACTION: Final regulation. AGENCY: This document contains final regulations providing guidance on the definition of an eligible terminated S corporation and rules relating to distributions of money by such a corporation after the post-termination transition period. This document also amends current regulations to extend the treatment of distributions of money during the post-termination transition period to all shareholders of the corporation and clarifies the allocation of current earnings and profits to distributions of money and other property. The final regulations affect C corporations that were formerly S corporations and the shareholders of such corporations. DATES: Effective Date: These regulations are effective October 20, 2020. Applicability Dates: For dates of applicability, see §§ 1.481–6(b), 1.1371– 1(e), 1.1371–2(d), and 1.1377–3(c). FOR FURTHER INFORMATION CONTACT: Concerning §§ 1.481–5, 1.481–6, 1.1362–2(a)(2)(iii), 1.1377–2, and 1.1377–3, Margaret Burow or Michael Gould at (202) 317–5279; concerning §§ 1.1371–1 and 1.1371–2, Aglaia Ovtchinnikova at (202) 317–6975 or Margaret Burow or Michael Gould at (202) 317–5279; concerning § 1.316–2, Aglaia Ovtchinnikova at (202) 317– 6975. SUMMARY: SUPPLEMENTARY INFORMATION: VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 Background In the case of an S corporation, as defined in section 1361(a)(1) of the Internal Revenue Code (Code), having accumulated earnings and profits (as described in section 316(a)(1) of the Code (AE&P)) that makes a distribution of property to which section 301 would otherwise apply, section 1368(c)(1) of the Code generally treats the amount of the distribution not in excess of the S corporation’s accumulated adjustments account (as defined in § 1.1368–2(a)(1) (AAA)) or the recipient shareholder’s adjusted basis in such S corporation’s stock as excluded from the shareholder’s gross income. Section 1368(c)(2) provides that the remaining portion of the distribution is treated as a dividend (as defined in section 316(a)) to the extent of the S corporation’s AE&P. Finally, section 1368(c)(3) provides that any amount of the distribution in excess of the S corporation’s AAA and AE&P is applied against the shareholder’s remaining adjusted basis in the stock, with any amount exceeding that adjusted basis treated as gain from the sale or exchange of property. Generally, a distribution by a C corporation to its shareholders with respect to their stock ownership is treated as a taxable dividend to the extent of the corporation’s earnings and profits. See sections 301(c) and 316(a). However, following the termination of a corporation’s S election made under section 1362 of the Code (S election), section 1371(e) of the Code allows shareholders of the resulting C corporation to benefit from the corporation’s former status as an S corporation with respect to distributions of money during the corporation’s posttermination transition period (PTTP), which is generally the one-year period after the corporation terminates its S election. Specifically, during the PTTP, a distribution of money by the C corporation is characterized as a distribution from the corporation’s AAA. The receipt of such a distribution is tax-free to the extent of the recipient shareholder’s basis in its stock and the corporation’s AAA balance. If the distribution exceeds the recipient shareholder’s basis in its stock, but not the corporation’s AAA, then the distribution is tax-free to the extent of the recipient shareholder’s basis, with the remainder treated as gain from the sale of property. If the distribution exceeds the corporation’s AAA, then the excess is taxed as a dividend from current earnings and profits (as described in section 316(a)(2) (CE&P)) or any AE&P from the corporation’s PO 00000 Frm 00003 Fmt 4700 Sfmt 4700 66471 previous existence as a corporation taxed under subchapter C. Without section 1371(e), shareholders of the former S corporation would be precluded from receiving distributions allocable to AAA. Section 13543(a) and (b) of Public Law 115–97, 131 Stat. 2054, 2155 (2017), commonly referred to as the Tax Cuts and Jobs Act (TJCA), amended the Code by adding new sections 481(d) and 1371(f), effective as of December 22, 2017, the date of enactment of the TCJA. Section 481(d)(1) of the Code permits a corporation that qualifies as an eligible terminated S corporation (ETSC) to take into account any 481 adjustments (as defined in part II.C of the Summary of Comments and Explanation of Revisions) which are attributable to the revocation of an S election over the section 481(d) inclusion period, which is the six-taxable-year-period beginning with the year of change (as defined in part II.C of the Summary of Comments and Explanation of Revisions). Section 481(d)(2) defines an ETSC as a C corporation meeting the following three requirements: (i) The corporation was an S corporation on December 21, 2017; (ii) the S corporation revoked its election under section 1362(a) to be an S corporation (that is, the S election) during the two-year period beginning on December 22, 2017 (revocation requirement); and (iii) the owners of the stock of the corporation, determined on the date the corporation made a revocation of its S election, are the same owners (and own identical proportions of the corporation’s stock) as on December 22, 2017 (shareholder identity requirement). Section 1371(f) extends the period during which shareholders of an ETSC can benefit from its AAA generated during the corporation’s former status as an S corporation (ETSC period) by providing that, in the case of distributions of money following the PTTP, (i) the distributing ETSC’s AAA is allocated to a distribution of money to which section 301 would otherwise apply (qualified distribution), and (ii) the qualified distribution is chargeable to AE&P in the same ratio as the amount of such AAA bears to the amount of such AE&P. In enacting section 1371(f), Congress determined that ‘‘it is important to provide rules to ease the transition from S corporation to C corporation for the affected taxpayers’’ because, based on the TCJA’s revisions to the Code, ‘‘taxpayers that previously elected to be taxed as S corporations may prefer instead to be taxed as C corporations.’’ H. Rept. 115–409, 115th Cong., 1st Sess., at 245 (Nov. 14, 2017) (House Report). E:\FR\FM\20OCR1.SGM 20OCR1 66472 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations On November 7, 2019, the Department of the Treasury (Treasury Department) and the IRS published a notice of proposed rulemaking (REG–131071–18) in the Federal Register (84 FR 60011) containing proposed regulations under section 1371 and proposed amendments to the Income Tax Regulations (26 CFR part 1) under sections 481 and 1377 (proposed regulations). The Treasury Department and the IRS received 16 written or electronic comments responding to the proposed regulations. All comments received on the proposed regulations are available at http:// www.regulations.gov or upon request. As no request for a public hearing was received, no hearing was held. After full consideration of the comments received, this Treasury decision adopts generally the proposed regulations with certain modifications in response to the comments received, as described in the Summary of Comments and Explanation of Revisions. A corporation can allow the effective date of its S election revocation to occur automatically by operation of section 1362(d)(1)(C), or it can specify an effective date under section 1362(d)(1)(D). For example, a revocation made before the 16th day of the third month of an S corporation’s taxable year generally is effective retroactively on the first day of that taxable year. See section 1362(d)(1)(C)(i); § 1.1362–2(a)(2)(i). In contrast, a revocation made after the 15th day of the third month of a corporation’s taxable year generally is effective prospectively on the first day of the corporation’s following taxable year. See section 1362(d)(1)(C)(ii); § 1.1362–2(a)(2)(i). Alternatively, the corporation may specify an immediate or prospective effective date for a revocation by expressing a date (in terms of a stated day, month, and year) that occurs on or after the date on which the revocation is made. See section 1362(d)(1)(D); § 1.1362–2(a)(2)(ii). Summary of Comments and Explanation of Revisions 1. Retroactive Effective Date of the Revocation Determines ETSC Status One commenter suggested that the final regulations revise proposed § 1.481–5(b)(2) to confirm that, in the case of a revocation with a retroactive effective date pursuant to section 1362(d)(1)(C)(i), the revocation may be treated as occurring on the retroactive effective date for purposes of ETSC qualification. Based on the stated congressional goal of facilitating the transition from S corporation status to C corporation status, the commenter contended that taxpayers reasonably could have interpreted the statute to indicate that compliance with the shareholder identity requirement would be tested on the retroactive revocation’s effective date. In support of this contention, the commenter correctly noted that, in the absence of such an interpretation, a corporation would not satisfy the shareholder identity requirement for qualifying as an ETSC in proposed § 1.481–5(b)(2) and (3) if the corporation (i) had the same shareholders (and in identical proportions) on both December 22, 2017, and the retroactive effective date of the revocation, but (ii) experienced a change in shareholder ownership during the period between the retroactive effective date of the revocation and the date on which the revocation was made. The Treasury Department and the IRS agree with the commenter’s interpretation. Proposed § 1.481–5(b)(2) and (3) directly address revocations with prospective effective dates, which can be specified with significant flexibility in the revocation. A retroactive effective date for a I. Overview The final regulations retain the approach and structure of the proposed regulations, with certain revisions. This Summary of Comments and Explanation of Revisions discusses those revisions, as well as the comments received in response to the proposed regulations. II. Comments on Qualification as an Eligible Terminated S Corporation A. Significance of Date of Revocation of S Election To qualify as an ETSC under section 481(d)(2), a corporation must satisfy the revocation requirement by making a revocation of its S election during the two-year period beginning on December 22, 2017 (two-year period). See section 481(d)(2)(A)(ii) (setting forth the revocation requirement); proposed § 1.481–5(b)(2) (same). In addition, the shareholder identity requirement must be satisfied by the same shareholders owning identical proportions of the corporation’s stock on two dates: December 22, 2017, and the date on which the corporation made a revocation of its S election. See section 481(d)(2)(B) (setting forth the shareholder identity requirement); proposed § 1.481–5(b)(3) (same). But see proposed § 1.481–5(c)(1) (identifying five categories of share transfers that do not result in a change in shareholder ownership for purposes of section 481(d)(2)(B)). Consequently, the date on which a corporation makes a revocation of its S election is critical for determining ETSC qualification. VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 PO 00000 Frm 00004 Fmt 4700 Sfmt 4700 revocation results solely by operation of section 1362(d)(1)(C)(i) and § 1.1362– 2(a)(2)(i) and, in such instance, is always effective on the first day of the corporation’s taxable year. To confirm the commenter’s interpretation, § 1.481–5(c)(2) of the final regulations provides that, solely with regard to revocations with retroactive effective dates, a revocation may be treated as having been made on the effective date of such revocation. Accordingly, for purposes of § 1.481–5(b)(2) and (3), a corporation may test compliance with the revocation requirement and the shareholder identity requirement on either the date the revocation was made or, in the case of a revocation with a retroactive effective date, the date the revocation was effective. 2. Application of Section 7503 to a Revocation of an S Election As discussed in part II.A of this Summary of Comments and Explanation of Revisions, the revocation requirement of section 481(d)(2)(A)(ii) requires that a corporation must make a revocation during the two-year period to qualify as an ETSC. Section 7503 provides that, ‘‘when the last day prescribed under authority of the internal revenue laws for performing any act falls on Saturday, Sunday, or a legal holiday, the performance of such act shall be considered timely if it is performed on the next succeeding day which is not a Saturday, Sunday, or a legal holiday.’’ Because a revocation is an act made under authority of the internal revenue laws (that is, section 1362 of the Code), section 7503 applies for purposes of determining whether the revocation was made within the required two-year period. As a result of the application of section 7503 in conjunction with section 1362 and § 1.1362–2(a)(2), December 23, 2019 (a Monday), is the last day of the two-year period. Therefore, a revocation made on that date would be treated as made within the two-year period. Without the application of section 7503, December 21, 2019 (a Saturday), would have been the last day of the two-year period. To avoid any doubt, these final regulations clarify the text of § 1.1362– 2(a)(2) to provide explicitly that section 7503 applies where the last day prescribed for making a revocation occurs on a Saturday, Sunday, or legal holiday. Therefore, a revocation made on December 23, 2019, will be treated as made during the two-year period. B. Applicability of PTTP and ETSC Period to S Corporations With No AE&P Following the termination of an S election, section 1371(e) permits E:\FR\FM\20OCR1.SGM 20OCR1 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations shareholders of the resulting C corporation to benefit from the corporation’s former status as an S corporation with respect to distributions of money during the corporation’s PTTP, which generally is the one-year period after the corporation terminates its S election. Specifically, during the PTTP, a distribution of money by the C corporation is characterized as a distribution from the corporation’s AAA. The receipt of such a distribution is tax-free to the extent of the recipient shareholder’s basis in the stock with respect to which the shareholder received the distribution, and is taxed as gain from the sale of property to the extent the distribution exceeds the shareholder’s basis in that stock. See section 1371(e)(1). If the corporation exhausts its AAA during the PTTP, subsequent distributions are subject to treatment under section 301. A commenter requested confirmation that the rules regarding distributions made during the PTTP, including section 1371(e) and § 1.1377–2, apply if the corporation did not have AE&P at the time that it terminated its S election. Section 1371(e)(1) provides special treatment to distributions made by a corporation during the PTTP if such distributions (i) consist of money and (ii) are made with respect to the corporation’s stock. Those two conditions would be satisfied regardless of whether the distributing corporation had AE&P. Therefore, the Treasury Department and the IRS agree with the commenter’s interpretation of section 1371(e) and § 1.1377–2, but have determined that no clarifying revisions to the regulations are necessary in this regard. The commenter also requested confirmation that the rules regarding distributions made during the ETSC period would apply if the distributing corporation did not have AE&P as of the effective date of the revocation. Example 1 of proposed § 1.1371–1(d) illustrates that, if an ETSC has no AE&P as of the beginning of the day on which the revocation is effective, its historical AE&P is zero. Pursuant to proposed § 1.1371–1(a)(2)(ix) and (x), such a corporation would enter its ETSC period with a AAA ratio of 1 and an AE&P ratio of zero. Therefore, each qualified distribution would be characterized as a distribution of AAA. Based on the guidance provided in Example 1, as well as the definition of the ‘‘AAA ratio’’ set forth in proposed § 1.1371– 1(a)(ii), the Treasury Department and the IRS have determined that no clarifying revisions to the regulations are necessary in this regard. VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 C. Application of Section 481(d) to Qualified Subchapter S Subsidiaries If an S corporation wholly owns the stock of a domestic C corporation that is not an ineligible corporation described in section 1361(b)(2), the S corporation may elect under section 1361(b)(3)(B)(ii) and § 1.1361–3 to treat the C corporation as a qualified subchapter S subsidiary (QSub) such that (i) the QSub will no longer be treated as a separate corporation and (ii) all of the QSub’s assets, liabilities, and items of income, deduction, and credit will be treated as assets, liabilities, and such items (as the case may be) of the S corporation parent. If the requirements of section 1361(b)(3)(B) cease to be satisfied with respect to a QSub, including by reason of the revocation of the parent’s S election, section 1361(b)(3)(C)(i) and § 1.1361– 5(b)(1)(i) provide that the corporation’s QSub election is terminated such that the QSub is treated, for purposes of the Code, as (i) a newly formed C corporation subsidiary separate from the parent and (ii) acquiring all of its assets (and assuming all of its liabilities) from the parent through an exchange to which section 351 of the Code applies (deemed section 351 exchange). If the taxable income of any taxpayer, including a corporation, for the current year (year of change) is computed under a method of accounting that is different from the method of accounting used by the taxpayer in the preceding year (accounting method change), section 481 requires that the taxpayer must take into account those adjustments that are determined to be necessary solely by reason of the accounting method change to prevent items of income or expense from being duplicated or omitted (481 adjustments). Section 481(a). The 481 adjustments are generally taken into account in computing the taxpayer’s taxable income in the year of change. However, section 481(c) permits a taxpayer, in such manner and subject to such conditions prescribed in regulations by the Secretary of the Treasury or his delegate (Secretary), to take 481 adjustments into account in computing taxable income for the taxable year or years permitted under such regulations. As noted earlier, section 481(d)(1) permits an ETSC to take into account any 481 adjustments that are attributable to the revocation of an S election over a six-taxable year period beginning with the year of change (that is, the section 481(d) inclusion period). Commenters have correctly observed that section 481(a) and (d) do not apply to an ETSC’s newly formed C PO 00000 Frm 00005 Fmt 4700 Sfmt 4700 66473 corporation subsidiary (ETSC corporate subsidiary) that operated as a QSub prior to the revocation of its parent’s S election. Upon such a revocation, the ETSC corporate subsidiary is treated as acquiring all of its assets and assuming all of its liabilities from the ETSC in a deemed section 351 exchange. See section 1361(b)(3)(C)(i); § 1.1361– 5(b)(1)(i). A corporation formed for a business purpose is a taxpayer separate from its shareholder(s). See generally Moline Properties v. Commissioner, 319 U.S. 436 (1943). As a result of the ETSC corporate subsidiary’s status as a new C corporation with no prior taxable year (rather than, for example, as a successor under section 381(a) of the Code), commenters have noted that the ETSC corporate subsidiary lacks any historical method of accounting from which to change. Compare § 1.446–1(e)(1) (providing that a taxpayer filing its first return may adopt any permissible method of accounting in computing taxable income for the taxable year covered by such return) with section 381(c)(4) (providing that, in general, a successor corporation must use the method of accounting used by the predecessor corporation as of the date of the section 381(a) transaction). Notwithstanding those observations of the law, commenters have requested that the final regulations extend the section 481(d) inclusion period to an accrual method ETSC corporate subsidiary that operated as a cash method QSub of a cash method S corporation prior to the revocation of the parent’s S election. These commenters highlighted that, in the deemed section 351 exchange required by section 1361(b)(3)(C)(i) and § 1.1361–5(b)(1)(i) that results from the revocation of the parent’s S election, the accounts receivable of a former cash method QSub would be deemed transferred to the accrual method ETSC corporate subsidiary with a zero basis. See generally Raich v. Commissioner, 46 T.C. 604 (1966) (holding that trade accounts receivable of a cash method transferor received by an accrual basis transferee in a section 351 exchange had a zero basis). Therefore, the ETSC corporate subsidiary would recognize income as it collects amounts on the transferred receivables. In the case where the ETSC corporate subsidiary collects the entire amount of the transferred receivables during its first taxable year, commenters contended that the ETSC corporate subsidiary’s inability to include the amount received over the six-year section 481(d) inclusion period would inappropriately disadvantage the former QSub as E:\FR\FM\20OCR1.SGM 20OCR1 66474 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations compared to its former S corporation parent. The Treasury Department and the IRS understand the commenters’ concerns regarding the statutorily limited application of section 481(d) and observe that the commenters’ request is not unique to the application of section 481(d), but rather addresses the longstanding treatment of former S corporations and QSubs under section 481 with regard to a deemed section 351 exchange. Throughout the nearly 25year period since the 1996 enactment of the QSub provisions under section 1361, section 481(a)(2) and any inclusion period for a 481 adjustment have not applied with respect to former QSubs. See section 1308 of the Small Business Job Protection Act of 1996, Public Law 104–188, 110 Stat. 1755, 1782–3 (August 20, 1996). See also Rev. Proc. 97–27, 1997–1 C.B. 680, section 5.02(3)(a) (providing a four-year amortization period solely to taxpayers that have a 481 adjustment); Rev. Proc. 2015–13, 2015–5 I.R.B. 419, section 7.03(1) (same). After considering the commenters’ analysis and the explicit reference in section 481(d) to section 481(a)(2), the Treasury Department and the IRS have determined that section 481(d) does not apply to ETSC corporate subsidiaries, but rather maintains the longstanding application of section 481(a) solely to taxpayers that make an accounting method change. Accordingly, there is no authority under section 481(d) to extend the section 481(d) inclusion period to ETSC corporate subsidiaries. Commenters also contended that the Treasury Department and the IRS could override the limited scope of section 481(d) through special QSub regulations issued under the authority provided by section 481(c), which, in the case of a taxpayer making an accounting method change, authorizes regulations permitting a taxpayer to take any 481 adjustment into account in computing taxable income for the taxable year or years permitted under such regulations. For example, commenters suggested that the final regulations permit an accrual method ETSC corporate subsidiary to elect to treat the assets received (and liabilities assumed) by the ETSC corporate subsidiary in the deemed section 351 exchange as though the subsidiary had owned such assets (and had such liabilities) in a prior taxable year, thereby creating an accounting method change upon the revocation. However, this approach contradicts the explicit text of section 1362(b)(3)(C)(i), which provides that, ‘‘[f]or purposes of this title’’ (that is, for purposes of all of the provisions of the Code), an ETSC VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 corporate subsidiary ‘‘shall be treated as a new corporation.’’ In the alternative, commenters suggested that the final regulations could permit taxpayers to treat the assets received (and liabilities assumed) by an ETSC corporate subsidiary as though still owned by the former S corporation on the date on which the former S corporation becomes an ETSC. Under this approach, the ETSC’s 481 adjustment would be computed as if the ETSC owned such assets and was subject to such liabilities. For support, these commenters highlighted antiabuse regulations issued under section 263A of the Code (UNICAP anti-abuse regulations) that utilized this alternative approach. See § 1.263A–7(c)(4)(ii) (providing an anti-abuse rule regarding the use of section 351 exchanges to avoid application of section 263A). However, the UNICAP anti-abuse regulations were issued under the authority of section 263A(h)(1) rather than the authority granted the Secretary under section 481(c). See 52 FR 10052, 10059 (March 30, 1987). Section 263A(h)(1) requires the Secretary to ‘‘prescribe rules to carry out the purpose of section 263A, including regulations to prevent the use of related parties, pass-thru entities, or intermediaries to avoid the application of this section.’’ Section 263A(j)(1). The Treasury Department and the IRS have considered the commenters’ suggested approaches for extending the section 481(d) inclusion period to ETSC corporate subsidiaries but have determined that section 481(c) would not support either approach. Section 481(c) and § 1.481–1(c)(2) provide the general rule that the 481 adjustment is taken into account in computing taxable income in the year of change, unless the Commissioner prescribes a different taxable year or years to take the 481 adjustment into account under §§ 1.446–1(e)(3) and 1.481–4. Any regulations issued under section 481(c) can apply only ‘‘[i]n the case of any change described in [section 481](a)’’ with regard to ‘‘adjustments required by [section 481](a)(2).’’ As acknowledged by the commenters, section 481(a) does not apply to an ETSC corporate subsidiary because such entity is newly formed and therefore could not have had a prior accounting method to potentially change. Based on the foregoing, the final regulations do not adopt either of the commenters’ alternative suggestions or provide any inclusion period for ETSC corporate subsidiaries under section 481. The Treasury Department and the IRS, however, note that TCJA amendments to section 448(c) of the PO 00000 Frm 00006 Fmt 4700 Sfmt 4700 Code have significantly expanded the applicability of the cash method to C corporations, including ETSC corporate subsidiaries. As amended by section 13102(a) of the TCJA (131 Stat. 2054, 2102–3), section 448(c) provides that a C corporation may use the cash method if the corporation has average annual gross receipts not exceeding $25 million (adjusted for inflation) for its three prior taxable years. Prior to the TCJA, the gross receipts threshold under section 448(c) was $5 million. As a result, fewer ETSC corporate subsidiaries will be required to adopt the accrual method as their permissible method of accounting for their first tax return than if the section 448(c) gross receipts threshold had not been increased from $5 million to $25 million. III. Comments Regarding the PostTermination Transition Period The last sentence of § 1.1377–2(b), as in effect prior to the effective date of these final regulations (no-newcomer rule), limited the special treatment provided under section 1371(e)(1) (with respect to distributions of money during a corporation’s PTTP) solely to those shareholders who were shareholders of the corporation at the time that it terminated or revoked its S election (collectively, legacy shareholders). Because the rules pertaining to the PTTP and to the ETSC period serve a similar objective of easing the transition from S corporation to C corporation status, the Treasury Department and the IRS determined that the rules regarding newcomers (that is, non-legacy shareholders) should be consistent. See preamble to the proposed regulations, Explanation of Provisions, part IV. Therefore, based on the rationale for rejecting a no-newcomer rule with respect to the ETSC period, as set forth in part II.A of the Explanation of Provisions of the preamble to the proposed regulations, the Treasury Department and the IRS determined that such a rule should also not apply with respect to the PTTP and proposed the removal of the no-newcomer rule in § 1.1377–2(b). See Id. A. Reliance on the § 1.1377–2(b) NoNewcomer Rule One commenter expressed concern that elimination of the no-newcomer rule in § 1.1377–2(b) could alter bargained-for economic results if a legacy shareholder had transferred less than all of its shares prior to November 7, 2019 (that is, the publication date of the proposed regulations) or after that date but pursuant to a binding agreement entered into before that date. In particular, the commenter contended E:\FR\FM\20OCR1.SGM 20OCR1 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations that legacy shareholders who transferred less than all of their shares would have expected that only legacy shareholders could receive distributions of AAA during the PTTP, and perhaps even during the ETSC period. According to the commenter, this expectation would have reduced the bargained-for price for the transferred shares to reflect the tax benefit of the future tax-free distributions. The commenter provided an example in which a sole shareholder of an ETSC sold 40 percent of its stock to a thirdparty. The sale price was set prior to November 7, 2019, and the parties assumed that the no-newcomer rule would limit distributions of AAA to the legacy shareholder during the PTTP, and that a similar rule would apply during the ETSC period. Under the proposed elimination of the nonewcomer rule in § 1.1377–2(b), however, the newcomer, and not the legacy shareholder, would be eligible to receive 40 percent of any AAA distributed during the PTTP or ETSC period. The commenter observed that the newcomer’s accession to a 40 percent interest in the corporation’s AAA during the PTTP and ETSC period amounts to a transfer of a tax benefit from the legacy shareholder to the newcomer for no consideration, contrary to the parties’ expectations. Therefore, the commenter recommended that the final regulations include an additional transition rule. Under this rule, if shares of a former S corporation were transferred to a newcomer pursuant to a binding agreement entered into before the applicability date of the final regulations, then, except upon unanimous agreement of current shareholders of a corporation that are legacy shareholders, the no-newcomer rule would apply during the PTTP, and a similar rule would apply during the ETSC period. The Treasury Department and the IRS understand the concern underlying the commenter’s recommendation. However, the Treasury Department and the IRS intended the applicability date provisions in the proposed regulations, and as adopted in these final regulations, to afford corporations transition flexibility in applying § 1.1377–2(b) with regard to the PTTP. Section 1.1377–2(b), as revised by the final regulations to eliminate the nonewcomer rule for special treatment under section 1371(e)(1) of distributions of money by a corporation with respect to its stock during the post-termination transition period applies to a corporation’s taxable years beginning after the date of publication of the final VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 regulations. In the case of a corporation using the calendar year as its annual accounting period, newcomers are not entitled to receive distributions of AAA before January 1, 2021, unless the corporation chooses to apply § 1.1377– 2(b) before January 1, 2021. Corporations to which the commenter’s transition rule would have applied generally will thus have completed their PTTPs prior to the applicability of § 1.1377–2(b). Distributions of AAA during those PTTPs would have been limited to legacy shareholders. Additionally, the commenter’s proposed transition rule would add complexity in administering these rules. Accordingly, the Treasury Department and the IRS have determined that the applicability date provisions, as set forth in the proposed regulations and adopted in these final regulations, balance appropriately the protection of legacy taxpayers’ expectations with the goal of the Treasury Department and the IRS to minimize complexity and administrative difficulties for S corporations, their shareholders, and the IRS. With regard to the ETSC period, as discussed in part II.A of the Explanation of Provisions of the preamble to the proposed regulations, section 1371(f) does not contain a no-newcomer rule similar to § 1.1377–2(b), and the Treasury Department and the IRS have concluded that it is inappropriate to adopt one. Corporations may have applied a similar analysis of section 1371(f) and made distributions of AAA to newcomers during their respective ETSC periods. Providing an alternate rule in these final regulations for the ETSC period could unexpectedly alter taxpayers’ bargained-for economic results. Therefore, the Treasury Department and the IRS have determined that the best way to address this situation is to allow but not require corporations to apply the final regulations addressing distributions made during the ETSC period to taxable years beginning on or before the date that these final regulations are published in the Federal Register. B. Consideration of Request for an Additional 120-Day PTTP A commenter recommended that the final regulations provide a new 120-day PTTP that would begin on the applicability date of the final regulations. The commenter noted that this new PTTP would create an opportunity for any C corporation with undistributed AAA that expired at the end of its PTTP to restore and distribute such AAA pursuant to section 1371(e)(1) and § 1.1377–2. The PO 00000 Frm 00007 Fmt 4700 Sfmt 4700 66475 commenter contended that the elimination of the no-newcomer rule only for terminations that occur after the issuance of the proposed regulations disadvantages corporations that terminated their S election more than one year prior to issuance of the proposed regulations, as compared to corporations that terminated their S election after the issuance of the proposed regulations. The Code sets forth a statutory definition of the PTTP that includes detailed limits on its duration. Specifically, section 1377(b)(1)(A), (B), and (C) provide three separate durations for the PTTP, the respective applicability of which depends upon particular events. While the Treasury Department and the IRS acknowledge the concerns raised by the commenter, the final regulations do not adopt the commenter’s recommendation because (i) section 1377(b) provides specific, detailed, and unambiguous guidance on the duration of a PTTP, and (ii) the recommended revision to § 1.1377–2 exceeds the scope of the authority granted to prescribe regulations under sections 1371 or 1377. IV. Consideration of Comment Regarding Treatment of ETSC Status and AAA as Section 381 Items In the case of certain asset acquisitions, section 381(a) generally requires the acquiring corporation to succeed to and take into account the tax items described in section 381(c) of the distributor or transferor corporation. See section 381(a) (describing distributions to which section 332 of the Code applies and transfers to which section 361 of the Code applies that are carried out in connection with certain reorganizations described in section 368(a)(1) of the Code); section 381(c) (enumerating tax items of the distributor or transferor corporation that the acquiring corporation succeeds to and takes into account under section 381(a)). A commenter requested that the final regulations confirm that ETSC status and AAA constitute tax items that an acquiring corporation would succeed to or take into account under section 381(a). The Treasury Department and the IRS have considered the issue raised by the commenter but have determined that further study would be required to promulgate the appropriate rule. In addition, the Treasury Department and the IRS have concluded that this issue exceeds the scope of the final regulations because whether AAA constitutes a tax item to which a successor may succeed under section 381 is not limited to the ETSC context. E:\FR\FM\20OCR1.SGM 20OCR1 66476 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations Therefore, the final regulations do not address the commenter’s request. Applicability Dates These regulations generally apply to taxable years beginning after October 20, 2020. See §§ 1.481–6(b), 1.1371–1(e), 1.1371–2(d), and 1.1377–3(c). However, a corporation may choose to apply the rules set forth in §§ 1.481–5, 1.1371–1, and 1.1371–2 in their entirety to taxable years beginning on or before October 20, 2020. If a corporation makes the choice described in the previous sentence, all shareholders of the corporation must report consistently, and the corporation must continue to apply the rules in §§ 1.481–5, 1.1371–1, and 1.1371–2 in their entirety for the corporation’s subsequent taxable years. In addition, a corporation generally may choose to not apply the nonewcomer rule in § 1.1377–2(b) to taxable years beginning on or before October 20, 2020 and with respect to which the period described in section 6501(a) as applied to that corporation has not expired. If a corporation makes the choice described in the previous sentence, all shareholders of the corporation must report consistently, and the corporation must adopt §§ 1.481–5, 1.1371–1, 1.1371–2 (if an ETSC), and § 1.1377–2(b) in their entirety and continue to apply those rules in their entirety for the corporation’s subsequent taxable years. Special Analyses These final regulations are not subject to review under section 6(b) of Executive Order 12866 pursuant to the Memorandum of Agreement (April 11, 2018) between the Treasury Department and the Office of Management and Budget regarding review of tax regulations. I. Regulatory Flexibility Act Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it is hereby certified that these final regulations will not have a significant economic impact on a substantial number of small entities within the meaning of section 601(6) of the Regulatory Flexibility Act. Notwithstanding this certification, the Treasury Department and the IRS provided such an analysis in the notice of proposed rulemaking preceding these final regulations (see 84 FR 60011) and received no comments on the impact that the proposed regulations would have on small entities. This certification is based on the fact that the amount of time necessary to report the required information will be minimal in that it requires ETSCs to provide information already required to be collected by VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 previously existing statutory and regulatory requirements. Accordingly, the Secretary certifies that these regulations will not have a significant economic impact on a substantial number of small entities. Pursuant to section 7805(f), the notice of proposed rulemaking preceding this regulation was submitted to the Chief Counsel for the Office of Advocacy of the Small Business Administration for comment on its impact on small businesses. No comments were received from the Chief Counsel for the Office of Advocacy of the Small Business Administration. Chief Counsel (Passthroughs and Special Industries) and Aglaia Ovtchinnikova of the Office of Associate Chief Counsel (Corporate). However, other personnel from the Treasury Department and the IRS participated in the development of the final regulations. II. Paperwork Reduction Act These final regulations do not require collection of any new or additional information pursuant to the Paperwork Reduction Act (44 U.S.C. 3501 et seq.). Nevertheless, the Treasury Department and the IRS provided such an analysis in the notice of proposed rulemaking preceding these final regulations. See 84 FR 60011. PART 1—INCOME TAXES III. Unfunded Mandates Reform Act Section 202 of the Unfunded Mandates Reform Act of 1995 requires that agencies assess anticipated costs and benefits and take certain other actions before issuing a final rule that includes any Federal mandate that may result in expenditures in any one year by a state, local, or tribal government, in the aggregate, or by the private sector, of $100 million in 1995 dollars, updated annually for inflation. In 2020, that threshold is approximately $156 million. This final rule does not include any mandate that may result in expenditures by state, local, or tribal governments, or by the private sector in excess of that threshold. IV. Executive Order 13132: Federalism Executive Order 13132 (entitled ‘‘Federalism’’) prohibits an agency from publishing any rule that has federalism implications if the rule either imposes substantial, direct compliance costs on state and local governments, and is not required by statute, or preempts state law, unless the agency meets the consultation and funding requirements of section 6 of the Executive Order. This final rule does not have federalism implications and does not impose substantial, direct compliance costs on state and local governments or preempt state law within the meaning of the Executive Order. Drafting Information The principal authors of these final regulations are Margaret Burow and Michael Gould of the Office of Associate PO 00000 Frm 00008 Fmt 4700 Sfmt 4700 List of Subjects in 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1 is amended as follows: Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order for § 1.481–6 to read in part as follows: ■ Authority: 26 U.S.C. 7805 * * * * * * * * Section 1.481–6 is also issued under 26 U.S.C. 481. * * § 1.316–2 * * * [Amended] Par. 2. Section 1.316–2 is amended by removing ‘‘consist only of money and’’ from the second sentence of paragraph (b). ■ § 1.481–5 [Redesignated as § 1.481–6] Par. 3. Section 1.481–5 is redesignated as § 1.481–6. ■ Par. 4. New § 1.481–5 is added to read as follows: ■ § 1.481–5 Eligible terminated S corporation. (a) Scope. Section 481(d)(2) of the Internal Revenue Code (Code) and this section provide rules relating to the qualification of a corporation as an eligible terminated S corporation (ETSC). Paragraph (b) of this section sets forth the requirements a corporation must meet to qualify as an ETSC. Paragraph (c) of this section describes certain transfers and other events that are disregarded for purposes of determining whether a corporation qualifies as an ETSC, as well as the treatment of revocations for which the effective date is the first day of the taxable year during which the revocation is made. Paragraph (d) of this section contains examples illustrating the rules of this section. (b) ETSC qualification. For a C corporation to qualify as an ETSC, it must satisfy the following requirements: (1) The corporation must have been an S corporation on December 21, 2017; (2) During the 2-year period beginning on December 22, 2017, the corporation E:\FR\FM\20OCR1.SGM 20OCR1 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations must have made a valid revocation of its S election under section 1362(d)(1) and the regulatory provisions in this part under section 1362 of the Code (revocation); and (3) Except as provided in paragraph (c) of this section, the owners of the shares of stock of the corporation must be the same (and in identical proportions) on both: (i) December 22, 2017; and (ii) The day on which the revocation is made. (c) Special rules—(1) Certain disregarded events. The following events are disregarded for purposes of determining whether the requirement in paragraph (b)(3) of this section is satisfied: (i) Transfers of stock between a shareholder and that shareholder’s trust treated as wholly owned by that shareholder under subpart E of subchapter J of chapter 1 of the Code; (ii) Transfers of stock between a shareholder and an entity owned by that shareholder that is disregarded as separate from its owner under § 301.7701–2(c)(2)(i) of the Procedure and Administration Regulations; (iii) An election by a shareholder trust to be treated as part of a decedent’s estate under section 645 of the Code or the termination of an election under that section; (iv) A change in the status of a shareholder trust from one type of eligible S corporation shareholder trust described in section 1361(c)(2)(A) of the Code to another type of eligible S corporation shareholder trust; for example, a trust to which the shares of stock were transferred pursuant to the terms of a will (testamentary trust) described in section 1361(c)(2)(A)(iii) that elects to become an electing small business trust described in section 1361(c)(2)(A)(v) and (e); and (v) A transaction that includes more than one of the events described in this paragraph (c)(1). (2) Certain revocations. For purposes of paragraphs (b)(2) and (b)(3)(ii) of this section, a revocation with an effective date that is the first day of the taxable year during which the revocation is made pursuant to section 1362(d)(1)(C)(i) may be treated as having been made on the day the revocation was made or on the effective date of the revocation. (d) Examples. Paragraphs (d)(1) through (3) of this section (Examples 1 through 3) illustrate the rules of this section. For purposes of paragraphs (d)(1) through (3) of this section (Examples 1 through 3), as of December 1, 2017, X is a calendar year S corporation with 100 shares of stock VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 outstanding that is owned equally by unrelated individuals A and B. Pursuant to section 1362(d)(1) and §§ 1.1362–2 and 1.1362–6, X made a valid revocation of its S election on March 15, 2019, effective on January 1, 2019. X treats the revocation as having been made on March 15, 2019, for purposes of paragraphs (b)(2) and (b)(3)(ii). At all times, X has a single class of stock outstanding. Paragraphs (d)(1) through (3) of this section (Examples 1 through 3) describe all relevant transactions involving the X stock from December 1, 2017, until March 15, 2019. (1) Example 1—(i) Facts. On June 5, 2018, A contributed 20 of its shares of X stock to Y, a wholly owned limited liability company that is disregarded as an entity separate from A pursuant to § 301.7701–2(c)(2)(i). On June 14, 2018, A contributed all of its interest in Y to Trust, which was a revocable trust treated as a wholly owned grantor trust of A pursuant to sections 671 and 676 of the Code. On December 27, 2018, B sold 10 shares of its X stock to C, an unrelated person. (ii) Analysis. X is an ETSC if it satisfies the requirements of paragraph (b) of this section. (A) S corporation. X was an S corporation on December 21, 2017. Therefore, X satisfies the requirement of paragraph (b)(1) of this section. (B) Date of revocation. X made a valid revocation of its S election pursuant to section 1362(d)(1) on March 15, 2019, which is during the two-year period specified in paragraph (b)(2) of this section. Therefore, X satisfies the requirement of paragraph (b)(2) of this section. (C) Ownership. For purposes of the requirement in paragraph (b)(3) of this section, the relevant dates are: December 22, 2017, and March 15, 2019 (the date X made a revocation of its S corporation status). (1) A’s ownership interest. As of December 22, 2017, A owned 50 shares of the outstanding shares of X stock. On June 5, 2018, A contributed 20 of its shares of X stock to Y (Transfer). On June 14, 2018, A contributed all of its interest in Y to Trust (Contribution). Both the Transfer and the Contribution are disregarded for purposes of determining whether the requirement of paragraph (b)(3) of this section is satisfied. See paragraphs (c)(2) and (1) of this section, respectively. Therefore, A owns 50 shares of the outstanding stock of X on March 15, 2019. (2) B’s ownership interest. As of December 22, 2017, B owned 50 shares of the outstanding shares of X stock. On December 27, 2018, B sold 10 shares to C. Therefore, B owns 40 shares of the PO 00000 Frm 00009 Fmt 4700 Sfmt 4700 66477 outstanding stock of X on March 15, 2019. (3) C’s ownership interest. As of December 22, 2017, C owned no shares of X stock. On December 27, 2018, C purchased 10 shares from B. Therefore, C owns 10 shares of the outstanding stock of X on March 15, 2019. (4) Failure to satisfy the requirement in paragraph (b)(3) of this section. As described in paragraphs (d)(1)(ii)(C)(2) and (3) of this section, B’s and C’s interest in X were not in the same proportions on December 22, 2017, and March 15, 2019. Therefore, X does not satisfy the requirement of paragraph (b)(3) of this section and does not qualify as an ETSC. (iii) Restoration of interests prior to end of PTTP. If C transferred its shares of X stock back to B on February 1, 2019, then on December 22, 2017, and March 15, 2019, A and B will have owned 50 shares of the outstanding stock of X. Under these facts, X satisfies the requirement of paragraph (b)(3) of this section and qualifies as an ETSC. (2) Example 2—(i) Facts. The facts are the same as in paragraph (d)(1)(i) of this section, except that B sold 10 shares of its X stock to C on December 18, 2017, in addition to the sale of 10 shares of X stock on December 27, 2018. (ii) Analysis. The analysis in paragraph (d)(1)(ii)(A) and (B) of this section remains the same regarding the requirements of paragraph (b)(1) and (2) of this section. With respect to the requirement of paragraph (b)(3) of this section, on December 22, 2017, A owned 50%, B owned 40%, and C owned 10% of the outstanding stock of X. As in paragraph (d)(1)(ii)(C)(1) of this section, the Transfer and the Contribution are disregarded for purposes of determining whether the requirement of paragraph (b)(3) of this section is satisfied. Therefore, on March 15, 2019, A owned 50% (50 shares), B owned 30% (30 shares), and C owned 20% (20 shares) of the outstanding shares of X. Even though A, B, and C owned shares of X on December 22, 2017, B’s and C’s proportionate ownership interest of X stock was not the same on December 22, 2017, and March 15, 2019. Therefore, X does not satisfy the requirement of paragraph (b)(3) of this section and does not qualify as an ETSC. (3) Example 3—(i) Facts. The facts are the same as in paragraph (d)(1)(i) of this section, except that X made a valid revocation of its S election on November 1, 2019, effective on January 1, 2020. (ii) Analysis. The analysis in paragraph (d)(1)(ii)(A) through (C) of this section remains the same regarding the requirements of paragraph (b)(1) E:\FR\FM\20OCR1.SGM 20OCR1 66478 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations through (3) of this section, except that the relevant dates are: December 22, 2017, and November 1, 2019 (the date X made a revocation of its S corporation status). Although the effective date of X’s revocation of its S election (January 1, 2020) occurs after the conclusion of the two-year period specified in paragraph (b)(2) of this section, it is irrelevant for purposes of determining whether the requirements of paragraph (b)(2) and (3) of this section are satisfied. Par. 5. Newly redesignated § 1.481–6 is revised to read as follows: ■ § 1.481–6 dates. Effective dates; applicability (a) Sections 1.481–1, 1.481–2, 1.481– 3, and 1.481–4 are effective for Consent Agreements signed on or after December 27, 1994. For Consent Agreements signed before December 27, 1994, see §§ 1.481–1, 1.481–2, 1.481–3, 1.481–4, and 1.481–5 as contained in 26 CFR part 1, revised as of April 1, 1995. (b) Section 1.481–5 applies to taxable years beginning October 20, 2020. However, a corporation may choose to apply the rules in §§ 1.481–5, 1.1371– 1, and 1.1371–2 in their entirety to taxable years beginning on or before October 20, 2020. If a corporation makes the choice described in the previous sentence, the corporation must continue to apply the rules in §§ 1.481–5, 1.1371–1, and 1.1371–2 in their entirety for the corporation’s subsequent taxable years. Par. 6. Section 1.1362–2 is amended by adding paragraph (a)(2)(iii) to read as follows: ■ § 1.1362–2 Termination of election. (a) * * * (2) * * * (iii) Applicability of section 7503. With respect to a revocation made under paragraph (a)(2) of this section, see section 7503 (addressing time for performance of acts where the last day occurs on a Saturday, Sunday, or legal holiday). This paragraph (a)(2)(iii) applies to revocations made under paragraph (a)(2) of this section effective after October 20, 2020. A corporation may apply this paragraph (a)(2)(iii) retroactively to a revocation made by the corporation under paragraph (a)(2) of this section effective on or before October 20, 2020. * * * * * Par. 6. Sections 1.1371–1 and 1.1371– 2 are added to read as follows: ■ VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 § 1.1371–1 Distributions of money by an eligible terminated S corporation. (a) Scope and definitions—(1) Scope. This section provides rules relating to qualified distributions and distributions to which section 301 of the Internal Revenue Code (Code) applies during each taxable year of the ETSC period, including the taxable year in which the ETSC period ends. If an ETSC does not make any qualified distributions during a taxable year, then no distribution by the ETSC is governed by section 1371(f) of the Code or this section. Paragraph (a)(2) of this section contains definitions that apply for purposes of this section. Paragraph (b) of this section contains rules regarding the characterization of a qualified distribution. Paragraph (c) of this section contains rules regarding the characterization of any excess qualified distribution and non-qualified distribution during each taxable year of the ETSC period, including the taxable year in which the ETSC period ends. Paragraph (d) of this section contains examples illustrating the rules of this section. Paragraph (e) of this section contains the applicability date of this section. (2) Definitions. The following definitions apply for purposes of this section— (i) AAA. The term AAA means the accumulated adjustments account, within the meaning of section 1368(e)(1)(A) of the Code and § 1.1368– 2(a)(1). (ii) AAA ratio. Except as provided in this paragraph or paragraph (b)(3)(iv) of this section, the term AAA ratio means the fraction of which the numerator is historical AAA and the denominator is the sum of historical AAA and historical AE&P. Notwithstanding the preceding sentence, if the AE&P of the ETSC is less than or equal to zero as of the beginning of a taxable year, then the AAA ratio is one for such year and for all subsequent taxable years of the ETSC period. (iii) AE&P. The term AE&P means earnings and profits described in section 316(a)(1) of the Code. (iv) AE&P ratio. Except as provided in this paragraph or paragraph (b)(3)(iv) of this section, the term AE&P ratio means the fraction of which the numerator is historical AE&P, and the denominator is the sum of historical AAA and historical AE&P. Notwithstanding the preceding sentence, if the AE&P of the ETSC is less than or equal to zero as of the beginning of a taxable year, then the AE&P ratio is zero for such year and all subsequent taxable years of the ETSC period. (v) CE&P. The term CE&P means earnings and profits that are described in section 316(a)(2). PO 00000 Frm 00010 Fmt 4700 Sfmt 4700 (vi) ETSC. The term ETSC means an eligible terminated S corporation, within the meaning of section 481(d) of the Code and § 1.481–5. (vii) ETSC period. In general, the term ETSC period means any taxable year, or portion thereof, of an ETSC beginning on the first day after the posttermination period within the meaning of section 1377(b)(1)(A) of the Code and ending on the date on which the ETSC’s AAA balance is zero. Additionally, an ETSC does not have an ETSC period if the ETSC’s AAA balance is not greater than zero at the end of its posttermination transition period. See § 1.1371–2 for rules governing the impact of a post-termination period, within the meaning of section 1377(b)(1)(B), on the ETSC period. (viii) Excess qualified distribution. The term excess qualified distribution means the portion of a qualified distribution that is not characterized pursuant to paragraph (b)(2) or (3) of this section. (ix) Historical AAA. The term historical AAA means the AAA of the ETSC as of the beginning of the day on which the revocation of an election under section 1362(a) of the Code is effective pursuant to section 1362(d)(1). (x) Historical AE&P. The term historical AE&P means the AE&P of the ETSC as of the beginning of the day on which the revocation of an election under section 1362(a) is effective pursuant to section 1362(d)(1). For purposes of the preceding sentence, if the ETSC’s historical AE&P is less than zero, then the historical AE&P is treated as zero. (xi) Non-qualified distribution. The term non-qualified distribution means a distribution that is not a qualified distribution and to which section 301 applies. (xii) Qualified distribution. The term qualified distribution means a distribution of money by an ETSC during the ETSC period to which, absent the application of section 1371(f) and this section, section 301 would apply. However, if paragraph (d)(2)(i) of this section applies to the ETSC, then a qualified distribution to a non-legacy shareholder is treated as a non-qualified distribution. (b) Characterization of qualified distribution—(1) In general. Paragraph (b)(2) of this section provides rules regarding the determination of the amount of a qualified distribution that is sourced from AAA and the corollary effects of such a characterization. Paragraph (b)(3) of this section provides rules regarding the determination of the amount of a qualified distribution that is sourced from AE&P and the corollary E:\FR\FM\20OCR1.SGM 20OCR1 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations effects of such a characterization. Paragraph (b)(4) of this section provides rules regarding the characterization of an excess qualified distribution as a separate qualified distribution. The rules in paragraphs (b)(2) through (4) of this section are applied before the application of paragraph (c) of this section. (2) Distribution of AAA—(i) Amount. The portion of a qualified distribution that is sourced from an ETSC’s AAA is equal to the lesser of: (A) The product of the qualified distribution and the AAA ratio; and (B) The ETSC’s AAA immediately before the qualified distribution. (ii) Reduction or elimination of ETSC’s AAA. The ETSC’s AAA is reduced by the amount of the distribution described in paragraph (b)(2)(i) of this section. If, with respect to a qualified distribution, the amount described in paragraph (b)(2)(i)(A) of this section equals or exceeds the amount described in paragraph (b)(2)(i)(B) of this section, then the rules in this paragraph (b) do not apply to any subsequent distributions by the ETSC. Instead, the subsequent distributions are treated in the manner provided in paragraph (c) of this section. (iii) Effect on the shareholder. The amount described in paragraph (b)(2)(i) of this section is applied against and reduces the shareholder’s adjusted basis of the shares of stock with respect to which the distribution is made under the principles of section 301(c)(2). If the application of the amount described in paragraph (b)(2)(i) of this section would result in a reduction of basis that exceeds the shareholder’s adjusted basis of any share of stock with respect to which the distribution is made, such excess is treated as gain from the sale or exchange of property. The reduction of the shareholder’s basis described in this paragraph with respect to a qualified distribution occurs prior to the application of paragraph (c) of this section to the excess qualified distribution, if any, with respect to such qualified distribution. (3) Distribution of AE&P—(i) Amount. This paragraph (b)(3) applies if an ETSC’s AE&P ratio is greater than zero. If this paragraph (b)(3) applies, the portion of a qualified distribution that is sourced from the ETSC’s AE&P is equal to the lesser of: (A) The product of the qualified distribution and the AE&P ratio; and (B) The ETSC’s AE&P immediately before the qualified distribution. For purposes of the preceding sentence, if the ETSC’s AE&P immediately before the qualified distribution is less than VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 zero, then the ETSC’s AE&P is treated as zero. (ii) Effect on ETSC’s AE&P. The ETSC’s AE&P is reduced, as described in section 312(a)(1), by the amount of the distribution described in paragraph (b)(3)(i) of this section. The AE&P reduction described in this paragraph occurs prior to the application of paragraph (c) of this section, even if a distribution to which paragraph (c) of this section applies (regarding excess qualified distributions and nonqualified distributions) occurs earlier in time than the qualified distribution to which this paragraph applies. (iii) Effect on the shareholder. The amount of the qualified distribution that is sourced from the ETSC’s AE&P described in paragraph (b)(3)(i) of this section is included in the gross income of the shareholder as a dividend under section 301(c)(1). (iv) Adjustment to the AAA ratio and the AE&P ratio. After the application of paragraph (b)(3)(ii) of this section, if the ETSC’s AE&P is zero and the ETSC’s AAA is greater than zero, then the ETSC’s AAA ratio is one and the ETSC’s AE&P ratio is zero for all subsequent qualified distributions during: (A) That taxable year; and (B) All subsequent taxable years of the ETSC period. (4) Excess qualified distribution treated as a separate qualified distribution—(i) In general. After the application of paragraph (b)(2)(ii) of this section with respect to a qualified distribution, if the ETSC has any remaining AAA, then any amount of excess qualified distribution, with respect to such qualified distribution, is treated as a separate qualified distribution and is analyzed pursuant to paragraph (b) of this section. (ii) No change in characterization of previously characterized portion of qualified distribution. Paragraph (b)(4)(i) will not change the characterization of any portion of a qualified distribution that was previously characterized pursuant to paragraphs (b)(2) and (3) of this section and will reflect the application of paragraphs (b)(2) and (3) of this section to the portion of the qualified distribution previously characterized. (c) Characterization of excess qualified distribution and non-qualified distributions. After the application of paragraph (b), the excess qualified distributions, if any, and non-qualified distributions, if any, are treated in the manner provided in sections 301(c) and 316. (d) Examples. Paragraphs (d)(1) through (5) of this section (Examples 1 through 5) illustrate the rules of this PO 00000 Frm 00011 Fmt 4700 Sfmt 4700 66479 section. For purposes of paragraphs (d)(1) through (5) of this section (Examples 1 through 5), X is a calendar year S corporation with a single share of stock outstanding. A, an individual, purchased its share of X stock prior to December 22, 2017, and, except as otherwise indicated, never contributed any amounts to X’s capital. A remained the sole shareholder of X when X made a valid revocation on March 15, 2018, pursuant to section 1362(d)(1) and §§ 1.1362–2 and 1.1362–6, of its S election and when that revocation became effective on January 1, 2018. X qualified as an ETSC pursuant to § 1.481–5(b) and its ETSC period began on January 1, 2019. Additionally, X did not make any distributions during its post-termination transition period, within the meaning of section 1377(b)(1)(A). Furthermore, A remains the sole shareholder of X at the time of the distribution(s) described. (1) Example 1: Historical AE&P is zero—(i) Facts. At the beginning of January 1, 2018, X had AAA of $100 and AE&P of $0. During 2018, X had $300 of CE&P and made no distributions. At the beginning of January 1, 2019, X has AAA of $100 and AE&P of $300, and A’s adjusted basis in its share of X stock is $460. During 2019, the only distribution that X makes is a $60 distribution of money to A on December 27. X’s CE&P during 2019 is $150, without diminution by reason of any distributions made during the taxable year. (ii) Analysis—(A) Calculation of AAA ratio and AE&P ratio. Pursuant to paragraphs (a)(2)(ix) and (x) of this section, respectively, X’s historical AAA and X’s historical AE&P are determined as of the beginning of January 1, 2018, the beginning of the day on which the revocation of X’s election under section 1362(a) is effective pursuant to section 1362(d)(1). Accordingly, X’s historical AAA is $100 and X’s historical AE&P is $0. Therefore, X’s AAA ratio is 1 ($100/ ($100 + $0)), and X’s AE&P ratio is zero ($0/($100 + $0)). (B) Characterization of distribution. Pursuant to paragraph (a)(2)(xii) of this section, the $60 distribution on December 27, 2019, is a qualified distribution because it is a distribution of money by an ETSC during the ETSC period to which section 301 would apply absent the application of section 1371(f) and this section. (C) Analysis of qualified distribution—(1) Distribution of AAA. Pursuant to paragraph (b)(2)(i) of this section, the portion of the qualified distribution that is sourced from AAA is equal to the lesser of: The product of the qualified distribution and the AAA ratio E:\FR\FM\20OCR1.SGM 20OCR1 66480 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations ($60 × 1, or $60), and X’s AAA immediately before the qualified distribution ($100). Therefore, $60 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section, after the distribution, X’s AAA is reduced by $60 to $40. Pursuant to paragraph (b)(2)(iii) of this section, A’s basis in its X stock is reduced by $60 to $400. (2) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this section, the portion of the distribution that is sourced from AE&P is equal to the lesser of: The product of the qualified distribution and the AE&P ratio ($60 × 0, or $0), and X’s AE&P immediately before the qualified distribution ($300). Therefore, $0 is sourced from AE&P. (2) Example 2: Qualified distributions with both historical AAA and historical AE&P—(i) Facts. At the beginning of January 1, 2018, X had AAA of $200 and AE&P of $100. During 2018, X had $0 of CE&P and made no distributions. At the beginning of January 1, 2019, X has AAA of $200 and AE&P of $100, and A’s adjusted basis in its share of X stock is $500. During 2019, X makes a $90 distribution of money on February 9 and a $150 distribution of money on June 5. X’s CE&P during 2019 is $500, without diminution by reason of any distributions made during the taxable year. (ii) Analysis—(A) Calculation of AAA ratio and AE&P ratio. Pursuant to paragraphs (a)(2)(ix) and (x) of this section, respectively, X’s historical AAA and X’s historical AE&P are determined as of the beginning of January 1, 2018, the beginning of the day on which the revocation of X’s election under section 1362(a) is effective pursuant to section 1362(d)(1). Accordingly, X’s historical AAA is $200 and X’s historical AE&P is $100. Therefore, X’s AAA ratio is 0.67 ($200/($200 + $100)), and X’s AE&P ratio is 0.33 ($100/($200 + $100)). (B) Characterization of distributions. Pursuant to paragraph (a)(2)(xii) of this section, the $90 distribution on February 9, 2019, and the $150 distribution on June 5, 2019, are both qualified distributions because they are distributions of money by an ETSC during the ETSC period to which section 301 would apply absent the application of section 1371(f) and this section. (C) Analysis of qualified distributions—(1) February 9, 2019 distribution—(i) Distribution of AAA. Pursuant to paragraph (b)(2)(i) of this section, the portion of the qualified distribution that is sourced from AAA is equal to the lesser of: The product of the qualified distribution and the AAA ratio ($90 × 0.67, or $60), and X’s AAA immediately before the qualified VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 distribution ($200). Therefore, $60 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section, after the distribution, X’s AAA is reduced by $60 to $140. Pursuant to paragraph (b)(2)(iii) of this section, A’s basis in its X stock is reduced by $60 to $440. (ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this section, the portion of the distribution that is sourced from AE&P is equal to the lesser of: the product of the qualified distribution and the AE&P ratio ($90 × 0.33, or $30), and X’s AE&P immediately before the qualified distribution ($100). Therefore, $30 is sourced from AE&P. Pursuant to paragraph (b)(3)(ii) of this section, after the distribution, X’s AE&P is reduced by $30 to $70. Pursuant to paragraph (b)(3)(iii) of this section, the $30 distribution is characterized as a dividend. (2) June 5, 2019 distribution—(i) Distribution of AAA. Pursuant to paragraph (b)(2)(i) of this section, the portion of the qualified distribution that is sourced from AAA is equal to the lesser of: The product of the qualified distribution and the AAA ratio ($150 × 0.67, or $100), and X’s AAA immediately before the qualified distribution ($140). Therefore, $100 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section, after the distribution, X’s AAA is reduced by $100 to $40. Pursuant to paragraph (b)(2)(iii) of this section, A’s basis in its X stock is reduced by $100 to $340. (ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this section, the portion of the distribution that is sourced from AE&P is equal to the lesser of: The product of the qualified distribution and the AE&P ratio ($150 × 0.33, or $50), and X’s AE&P immediately before the qualified distribution ($70). Therefore, $50 is sourced from AE&P. Pursuant to paragraph (b)(3)(ii) of this section, after the distribution, X’s AE&P is reduced by $50 to $20. Pursuant to paragraph (b)(3)(iii) of this section, the $50 distribution is characterized as a dividend. (3) Example 3: Limitation on amount characterized as AAA—(i) Facts. At the beginning of January 1, 2018, X had AAA of $100 and AE&P of $300. During 2018, X had $280 of CE&P and made no distributions. At the beginning of January 1, 2019, X has AAA of $100 and AE&P of $580, and A’s adjusted basis in its share of X stock is $450. During 2019, the only distribution that X makes is a $500 distribution of money to A on October 5. X’s CE&P during 2019 is $150, without diminution by reason of PO 00000 Frm 00012 Fmt 4700 Sfmt 4700 any distributions made during the taxable year. (ii) Analysis—(A) Calculation of AAA ratio and AE&P ratio. Pursuant to paragraphs (a)(2)(ix) and (x) of this section, respectively, X’s historical AAA and X’s historical AE&P are determined as of the beginning of January 1, 2018, the beginning of the day on which the revocation of X’s election under section 1362(a) is effective pursuant to section 1362(d)(1). Accordingly, X’s historical AAA is $100 and X’s historical AE&P is $300. Therefore, X’s AAA ratio is 0.25 ($100/($100 + $300)), and X’s AE&P ratio is 0.75 ($300/($100 + $300)). (B) Characterization of distribution. Pursuant to paragraph (a)(2)(xii) of this section, the $500 distribution on October 5, 2019, is a qualified distribution because it is a distribution of money by an ETSC during the ETSC period to which section 301 would apply absent the application of section 1371(f) and this section. (C) Analysis of qualified distribution—(1) Distribution of AAA. Pursuant to paragraph (b)(2)(i) of this section, the portion of the qualified distribution that is sourced from AAA is equal to the lesser of: The product of the qualified distribution and the AAA ratio ($500 × 0.25, or $125), and X’s AAA immediately before the qualified distribution ($100). Therefore, $100 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section, after the distribution, X’s AAA is reduced by $100 to $0. Pursuant to paragraph (b)(2)(iii) of this section, A’s basis in its X stock is reduced by $100 to $350. (2) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this section, the portion of the distribution that is sourced from AE&P is equal to the lesser of: the product of the qualified distribution and the AE&P ratio ($500 × 0.75, or $375), and X’s AE&P immediately before the qualified distribution ($580). Therefore, $375 is sourced from AE&P. Pursuant to paragraph (b)(3)(ii) of this section, after the distribution, X’s AE&P is reduced by $375 to $205. Pursuant to paragraph (b)(3)(iii) of this section, the $375 distribution is characterized as a dividend. (D) Effect of qualified distribution on ETSC period. Pursuant to paragraph (a)(2)(vii) of this section, X’s ETSC period ends because X’s AAA balance is zero following the October 5, 2019 distribution. (E) Analysis of excess qualified distribution—(1) Amount of excess qualified distribution. Pursuant to paragraph (a)(2)(viii) of this section, the amount of the excess qualified distribution is $25, the portion of the E:\FR\FM\20OCR1.SGM 20OCR1 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations qualified distribution ($500) not characterized pursuant to paragraph (b)(2) or (3) of this section ($100 AAA distribution + $375 AE&P distribution). (2) Characterization of excess qualified distribution. Paragraph (b)(4) of this section does not apply to the excess qualified distribution because X’s AAA balance is zero after the application of paragraph (b)(2)(ii) of this section (see paragraph (d)(3)(ii)(C)(1) of this section). Pursuant to paragraph (c) of this section, section 301(c) applies to the excess qualified distribution. Pursuant to sections 301(c)(1) and 316, the $25 excess qualified distribution is sourced from CE&P. (iii) Subsequent contribution. The facts are the same as paragraph (d)(3)(i) of this section, except that at the time of the October 5, 2019 distribution, A’s adjusted basis in its X stock is $90. Further, on December 27, 2019, A contributes $100 to X in a transaction described in section 351(a). The analysis in paragraph (d)(3)(ii) of this section remains the same, except that, unlike the second to last sentence of paragraph (d)(3)(ii)(C)(1) of this section, A’s basis in its X stock is reduced by $90 to $0 and pursuant to paragraph (b)(2)(iii) of this section, $10 is treated as gain from the sale or exchange of property. Additionally, as a result of the December 27, 2019 contribution of $100, A’s basis in its X stock is increased by $100, so that at the end of 2019, A’s basis in its X stock is $100. (4) Example 4: Limitation on the amount characterized as AE&P—(i) Facts. At the beginning of January 1, 2018, X had AAA of $100 and AE&P of $100. During 2018, X had CE&P of $(75) and made no distributions. At the beginning of January 1, 2019, X has AAA of $100 and AE&P of $25, and A’s adjusted basis in its share of X stock is $500. During 2019, the only distributions that X makes are a $100 distribution of money to A on July 9 and a $40 distribution of money to A on September 27. X’s CE&P during 2019 is $20, without diminution by reason of any distributions made during the taxable year. (ii) Analysis—(A) Calculation of AAA ratio and AE&P ratio. Pursuant to paragraphs (a)(2)(ix) and (x) of this section, respectively, X’s historical AAA and X’s historical AE&P are determined as of the beginning of January 1, 2018, the beginning of the day on which the revocation of X’s election under section 1362(a) is effective pursuant to section 1362(d)(1). Accordingly, X’s historical AAA is $100 and X’s historical AE&P is $100. Therefore, X’s AAA ratio is 0.5 ($100/($100 + $100)), and X’s AE&P ratio is 0.5 ($100/($100 + $100)). VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 (B) Analysis of July 9, 2019 distribution—(1) Characterization of distribution. Pursuant to paragraph (a)(2)(xii) of this section, the $100 distribution on July 9, 2019, is a qualified distribution because it is a distribution of money by an ETSC during the ETSC period to which section 301 would apply absent the application of section 1371(f) and this section. (2) Analysis of qualified distribution— (i) Distribution of AAA. Pursuant to paragraph (b)(2)(i) of this section, the portion of the distribution that is sourced from AAA is equal to the lesser of: The product of the qualified distribution and the AAA ratio ($100 × 0.5, or $50), and X’s AAA immediately before the qualified distribution ($100). Therefore, $50 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section, after the distribution, X’s AAA is reduced by $50 to $50. Pursuant to paragraph (b)(2)(iii) of this section, A’s basis in its X stock is reduced by $50 to $450. (ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this section, the portion of the distribution that is sourced from AE&P is equal to the lesser of: The product of the qualified distribution and the AE&P ratio ($100 × 0.5, or $50), and X’s AE&P immediately before the qualified distribution ($25). Therefore, $25 is sourced from AE&P. Pursuant to paragraph (b)(3)(ii) of this section, after the distribution, X’s AE&P is reduced by $25 to $0. Pursuant to paragraph (b)(3)(iii) of this section, $25 of the distribution is characterized as a dividend. (3) Recalculation of AAA and AE&P ratios. Pursuant to paragraph (b)(3)(iv) of this section, because the July 9, 2019 distribution caused X’s AE&P to be reduced to zero, the AAA ratio is one and the AE&P ratio is zero for all subsequent qualified distributions during the 2019 taxable year and subsequent taxable years of the ETSC period. (4) Excess qualified distribution—(i) Amount of excess qualified distribution. Pursuant to paragraph (a)(2)(viii) of this section, the amount of the excess qualified distribution is $25, the amount of the qualified distribution ($100) not characterized pursuant to paragraph (b)(2) or (3) of this section ($50 AAA distribution + $25 AE&P distribution). (ii) Characterization of excess qualified distribution as a separate qualified distribution. Pursuant to paragraph (b)(4) of this section, because X has AAA remaining after characterizing the qualified distribution (see paragraph (d)(4)(ii)(B)(2)(i) of this section), the $25 excess qualified PO 00000 Frm 00013 Fmt 4700 Sfmt 4700 66481 distribution is treated as a separate qualified distribution and is analyzed pursuant to paragraph (b) of this section. (iii) Analysis of excess qualified distribution that is treated as a separate qualified distribution. Pursuant to paragraph (b)(2)(i) of this section, the portion of the distribution that is sourced from AAA is equal to the lesser of: The product of the excess qualified distribution and the AAA ratio ($25 × 1, or $25), and X’s AAA immediately before the excess qualified distribution ($50). Therefore, $25 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section, after the distribution, X’s AAA is reduced by $25 to $25. Pursuant to paragraph (b)(2)(iii) of this section, A’s basis in its X stock is reduced by $25 to $425. Pursuant to paragraph (b)(3)(i) of this section, because X’s AE&P ratio is zero, paragraph (b)(3) of this section does not apply. (C) Analysis of September 27, 2019 distribution—(1) Characterization of the distribution. Pursuant to paragraph (a)(2)(xii) of this section, the $40 distribution on September 27, 2019, is a qualified distribution because it is a distribution of money by an ETSC during the ETSC period to which section 301 would apply absent the application of section 1371(f) and this section. (2) Analysis of qualified distribution— (i) Distribution of AAA. Pursuant to paragraph (b)(2)(i) of this section, the portion of the distribution that is sourced from AAA is equal to the lesser of: The product of the qualified distribution and the AAA ratio ($40 × 1, or $40), and X’s AAA immediately before the qualified distribution ($25) (see paragraph (d)(4)(ii)(B)(4)(iii) of this section). Therefore, $25 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section, after the distribution, X’s AAA is reduced by $25 to $0. Pursuant to paragraph (b)(2)(iii) of this section, A’s basis in its X stock is reduced by $25 to $400. (ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this section, because X’s AE&P ratio is zero, paragraph (b)(3) of this section does not apply. (3) Excess qualified distribution—(i) Amount of excess qualified distribution. Pursuant to paragraph (a)(2)(viii) of this section, the amount of the excess qualified distribution is $15, the portion of the qualified distribution ($40) not characterized pursuant to paragraph (b)(2) or (3) of this section ($25 AAA distribution + $0 AE&P distribution). (ii) Excess qualified distribution not characterized as a separate qualified distribution. Pursuant to paragraph (b)(4) of this section, because X has E:\FR\FM\20OCR1.SGM 20OCR1 66482 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations AAA of $0 after characterizing the qualified distribution (see paragraph (d)(4)(ii)(C)(2)(i) of this section), the $15 excess qualified distribution is not treated as a separate qualified distribution. (iii) Analysis of excess qualified distribution that is not treated as a separate qualified distribution. Pursuant to paragraph (c) of this section, section 301(c) applies to the excess qualified distribution. Pursuant to sections 301(c)(1) and 316, the $15 excess qualified distribution is sourced from CE&P. (5) Example 5: Distributions include non-qualified distributions—(i) Facts. At the beginning of January 1, 2018, X had AAA of $100 and AE&P of $100. During 2018, X had $0 of CE&P and made no distributions. At the beginning of January 1, 2019, X has AAA of $100 and AE&P of $100, and A’s adjusted basis in its X stock is $200. During 2019, X makes a $100 distribution of money on June 14; a $300 distribution of property on November 9; and a $200 distribution of money on December 18. X’s CE&P during 2019 is $160, without diminution by reason of any distributions made during the taxable year. (ii) Analysis—(A) Calculation of AAA ratio and AE&P ratio. Pursuant to paragraphs (a)(2)(ix) and (x) of this section, respectively, X’s historical AAA is $100 and X’s historical AE&P is $100. Therefore, X’s AAA ratio is 0.5 ($100/ ($100 + $100)), and X’s AE&P ratio is 0.5 ($100/($100 + $100)). (B) Characterization of distributions. Pursuant to paragraph (a)(2)(xii) of this section, the $100 distribution on June 14, 2019, and the $200 distribution on December 18, 2019, are both qualified distributions because they are distributions of money by an ETSC during the ETSC period to which section 301 would apply absent the application of section 1371(f) and this section. Pursuant to paragraph (a)(2)(xi) of this section, the $300 distribution of property on November 9, 2019, is a nonqualified distribution. Pursuant to paragraph (b)(1) of this section, the rules of paragraph (b)(2) through (b)(4) of this section apply to the qualified distributions before the rules of paragraph (c) of this section apply to the non-qualified distribution and any excess qualified distributions. (C) Analysis of qualified distributions—(1) June 14, 2019 distribution—(i) Distribution of AAA. Pursuant to paragraph (b)(2)(i) of this section, the portion of the distribution that is sourced from AAA is equal to the lesser of: The product of the qualified distribution and the AAA ratio ($100 × VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 0.5, or $50), and X’s AAA immediately before the qualified distribution ($100). Therefore, $50 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section, after the distribution, X’s AAA is reduced by $50 to $50. Pursuant to paragraph (b)(2)(iii) of this section, on June 14, 2019, A’s basis in its X stock is reduced by $50 to $150. (ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this section, the portion of the distribution that is sourced from AE&P is equal to the lesser of: The product of the qualified distribution and the AE&P ratio ($100 × 0.5, or $50), and X’s AE&P immediately before the qualified distribution ($100). Therefore, $50 is sourced from AE&P. Pursuant to paragraph (b)(3)(ii) of this section, after the distribution, X’s AE&P is reduced by $50 to $50. Pursuant to paragraph (b)(3)(iii) of this section, the $50 distribution is characterized as a dividend. (iii) Amount of excess qualified distribution. The amount of the excess qualified distribution is $0, the amount of the qualified distribution ($100) not characterized pursuant to paragraph (b)(2) or (3) of this section ($50 AAA distribution + $50 AE&P distribution). (2) December 18, 2019 distribution— (i) Distribution of AAA. Pursuant to paragraph (b)(2)(i) of this section, the portion of the distribution that is sourced from AAA is equal to the lesser of: The product of the qualified distribution and the AAA ratio ($200 × 0.5, or $100), and X’s AAA immediately before the qualified distribution ($50). Therefore, $50 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section, after the distribution, X’s AAA is reduced by $50 to $0. Pursuant to paragraph (b)(2)(iii) of this section, A must determine its basis as of December 18, 2019, in order to determine the consequences of receiving the $50 AAA distribution. Because the non-qualified distribution on November 9, 2019, which precedes the December 18, 2019 qualified distribution, could have the effect of reducing A’s basis, any effect on A’s basis from that non-qualified distribution must be analyzed prior to determining the effect of the December 18, 2019 distribution of AAA on A’s basis. See paragraphs (d)(5)(ii)(D)(3) and (4) of this section. Pursuant to paragraph (a)(2)(vii) of this section, X’s ETSC period ends because X’s AAA balance is zero following the December 18, 2019 distribution. (ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this section, the portion of the distribution that is sourced from AE&P is equal to the lesser of: The product of the qualified distribution and the AE&P ratio ($200 × PO 00000 Frm 00014 Fmt 4700 Sfmt 4700 0.5, or $100), and X’s AE&P immediately before the qualified distribution ($50). Therefore, $50 is sourced from AE&P. Pursuant to paragraph (b)(3)(ii) of this section, after the distribution, X’s AE&P is reduced by $50 to $0. Pursuant to paragraph (b)(3)(iii) of this section, the $50 distribution is characterized as a dividend. (iii) Amount of excess qualified distribution. The amount of the excess qualified distribution is $100, the amount of the qualified distribution ($200) not characterized pursuant to paragraph (b)(2) or (3) of this section ($50 AAA distribution + $50 AE&P distribution). (D) Analysis of non-qualified and excess qualified distributions—(1) In general. The $300 non-qualified distribution on November 9, 2019, and the $100 excess qualified distribution on December 18, 2019, are treated in the manner provided in section 301(c). (2) Allocation of CE&P. Pursuant to section 316 and § 1.316–2, X’s CE&P is allocated proportionately among the excess qualified and the non-qualified distributions. Therefore, the portion of X’s CE&P that is allocated to the November 9, 2019 distribution and the December 18, 2019 distribution is $120 ($160 CE&P × ($300 distribution/$400 total excess qualified and non-qualified distributions during 2019) and $40 ($160 CE&P × ($100 distribution/$400 total excess qualified and non-qualified distributions during 2019), respectively. (3) November 9, 2019 distribution. Pursuant to paragraph (d)(5)(ii)(D)(2) of this section, $120 of the $300 distribution is characterized as a distribution of CE&P. Pursuant to paragraph (d)(5)(ii)(C)(2)(ii) of this section, the amount of X’s AE&P available to allocate the November 9, 2019 distribution is $0. Therefore, the remaining $180 is characterized pursuant to section 301(c)(2) and (3). Pursuant to paragraph (d)(5)(ii)(C)(1)(i) of this section, A’s basis in its X stock prior to the November 9, 2019 distribution is $150. Therefore, $150 is applied against basis pursuant to section 301(c)(2) (reducing A’s basis to $0) and $30 is treated as gain from the sale or exchange of property pursuant to section 301(c)(3). (4) December 18, 2019 distribution— (i) Consequences of AAA distribution. As of December 18, 2019, A’s basis in its X stock is $0. See paragraph (d)(5)(ii)(D)(3) of this section. Pursuant to paragraph (d)(5)(ii)(C)(2)(i) of this section, $50 of the distribution is characterized as a distribution of AAA. Because the amount of the distribution of AAA ($50) exceeds A’s basis in its X E:\FR\FM\20OCR1.SGM 20OCR1 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations stock ($0), pursuant to paragraph (b)(2)(iii) of this section, on December 18, 2019, $50 is treated as gain from the sale or exchange of property. (ii) Characterization of excess qualified distribution. Pursuant to paragraph (d)(5)(ii)(C)(2)(iii) of this section, $100 of the December 18, 2019 distribution is an excess qualified distribution. Paragraph (b)(4) of this section does not apply to the excess qualified distribution because X’s AAA balance is zero after the application of paragraph (b)(2)(ii) of this section (see paragraph (d)(5)(ii)(C)(2)(i) of this section. Pursuant to paragraph (c) of this section, section 301(c) applies to the excess qualified distribution. Pursuant to paragraph (d)(5)(ii)(D)(2) of this section, $40 of the $100 excess qualified distribution is characterized as a distribution of CE&P. Pursuant to paragraph (d)(5)(ii)(D)(3) of this section, X’s AE&P as the time of the December 18, 2019 distribution is $0. Therefore, the remaining $60 is characterized pursuant to section 301(c)(2) and (3). Pursuant to paragraph (d)(5)(ii)(D)(4)(i) of this section, A’s basis in its X stock prior to characterization of the excess qualified distribution is $0. Therefore, $60 is treated as gain from the sale or exchange of property pursuant to section 301(c)(3). (e) Applicability date. This section applies to taxable years beginning after October 20, 2020. However, a corporation may choose to apply the rules in §§ 1.481–5, 1.1371–1, and 1.1371–2 in their entirety to taxable years beginning on or before October 20, 2020. If a corporation makes the choice described in the previous sentence, all shareholders of the corporation must report consistently, and the corporation must continue to apply the rules in §§ 1.481–5, 1.1371–1, and 1.1371–2 in their entirety for the corporation’s subsequent taxable years. § 1.1371–2 Period. Impact of Audit PTTP on ETSC (a) Definitions. For purposes of this section, the definitions used in § 1.1371–1(a)(2) are applicable. Additionally, the following definitions apply for purposes of this section— (1) Audit PTTP. The term audit PTTP means a post-termination transition period described in section 1377(b)(1)(B) of the Internal Revenue Code (Code). (2) Initial PTTP. The term initial PTTP means a post-termination transition period described in section 1377(b)(1)(A). (3) Intervening audit PTTP. The term intervening audit PTTP means an audit PTTP arising during the ETSC period. VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 (b) In general. If an intervening audit PTTP arises, the ETSC period immediately stops. Immediately following the end of the intervening audit PTTP, the ETSC period resumes if the ETSC’s AAA balance is greater than zero. Otherwise, any subsequent distributions by the ETSC are treated in the manner provided in section 301(c) of the Code. (c) Examples. Paragraphs (c)(1) and (2) of this section (Examples 1 and 2) illustrate the rules of this section. For purposes of paragraphs (c)(1) and (2) of this section (Examples 1 and 2), X is a calendar year S corporation. A, an individual, purchased all of the outstanding shares of X in a single transaction at the same price per share prior to December 22, 2017, and was the sole shareholder of X at all times. Pursuant to section 1362(d)(1) of the Code and §§ 1.1362–2 and 1.1362–6, X made a valid revocation of its S election on March 15, 2019, that became effective on January 1, 2019. No amount distributed by X is an extraordinary dividend within the meaning of section 1059. (1) Example 1: No ETSC period following initial PTTP—(i) Facts. At the beginning of January 1, 2019, X had AAA of $49,000 and AE&P of $2,000, and A’s adjusted basis in its shares of X stock was $50,000. During 2019, the only distribution that X made was a $49,000 distribution of money to A on March 13, 2019. X’s CE&P during 2019 was $0, without regard to any diminution by reason of any distributions made during the taxable year. (ii) Analysis—(A) Distribution during initial PTTP. Pursuant to sections 1371(e) and 1377(b)(1)(A), the $49,000 distribution of money on March 13, 2019, is characterized as a distribution of AAA because it was made during the initial PTTP. (B) Effect on corporation. Pursuant to § 1.1368–2(a)(3)(iii), X’s AAA is reduced by $49,000 to $0. Following the initial PTTP, even if X satisfies the requirements of section 481(d)(2) of the Code and § 1.481–5(b) to be an ETSC, X does not have an ETSC period because its AAA balance is zero at the end of its initial PTTP. Therefore, section 1371(f) of the Code and § 1.1371–1 will not apply to any subsequent distributions by X. (C) Effect on shareholder. Pursuant to section 1371(e)(1), A reduces its basis in its X stock by $49,000 to $1,000. (2) Example 2: Intervening audit PTTP—(i) Facts. The facts are the same as the facts in paragraph (c)(1) of this section. On May 20, 2020, which is after X’s initial PTTP, the IRS begins an audit PO 00000 Frm 00015 Fmt 4700 Sfmt 4700 66483 of X’s 2018 return. During the audit it is agreed that X overstated its advertising expense deduction by $10,000. On July 6, 2020, A signs a closing agreement whereby X’s overstatement results in an additional tax on A’s 2018 individual return. As a result, at the beginning of January 1, 2019, X had AAA of $59,000 ($49,000 + $10,000) and AE&P of $2,000. Additionally, at the beginning of January 1, 2019, A’s adjusted basis in its shares of X stock was $60,000 ($50,000 + $10,000). During 2020, the only distribution X makes is a $6,000 distribution of money to A on September 1, 2020. X’s CE&P during 2020 was $0, without regard to any diminution by reason of any distributions made during the taxable year. (ii) Analysis—(A) Analysis of March 13, 2019 distribution. The treatment of the March 13, 2019, distribution is the same as described in paragraph (c)(1)(ii)(A) of this section, because the amount of the distribution ($49,000) does not exceed X’s AAA balance at the beginning of January 1, 2019 ($59,000), and so the entirety of the $49,000 distribution is properly characterized as a distribution of AAA. (1) Effect on corporation. As described in paragraph (c)(1)(ii)(B) of this section, X’s AAA ($59,000 at the beginning of January 1, 2019) is reduced by $49,000 to $10,000. At the conclusion of X’s initial PTTP (ending on December 31, 2019), X’s AAA balance is $10,000. Pursuant to § 1.1371–1(a)(2)(vii), X has an ETSC period. Therefore, section 1371(f) and § 1.1371–1 will apply to any subsequent qualified distributions by X. (2) Effect on shareholder. As described in paragraph (c)(1)(ii)(C) of this section, A reduces its basis in its X stock ($60,000 at the beginning of January 1, 2019) by $49,000 to $11,000. (B) Intervening audit PTTP. Pursuant to section 1377(b)(1)(B), X enters an intervening audit PTTP that begins on July 6, 2020, and ends on November 2, 2020. The application of section 1371(f) and § 1.1371–1 to distributions during the intervening audit PTTP is stopped. Instead, sections 1371(e) and 1377(b)(1)(B) and §§ 1.1371–2 and 1.1377–2 apply for the duration of the intervening audit PTTP. During the intervening audit PTTP, the only distribution X made is a $6,000 distribution of money to A on September 1, 2020. Pursuant to sections 1371(e) and 1377(b)(1)(B), the $6,000 distribution is characterized as a distribution of AAA because it was made during the intervening audit PTTP. E:\FR\FM\20OCR1.SGM 20OCR1 66484 Federal Register / Vol. 85, No. 203 / Tuesday, October 20, 2020 / Rules and Regulations (1) Effect on corporation. Pursuant to § 1.1368–2(a)(3)(iii), X’s AAA is reduced by $6,000 to $4,000. Beginning on November 3, 2020, pursuant to § 1.1371–1(a)(2)(vii), X’s ETSC period resumes (after the intervening audit PTTP’s conclusion) because its AAA balance is greater than zero. (2) Effect on shareholder. Pursuant to section 1371(e)(1), A reduces its basis in its X stock by $6,000 to $5,000. (C) ETSC period. Beginning on November 3, 2020, X’s ETSC period resumes, and distributions of money are subject to section 1371(f) and § 1.1371– 1 until X’s AAA balance is zero. For purposes of calculating each of X’s AAA and AE&P ratios, X’s historical AAA is $59,000 (at the beginning of January 1, 2019, which includes the $10,000 increase as a result of the July 6, 2020, closing agreement). (d) Applicability date. This section applies to taxable years beginning after October 20, 2020. However, a corporation may choose to apply the rules in §§ 1.481–5, 1.1371–1, and 1.1371–2 in their entirety to taxable years that began on or before October 20, 2020. If a corporation makes the choice described in the previous sentence, all shareholders of the corporation must report consistently, and the corporation must continue to apply the rules in §§ 1.481–5, 1.1371– 1, and 1.1371–2 in their entirety for the corporation’s subsequent taxable years. § 1.1377–2 [Amended] Par. 7. Section 1.1377–2 is amended by removing the last sentence of paragraph (b). ■ taxable years beginning on or before October 20, 2020 and with respect to which the period described in section 6501(a) has not expired. If a corporation makes the choice described in the previous sentence, all shareholders of the corporation must report consistently, and the corporation must adopt §§ 1.481–5, 1.1371–1, 1.1371–2, if an ETSC, and 1.1377–2(b) in their entity and continue to apply those rules in their entirety for the corporation’s subsequent taxable years. Sunita Lough, Deputy Commissioner for Services and Enforcement. Approved: September 9, 2020. David J. Kautter, Assistant Secretary of the Treasury (Tax Policy). [FR Doc. 2020–21144 Filed 10–19–20; 8:45 am] BILLING CODE 4830–01–P ENVIRONMENTAL PROTECTION AGENCY 40 CFR Part 52 [EPA–R03–OAR–2019–0657; FRL–10014– 53–Region 3] Approval and Promulgation of Air Quality Implementation Plans; Pennsylvania; Reasonably Available Control Technology Determinations for Case-by-Case Sources Under the 1997 and 2008 8-Hour Ozone National Ambient Air Quality Standards Environmental Protection Agency (EPA). ACTION: Final rule. AGENCY: Par. 8. Section 1.1377–3 is revised to read as follows: ■ § 1.1377–3 Applicability dates. (a) In general. Except as otherwise provided in this section, §§ 1.1377–1 and 1.1377–2 apply to taxable years of an S corporation beginning after December 31, 1996. (b) Certain conversions. Section 1.1377–1(a)(2)(iii) and (c)(3) (Example 3) are applicable for taxable years beginning on and after May 14, 2002. (c) Special treatment of distributions of money during post-termination transition period—(1) In general. Except as provided in paragraph (c)(2) of this section, § 1.1377–2(b) applies to taxable years beginning after October 20, 2020. For taxable years beginning on or before October 20, 2020, see § 1.1377–2(b) as contained in 26 CFR part 1, revised April 1, 2020. (2) Taxable years beginning on or before October 20, 2020. A corporation may choose to apply § 1.1377–2(b) to VerDate Sep<11>2014 16:20 Oct 19, 2020 Jkt 253001 The Environmental Protection Agency (EPA) is approving a state implementation plan (SIP) revision submitted by the Commonwealth of Pennsylvania. This revision was submitted by the Pennsylvania Department of Environmental Protection (PADEP) to establish and require reasonably available control technology (RACT) for individual major sources of volatile organic compounds (VOC) and nitrogen oxides (NOX) pursuant to the Commonwealth of Pennsylvania’s conditionally approved RACT regulations. In this action, EPA is only approving source-specific (also referred to as ‘‘case-by-case’’) RACT determinations for nine major sources. These RACT evaluations were submitted to meet RACT requirements for the 1997 and 2008 8-hour ozone national ambient air quality standards (NAAQS). EPA is approving these revisions to the Pennsylvania SIP in accordance with the requirements of the SUMMARY: PO 00000 Frm 00016 Fmt 4700 Sfmt 4700 Clean Air Act (CAA) and EPA’s implementing regulations. DATES: This final rule is effective on November 19, 2020. ADDRESSES: EPA has established a docket for this action under Docket ID Number EPA–R03–OAR–2019–0657. All documents in the docket are listed on the https://www.regulations.gov website. Although listed in the index, some information is not publicly available, e.g., confidential business information (CBI) or other information whose disclosure is restricted by statute. Certain other material, such as copyrighted material, is not placed on the internet and will be publicly available only in hard copy form. Publicly available docket materials are available through https:// www.regulations.gov, or please contact the person identified in the FOR FURTHER INFORMATION CONTACT section for additional availability information. FOR FURTHER INFORMATION CONTACT: Ms. Emily Bertram, Permits Branch (3AD10), Air & Radiation Division, U.S. Environmental Protection Agency, Region III, 1650 Arch Street, Philadelphia, Pennsylvania 19103. The telephone number is (215) 814–5273. Ms. Bertram can also be reached via electronic mail at bertram.emily@ epa.gov. SUPPLEMENTARY INFORMATION: I. Background On May 5, 2020, EPA published a notice of proposed rulemaking (NPRM). 85 FR 26643. In the NPRM, EPA proposed approval of case-by-case RACT determinations for nine of the 10 sources included in the subject SIP submission for the 1997 and 2008 8hour ozone NAAQS.1 The case-by-case RACT determinations for these sources were included in a SIP revision submitted by PADEP on April 11, 2019. Under certain circumstances, states are required to submit SIP revisions to address RACT requirements for major sources of NOX and VOC or any source category for which EPA has promulgated control technique guidelines (CTG) for each ozone NAAQS. Which NOX and VOC sources in Pennsylvania are considered ‘‘major,’’ and therefore to be addressed for RACT revisions, is dependent on the location of each source within the Commonwealth. Sources located in nonattainment areas would be subject to the ‘‘major source’’ definitions 1 The portion of PADEP’s SIP submission related to American Craft Brewery, LLC was withdrawn on October 21, 2019. EPA will be taking action on this source in a future rulemaking action, once resubmitted by PADEP for approval into the PA SIP. E:\FR\FM\20OCR1.SGM 20OCR1

Agencies

[Federal Register Volume 85, Number 203 (Tuesday, October 20, 2020)]
[Rules and Regulations]
[Pages 66471-66484]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-21144]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9914]
RIN 1545-BP20


Eligible Terminated S Corporations

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulation.

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SUMMARY: This document contains final regulations providing guidance on 
the definition of an eligible terminated S corporation and rules 
relating to distributions of money by such a corporation after the 
post-termination transition period. This document also amends current 
regulations to extend the treatment of distributions of money during 
the post-termination transition period to all shareholders of the 
corporation and clarifies the allocation of current earnings and 
profits to distributions of money and other property. The final 
regulations affect C corporations that were formerly S corporations and 
the shareholders of such corporations.

DATES: 
    Effective Date: These regulations are effective October 20, 2020.
    Applicability Dates: For dates of applicability, see Sec. Sec.  
1.481-6(b), 1.1371-1(e), 1.1371-2(d), and 1.1377-3(c).

FOR FURTHER INFORMATION CONTACT: Concerning Sec. Sec.  1.481-5, 1.481-
6, 1.1362-2(a)(2)(iii), 1.1377-2, and 1.1377-3, Margaret Burow or 
Michael Gould at (202) 317-5279; concerning Sec. Sec.  1.1371-1 and 
1.1371-2, Aglaia Ovtchinnikova at (202) 317-6975 or Margaret Burow or 
Michael Gould at (202) 317-5279; concerning Sec.  1.316-2, Aglaia 
Ovtchinnikova at (202) 317-6975.

SUPPLEMENTARY INFORMATION:

Background

    In the case of an S corporation, as defined in section 1361(a)(1) 
of the Internal Revenue Code (Code), having accumulated earnings and 
profits (as described in section 316(a)(1) of the Code (AE&P)) that 
makes a distribution of property to which section 301 would otherwise 
apply, section 1368(c)(1) of the Code generally treats the amount of 
the distribution not in excess of the S corporation's accumulated 
adjustments account (as defined in Sec.  1.1368-2(a)(1) (AAA)) or the 
recipient shareholder's adjusted basis in such S corporation's stock as 
excluded from the shareholder's gross income. Section 1368(c)(2) 
provides that the remaining portion of the distribution is treated as a 
dividend (as defined in section 316(a)) to the extent of the S 
corporation's AE&P. Finally, section 1368(c)(3) provides that any 
amount of the distribution in excess of the S corporation's AAA and 
AE&P is applied against the shareholder's remaining adjusted basis in 
the stock, with any amount exceeding that adjusted basis treated as 
gain from the sale or exchange of property.
    Generally, a distribution by a C corporation to its shareholders 
with respect to their stock ownership is treated as a taxable dividend 
to the extent of the corporation's earnings and profits. See sections 
301(c) and 316(a). However, following the termination of a 
corporation's S election made under section 1362 of the Code (S 
election), section 1371(e) of the Code allows shareholders of the 
resulting C corporation to benefit from the corporation's former status 
as an S corporation with respect to distributions of money during the 
corporation's post-termination transition period (PTTP), which is 
generally the one-year period after the corporation terminates its S 
election. Specifically, during the PTTP, a distribution of money by the 
C corporation is characterized as a distribution from the corporation's 
AAA. The receipt of such a distribution is tax-free to the extent of 
the recipient shareholder's basis in its stock and the corporation's 
AAA balance. If the distribution exceeds the recipient shareholder's 
basis in its stock, but not the corporation's AAA, then the 
distribution is tax-free to the extent of the recipient shareholder's 
basis, with the remainder treated as gain from the sale of property. If 
the distribution exceeds the corporation's AAA, then the excess is 
taxed as a dividend from current earnings and profits (as described in 
section 316(a)(2) (CE&P)) or any AE&P from the corporation's previous 
existence as a corporation taxed under subchapter C. Without section 
1371(e), shareholders of the former S corporation would be precluded 
from receiving distributions allocable to AAA.
    Section 13543(a) and (b) of Public Law 115-97, 131 Stat. 2054, 2155 
(2017), commonly referred to as the Tax Cuts and Jobs Act (TJCA), 
amended the Code by adding new sections 481(d) and 1371(f), effective 
as of December 22, 2017, the date of enactment of the TCJA.
    Section 481(d)(1) of the Code permits a corporation that qualifies 
as an eligible terminated S corporation (ETSC) to take into account any 
481 adjustments (as defined in part II.C of the Summary of Comments and 
Explanation of Revisions) which are attributable to the revocation of 
an S election over the section 481(d) inclusion period, which is the 
six-taxable-year-period beginning with the year of change (as defined 
in part II.C of the Summary of Comments and Explanation of Revisions). 
Section 481(d)(2) defines an ETSC as a C corporation meeting the 
following three requirements: (i) The corporation was an S corporation 
on December 21, 2017; (ii) the S corporation revoked its election under 
section 1362(a) to be an S corporation (that is, the S election) during 
the two-year period beginning on December 22, 2017 (revocation 
requirement); and (iii) the owners of the stock of the corporation, 
determined on the date the corporation made a revocation of its S 
election, are the same owners (and own identical proportions of the 
corporation's stock) as on December 22, 2017 (shareholder identity 
requirement).
    Section 1371(f) extends the period during which shareholders of an 
ETSC can benefit from its AAA generated during the corporation's former 
status as an S corporation (ETSC period) by providing that, in the case 
of distributions of money following the PTTP, (i) the distributing 
ETSC's AAA is allocated to a distribution of money to which section 301 
would otherwise apply (qualified distribution), and (ii) the qualified 
distribution is chargeable to AE&P in the same ratio as the amount of 
such AAA bears to the amount of such AE&P. In enacting section 1371(f), 
Congress determined that ``it is important to provide rules to ease the 
transition from S corporation to C corporation for the affected 
taxpayers'' because, based on the TCJA's revisions to the Code, 
``taxpayers that previously elected to be taxed as S corporations may 
prefer instead to be taxed as C corporations.'' H. Rept. 115-409, 115th 
Cong., 1st Sess., at 245 (Nov. 14, 2017) (House Report).

[[Page 66472]]

    On November 7, 2019, the Department of the Treasury (Treasury 
Department) and the IRS published a notice of proposed rulemaking (REG-
131071-18) in the Federal Register (84 FR 60011) containing proposed 
regulations under section 1371 and proposed amendments to the Income 
Tax Regulations (26 CFR part 1) under sections 481 and 1377 (proposed 
regulations). The Treasury Department and the IRS received 16 written 
or electronic comments responding to the proposed regulations. All 
comments received on the proposed regulations are available at http://www.regulations.gov or upon request. As no request for a public hearing 
was received, no hearing was held. After full consideration of the 
comments received, this Treasury decision adopts generally the proposed 
regulations with certain modifications in response to the comments 
received, as described in the Summary of Comments and Explanation of 
Revisions.

Summary of Comments and Explanation of Revisions

I. Overview

    The final regulations retain the approach and structure of the 
proposed regulations, with certain revisions. This Summary of Comments 
and Explanation of Revisions discusses those revisions, as well as the 
comments received in response to the proposed regulations.

II. Comments on Qualification as an Eligible Terminated S Corporation

A. Significance of Date of Revocation of S Election
    To qualify as an ETSC under section 481(d)(2), a corporation must 
satisfy the revocation requirement by making a revocation of its S 
election during the two-year period beginning on December 22, 2017 
(two-year period). See section 481(d)(2)(A)(ii) (setting forth the 
revocation requirement); proposed Sec.  1.481-5(b)(2) (same). In 
addition, the shareholder identity requirement must be satisfied by the 
same shareholders owning identical proportions of the corporation's 
stock on two dates: December 22, 2017, and the date on which the 
corporation made a revocation of its S election. See section 
481(d)(2)(B) (setting forth the shareholder identity requirement); 
proposed Sec.  1.481-5(b)(3) (same). But see proposed Sec.  1.481-
5(c)(1) (identifying five categories of share transfers that do not 
result in a change in shareholder ownership for purposes of section 
481(d)(2)(B)). Consequently, the date on which a corporation makes a 
revocation of its S election is critical for determining ETSC 
qualification.
    A corporation can allow the effective date of its S election 
revocation to occur automatically by operation of section 
1362(d)(1)(C), or it can specify an effective date under section 
1362(d)(1)(D). For example, a revocation made before the 16th day of 
the third month of an S corporation's taxable year generally is 
effective retroactively on the first day of that taxable year. See 
section 1362(d)(1)(C)(i); Sec.  1.1362-2(a)(2)(i). In contrast, a 
revocation made after the 15th day of the third month of a 
corporation's taxable year generally is effective prospectively on the 
first day of the corporation's following taxable year. See section 
1362(d)(1)(C)(ii); Sec.  1.1362-2(a)(2)(i). Alternatively, the 
corporation may specify an immediate or prospective effective date for 
a revocation by expressing a date (in terms of a stated day, month, and 
year) that occurs on or after the date on which the revocation is made. 
See section 1362(d)(1)(D); Sec.  1.1362-2(a)(2)(ii).
1. Retroactive Effective Date of the Revocation Determines ETSC Status
    One commenter suggested that the final regulations revise proposed 
Sec.  1.481-5(b)(2) to confirm that, in the case of a revocation with a 
retroactive effective date pursuant to section 1362(d)(1)(C)(i), the 
revocation may be treated as occurring on the retroactive effective 
date for purposes of ETSC qualification. Based on the stated 
congressional goal of facilitating the transition from S corporation 
status to C corporation status, the commenter contended that taxpayers 
reasonably could have interpreted the statute to indicate that 
compliance with the shareholder identity requirement would be tested on 
the retroactive revocation's effective date. In support of this 
contention, the commenter correctly noted that, in the absence of such 
an interpretation, a corporation would not satisfy the shareholder 
identity requirement for qualifying as an ETSC in proposed Sec.  1.481-
5(b)(2) and (3) if the corporation (i) had the same shareholders (and 
in identical proportions) on both December 22, 2017, and the 
retroactive effective date of the revocation, but (ii) experienced a 
change in shareholder ownership during the period between the 
retroactive effective date of the revocation and the date on which the 
revocation was made.
    The Treasury Department and the IRS agree with the commenter's 
interpretation. Proposed Sec.  1.481-5(b)(2) and (3) directly address 
revocations with prospective effective dates, which can be specified 
with significant flexibility in the revocation. A retroactive effective 
date for a revocation results solely by operation of section 
1362(d)(1)(C)(i) and Sec.  1.1362-2(a)(2)(i) and, in such instance, is 
always effective on the first day of the corporation's taxable year. To 
confirm the commenter's interpretation, Sec.  1.481-5(c)(2) of the 
final regulations provides that, solely with regard to revocations with 
retroactive effective dates, a revocation may be treated as having been 
made on the effective date of such revocation. Accordingly, for 
purposes of Sec.  1.481-5(b)(2) and (3), a corporation may test 
compliance with the revocation requirement and the shareholder identity 
requirement on either the date the revocation was made or, in the case 
of a revocation with a retroactive effective date, the date the 
revocation was effective.
2. Application of Section 7503 to a Revocation of an S Election
    As discussed in part II.A of this Summary of Comments and 
Explanation of Revisions, the revocation requirement of section 
481(d)(2)(A)(ii) requires that a corporation must make a revocation 
during the two-year period to qualify as an ETSC. Section 7503 provides 
that, ``when the last day prescribed under authority of the internal 
revenue laws for performing any act falls on Saturday, Sunday, or a 
legal holiday, the performance of such act shall be considered timely 
if it is performed on the next succeeding day which is not a Saturday, 
Sunday, or a legal holiday.'' Because a revocation is an act made under 
authority of the internal revenue laws (that is, section 1362 of the 
Code), section 7503 applies for purposes of determining whether the 
revocation was made within the required two-year period. As a result of 
the application of section 7503 in conjunction with section 1362 and 
Sec.  1.1362-2(a)(2), December 23, 2019 (a Monday), is the last day of 
the two-year period. Therefore, a revocation made on that date would be 
treated as made within the two-year period. Without the application of 
section 7503, December 21, 2019 (a Saturday), would have been the last 
day of the two-year period.
    To avoid any doubt, these final regulations clarify the text of 
Sec.  1.1362-2(a)(2) to provide explicitly that section 7503 applies 
where the last day prescribed for making a revocation occurs on a 
Saturday, Sunday, or legal holiday. Therefore, a revocation made on 
December 23, 2019, will be treated as made during the two-year period.
B. Applicability of PTTP and ETSC Period to S Corporations With No AE&P
    Following the termination of an S election, section 1371(e) permits

[[Page 66473]]

shareholders of the resulting C corporation to benefit from the 
corporation's former status as an S corporation with respect to 
distributions of money during the corporation's PTTP, which generally 
is the one-year period after the corporation terminates its S election. 
Specifically, during the PTTP, a distribution of money by the C 
corporation is characterized as a distribution from the corporation's 
AAA. The receipt of such a distribution is tax-free to the extent of 
the recipient shareholder's basis in the stock with respect to which 
the shareholder received the distribution, and is taxed as gain from 
the sale of property to the extent the distribution exceeds the 
shareholder's basis in that stock. See section 1371(e)(1). If the 
corporation exhausts its AAA during the PTTP, subsequent distributions 
are subject to treatment under section 301.
    A commenter requested confirmation that the rules regarding 
distributions made during the PTTP, including section 1371(e) and Sec.  
1.1377-2, apply if the corporation did not have AE&P at the time that 
it terminated its S election. Section 1371(e)(1) provides special 
treatment to distributions made by a corporation during the PTTP if 
such distributions (i) consist of money and (ii) are made with respect 
to the corporation's stock. Those two conditions would be satisfied 
regardless of whether the distributing corporation had AE&P. Therefore, 
the Treasury Department and the IRS agree with the commenter's 
interpretation of section 1371(e) and Sec.  1.1377-2, but have 
determined that no clarifying revisions to the regulations are 
necessary in this regard.
    The commenter also requested confirmation that the rules regarding 
distributions made during the ETSC period would apply if the 
distributing corporation did not have AE&P as of the effective date of 
the revocation. Example 1 of proposed Sec.  1.1371-1(d) illustrates 
that, if an ETSC has no AE&P as of the beginning of the day on which 
the revocation is effective, its historical AE&P is zero. Pursuant to 
proposed Sec.  1.1371-1(a)(2)(ix) and (x), such a corporation would 
enter its ETSC period with a AAA ratio of 1 and an AE&P ratio of zero. 
Therefore, each qualified distribution would be characterized as a 
distribution of AAA. Based on the guidance provided in Example 1, as 
well as the definition of the ``AAA ratio'' set forth in proposed Sec.  
1.1371-1(a)(ii), the Treasury Department and the IRS have determined 
that no clarifying revisions to the regulations are necessary in this 
regard.
C. Application of Section 481(d) to Qualified Subchapter S Subsidiaries
    If an S corporation wholly owns the stock of a domestic C 
corporation that is not an ineligible corporation described in section 
1361(b)(2), the S corporation may elect under section 1361(b)(3)(B)(ii) 
and Sec.  1.1361-3 to treat the C corporation as a qualified subchapter 
S subsidiary (QSub) such that (i) the QSub will no longer be treated as 
a separate corporation and (ii) all of the QSub's assets, liabilities, 
and items of income, deduction, and credit will be treated as assets, 
liabilities, and such items (as the case may be) of the S corporation 
parent. If the requirements of section 1361(b)(3)(B) cease to be 
satisfied with respect to a QSub, including by reason of the revocation 
of the parent's S election, section 1361(b)(3)(C)(i) and Sec.  1.1361-
5(b)(1)(i) provide that the corporation's QSub election is terminated 
such that the QSub is treated, for purposes of the Code, as (i) a newly 
formed C corporation subsidiary separate from the parent and (ii) 
acquiring all of its assets (and assuming all of its liabilities) from 
the parent through an exchange to which section 351 of the Code applies 
(deemed section 351 exchange).
    If the taxable income of any taxpayer, including a corporation, for 
the current year (year of change) is computed under a method of 
accounting that is different from the method of accounting used by the 
taxpayer in the preceding year (accounting method change), section 481 
requires that the taxpayer must take into account those adjustments 
that are determined to be necessary solely by reason of the accounting 
method change to prevent items of income or expense from being 
duplicated or omitted (481 adjustments). Section 481(a). The 481 
adjustments are generally taken into account in computing the 
taxpayer's taxable income in the year of change. However, section 
481(c) permits a taxpayer, in such manner and subject to such 
conditions prescribed in regulations by the Secretary of the Treasury 
or his delegate (Secretary), to take 481 adjustments into account in 
computing taxable income for the taxable year or years permitted under 
such regulations. As noted earlier, section 481(d)(1) permits an ETSC 
to take into account any 481 adjustments that are attributable to the 
revocation of an S election over a six-taxable year period beginning 
with the year of change (that is, the section 481(d) inclusion period).
    Commenters have correctly observed that section 481(a) and (d) do 
not apply to an ETSC's newly formed C corporation subsidiary (ETSC 
corporate subsidiary) that operated as a QSub prior to the revocation 
of its parent's S election. Upon such a revocation, the ETSC corporate 
subsidiary is treated as acquiring all of its assets and assuming all 
of its liabilities from the ETSC in a deemed section 351 exchange. See 
section 1361(b)(3)(C)(i); Sec.  1.1361-5(b)(1)(i). A corporation formed 
for a business purpose is a taxpayer separate from its shareholder(s). 
See generally Moline Properties v. Commissioner, 319 U.S. 436 (1943). 
As a result of the ETSC corporate subsidiary's status as a new C 
corporation with no prior taxable year (rather than, for example, as a 
successor under section 381(a) of the Code), commenters have noted that 
the ETSC corporate subsidiary lacks any historical method of accounting 
from which to change. Compare Sec.  1.446-1(e)(1) (providing that a 
taxpayer filing its first return may adopt any permissible method of 
accounting in computing taxable income for the taxable year covered by 
such return) with section 381(c)(4) (providing that, in general, a 
successor corporation must use the method of accounting used by the 
predecessor corporation as of the date of the section 381(a) 
transaction).
    Notwithstanding those observations of the law, commenters have 
requested that the final regulations extend the section 481(d) 
inclusion period to an accrual method ETSC corporate subsidiary that 
operated as a cash method QSub of a cash method S corporation prior to 
the revocation of the parent's S election. These commenters highlighted 
that, in the deemed section 351 exchange required by section 
1361(b)(3)(C)(i) and Sec.  1.1361-5(b)(1)(i) that results from the 
revocation of the parent's S election, the accounts receivable of a 
former cash method QSub would be deemed transferred to the accrual 
method ETSC corporate subsidiary with a zero basis. See generally Raich 
v. Commissioner, 46 T.C. 604 (1966) (holding that trade accounts 
receivable of a cash method transferor received by an accrual basis 
transferee in a section 351 exchange had a zero basis). Therefore, the 
ETSC corporate subsidiary would recognize income as it collects amounts 
on the transferred receivables. In the case where the ETSC corporate 
subsidiary collects the entire amount of the transferred receivables 
during its first taxable year, commenters contended that the ETSC 
corporate subsidiary's inability to include the amount received over 
the six-year section 481(d) inclusion period would inappropriately 
disadvantage the former QSub as

[[Page 66474]]

compared to its former S corporation parent.
    The Treasury Department and the IRS understand the commenters' 
concerns regarding the statutorily limited application of section 
481(d) and observe that the commenters' request is not unique to the 
application of section 481(d), but rather addresses the longstanding 
treatment of former S corporations and QSubs under section 481 with 
regard to a deemed section 351 exchange. Throughout the nearly 25-year 
period since the 1996 enactment of the QSub provisions under section 
1361, section 481(a)(2) and any inclusion period for a 481 adjustment 
have not applied with respect to former QSubs. See section 1308 of the 
Small Business Job Protection Act of 1996, Public Law 104-188, 110 
Stat. 1755, 1782-3 (August 20, 1996). See also Rev. Proc. 97-27, 1997-1 
C.B. 680, section 5.02(3)(a) (providing a four-year amortization period 
solely to taxpayers that have a 481 adjustment); Rev. Proc. 2015-13, 
2015-5 I.R.B. 419, section 7.03(1) (same). After considering the 
commenters' analysis and the explicit reference in section 481(d) to 
section 481(a)(2), the Treasury Department and the IRS have determined 
that section 481(d) does not apply to ETSC corporate subsidiaries, but 
rather maintains the longstanding application of section 481(a) solely 
to taxpayers that make an accounting method change. Accordingly, there 
is no authority under section 481(d) to extend the section 481(d) 
inclusion period to ETSC corporate subsidiaries.
    Commenters also contended that the Treasury Department and the IRS 
could override the limited scope of section 481(d) through special QSub 
regulations issued under the authority provided by section 481(c), 
which, in the case of a taxpayer making an accounting method change, 
authorizes regulations permitting a taxpayer to take any 481 adjustment 
into account in computing taxable income for the taxable year or years 
permitted under such regulations. For example, commenters suggested 
that the final regulations permit an accrual method ETSC corporate 
subsidiary to elect to treat the assets received (and liabilities 
assumed) by the ETSC corporate subsidiary in the deemed section 351 
exchange as though the subsidiary had owned such assets (and had such 
liabilities) in a prior taxable year, thereby creating an accounting 
method change upon the revocation. However, this approach contradicts 
the explicit text of section 1362(b)(3)(C)(i), which provides that, 
``[f]or purposes of this title'' (that is, for purposes of all of the 
provisions of the Code), an ETSC corporate subsidiary ``shall be 
treated as a new corporation.''
    In the alternative, commenters suggested that the final regulations 
could permit taxpayers to treat the assets received (and liabilities 
assumed) by an ETSC corporate subsidiary as though still owned by the 
former S corporation on the date on which the former S corporation 
becomes an ETSC. Under this approach, the ETSC's 481 adjustment would 
be computed as if the ETSC owned such assets and was subject to such 
liabilities. For support, these commenters highlighted anti-abuse 
regulations issued under section 263A of the Code (UNICAP anti-abuse 
regulations) that utilized this alternative approach. See Sec.  1.263A-
7(c)(4)(ii) (providing an anti-abuse rule regarding the use of section 
351 exchanges to avoid application of section 263A). However, the 
UNICAP anti-abuse regulations were issued under the authority of 
section 263A(h)(1) rather than the authority granted the Secretary 
under section 481(c). See 52 FR 10052, 10059 (March 30, 1987). Section 
263A(h)(1) requires the Secretary to ``prescribe rules to carry out the 
purpose of section 263A, including regulations to prevent the use of 
related parties, pass-thru entities, or intermediaries to avoid the 
application of this section.'' Section 263A(j)(1).
    The Treasury Department and the IRS have considered the commenters' 
suggested approaches for extending the section 481(d) inclusion period 
to ETSC corporate subsidiaries but have determined that section 481(c) 
would not support either approach. Section 481(c) and Sec.  1.481-
1(c)(2) provide the general rule that the 481 adjustment is taken into 
account in computing taxable income in the year of change, unless the 
Commissioner prescribes a different taxable year or years to take the 
481 adjustment into account under Sec. Sec.  1.446-1(e)(3) and 1.481-4. 
Any regulations issued under section 481(c) can apply only ``[i]n the 
case of any change described in [section 481](a)'' with regard to 
``adjustments required by [section 481](a)(2).'' As acknowledged by the 
commenters, section 481(a) does not apply to an ETSC corporate 
subsidiary because such entity is newly formed and therefore could not 
have had a prior accounting method to potentially change.
    Based on the foregoing, the final regulations do not adopt either 
of the commenters' alternative suggestions or provide any inclusion 
period for ETSC corporate subsidiaries under section 481. The Treasury 
Department and the IRS, however, note that TCJA amendments to section 
448(c) of the Code have significantly expanded the applicability of the 
cash method to C corporations, including ETSC corporate subsidiaries. 
As amended by section 13102(a) of the TCJA (131 Stat. 2054, 2102-3), 
section 448(c) provides that a C corporation may use the cash method if 
the corporation has average annual gross receipts not exceeding $25 
million (adjusted for inflation) for its three prior taxable years. 
Prior to the TCJA, the gross receipts threshold under section 448(c) 
was $5 million. As a result, fewer ETSC corporate subsidiaries will be 
required to adopt the accrual method as their permissible method of 
accounting for their first tax return than if the section 448(c) gross 
receipts threshold had not been increased from $5 million to $25 
million.

III. Comments Regarding the Post-Termination Transition Period

    The last sentence of Sec.  1.1377-2(b), as in effect prior to the 
effective date of these final regulations (no-newcomer rule), limited 
the special treatment provided under section 1371(e)(1) (with respect 
to distributions of money during a corporation's PTTP) solely to those 
shareholders who were shareholders of the corporation at the time that 
it terminated or revoked its S election (collectively, legacy 
shareholders). Because the rules pertaining to the PTTP and to the ETSC 
period serve a similar objective of easing the transition from S 
corporation to C corporation status, the Treasury Department and the 
IRS determined that the rules regarding newcomers (that is, non-legacy 
shareholders) should be consistent. See preamble to the proposed 
regulations, Explanation of Provisions, part IV. Therefore, based on 
the rationale for rejecting a no-newcomer rule with respect to the ETSC 
period, as set forth in part II.A of the Explanation of Provisions of 
the preamble to the proposed regulations, the Treasury Department and 
the IRS determined that such a rule should also not apply with respect 
to the PTTP and proposed the removal of the no-newcomer rule in Sec.  
1.1377-2(b). See Id.
A. Reliance on the Sec.  1.1377-2(b) No-Newcomer Rule
    One commenter expressed concern that elimination of the no-newcomer 
rule in Sec.  1.1377-2(b) could alter bargained-for economic results if 
a legacy shareholder had transferred less than all of its shares prior 
to November 7, 2019 (that is, the publication date of the proposed 
regulations) or after that date but pursuant to a binding agreement 
entered into before that date. In particular, the commenter contended

[[Page 66475]]

that legacy shareholders who transferred less than all of their shares 
would have expected that only legacy shareholders could receive 
distributions of AAA during the PTTP, and perhaps even during the ETSC 
period. According to the commenter, this expectation would have reduced 
the bargained-for price for the transferred shares to reflect the tax 
benefit of the future tax-free distributions.
    The commenter provided an example in which a sole shareholder of an 
ETSC sold 40 percent of its stock to a third-party. The sale price was 
set prior to November 7, 2019, and the parties assumed that the no-
newcomer rule would limit distributions of AAA to the legacy 
shareholder during the PTTP, and that a similar rule would apply during 
the ETSC period. Under the proposed elimination of the no-newcomer rule 
in Sec.  1.1377-2(b), however, the newcomer, and not the legacy 
shareholder, would be eligible to receive 40 percent of any AAA 
distributed during the PTTP or ETSC period. The commenter observed that 
the newcomer's accession to a 40 percent interest in the corporation's 
AAA during the PTTP and ETSC period amounts to a transfer of a tax 
benefit from the legacy shareholder to the newcomer for no 
consideration, contrary to the parties' expectations. Therefore, the 
commenter recommended that the final regulations include an additional 
transition rule. Under this rule, if shares of a former S corporation 
were transferred to a newcomer pursuant to a binding agreement entered 
into before the applicability date of the final regulations, then, 
except upon unanimous agreement of current shareholders of a 
corporation that are legacy shareholders, the no-newcomer rule would 
apply during the PTTP, and a similar rule would apply during the ETSC 
period.
    The Treasury Department and the IRS understand the concern 
underlying the commenter's recommendation. However, the Treasury 
Department and the IRS intended the applicability date provisions in 
the proposed regulations, and as adopted in these final regulations, to 
afford corporations transition flexibility in applying Sec.  1.1377-
2(b) with regard to the PTTP. Section 1.1377-2(b), as revised by the 
final regulations to eliminate the no-newcomer rule for special 
treatment under section 1371(e)(1) of distributions of money by a 
corporation with respect to its stock during the post-termination 
transition period applies to a corporation's taxable years beginning 
after the date of publication of the final regulations. In the case of 
a corporation using the calendar year as its annual accounting period, 
newcomers are not entitled to receive distributions of AAA before 
January 1, 2021, unless the corporation chooses to apply Sec.  1.1377-
2(b) before January 1, 2021. Corporations to which the commenter's 
transition rule would have applied generally will thus have completed 
their PTTPs prior to the applicability of Sec.  1.1377-2(b). 
Distributions of AAA during those PTTPs would have been limited to 
legacy shareholders. Additionally, the commenter's proposed transition 
rule would add complexity in administering these rules. Accordingly, 
the Treasury Department and the IRS have determined that the 
applicability date provisions, as set forth in the proposed regulations 
and adopted in these final regulations, balance appropriately the 
protection of legacy taxpayers' expectations with the goal of the 
Treasury Department and the IRS to minimize complexity and 
administrative difficulties for S corporations, their shareholders, and 
the IRS.
    With regard to the ETSC period, as discussed in part II.A of the 
Explanation of Provisions of the preamble to the proposed regulations, 
section 1371(f) does not contain a no-newcomer rule similar to Sec.  
1.1377-2(b), and the Treasury Department and the IRS have concluded 
that it is inappropriate to adopt one. Corporations may have applied a 
similar analysis of section 1371(f) and made distributions of AAA to 
newcomers during their respective ETSC periods. Providing an alternate 
rule in these final regulations for the ETSC period could unexpectedly 
alter taxpayers' bargained-for economic results. Therefore, the 
Treasury Department and the IRS have determined that the best way to 
address this situation is to allow but not require corporations to 
apply the final regulations addressing distributions made during the 
ETSC period to taxable years beginning on or before the date that these 
final regulations are published in the Federal Register.
B. Consideration of Request for an Additional 120-Day PTTP
    A commenter recommended that the final regulations provide a new 
120-day PTTP that would begin on the applicability date of the final 
regulations. The commenter noted that this new PTTP would create an 
opportunity for any C corporation with undistributed AAA that expired 
at the end of its PTTP to restore and distribute such AAA pursuant to 
section 1371(e)(1) and Sec.  1.1377-2. The commenter contended that the 
elimination of the no-newcomer rule only for terminations that occur 
after the issuance of the proposed regulations disadvantages 
corporations that terminated their S election more than one year prior 
to issuance of the proposed regulations, as compared to corporations 
that terminated their S election after the issuance of the proposed 
regulations.
    The Code sets forth a statutory definition of the PTTP that 
includes detailed limits on its duration. Specifically, section 
1377(b)(1)(A), (B), and (C) provide three separate durations for the 
PTTP, the respective applicability of which depends upon particular 
events. While the Treasury Department and the IRS acknowledge the 
concerns raised by the commenter, the final regulations do not adopt 
the commenter's recommendation because (i) section 1377(b) provides 
specific, detailed, and unambiguous guidance on the duration of a PTTP, 
and (ii) the recommended revision to Sec.  1.1377-2 exceeds the scope 
of the authority granted to prescribe regulations under sections 1371 
or 1377.

IV. Consideration of Comment Regarding Treatment of ETSC Status and AAA 
as Section 381 Items

    In the case of certain asset acquisitions, section 381(a) generally 
requires the acquiring corporation to succeed to and take into account 
the tax items described in section 381(c) of the distributor or 
transferor corporation. See section 381(a) (describing distributions to 
which section 332 of the Code applies and transfers to which section 
361 of the Code applies that are carried out in connection with certain 
reorganizations described in section 368(a)(1) of the Code); section 
381(c) (enumerating tax items of the distributor or transferor 
corporation that the acquiring corporation succeeds to and takes into 
account under section 381(a)).
    A commenter requested that the final regulations confirm that ETSC 
status and AAA constitute tax items that an acquiring corporation would 
succeed to or take into account under section 381(a). The Treasury 
Department and the IRS have considered the issue raised by the 
commenter but have determined that further study would be required to 
promulgate the appropriate rule. In addition, the Treasury Department 
and the IRS have concluded that this issue exceeds the scope of the 
final regulations because whether AAA constitutes a tax item to which a 
successor may succeed under section 381 is not limited to the ETSC 
context.

[[Page 66476]]

Therefore, the final regulations do not address the commenter's 
request.

Applicability Dates

    These regulations generally apply to taxable years beginning after 
October 20, 2020. See Sec. Sec.  1.481-6(b), 1.1371-1(e), 1.1371-2(d), 
and 1.1377-3(c). However, a corporation may choose to apply the rules 
set forth in Sec. Sec.  1.481-5, 1.1371-1, and 1.1371-2 in their 
entirety to taxable years beginning on or before October 20, 2020. If a 
corporation makes the choice described in the previous sentence, all 
shareholders of the corporation must report consistently, and the 
corporation must continue to apply the rules in Sec. Sec.  1.481-5, 
1.1371-1, and 1.1371-2 in their entirety for the corporation's 
subsequent taxable years.
    In addition, a corporation generally may choose to not apply the 
no-newcomer rule in Sec.  1.1377-2(b) to taxable years beginning on or 
before October 20, 2020 and with respect to which the period described 
in section 6501(a) as applied to that corporation has not expired. If a 
corporation makes the choice described in the previous sentence, all 
shareholders of the corporation must report consistently, and the 
corporation must adopt Sec. Sec.  1.481-5, 1.1371-1, 1.1371-2 (if an 
ETSC), and Sec.  1.1377-2(b) in their entirety and continue to apply 
those rules in their entirety for the corporation's subsequent taxable 
years.

Special Analyses

    These final regulations are not subject to review under section 
6(b) of Executive Order 12866 pursuant to the Memorandum of Agreement 
(April 11, 2018) between the Treasury Department and the Office of 
Management and Budget regarding review of tax regulations.

I. Regulatory Flexibility Act

    Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it 
is hereby certified that these final regulations will not have a 
significant economic impact on a substantial number of small entities 
within the meaning of section 601(6) of the Regulatory Flexibility Act. 
Notwithstanding this certification, the Treasury Department and the IRS 
provided such an analysis in the notice of proposed rulemaking 
preceding these final regulations (see 84 FR 60011) and received no 
comments on the impact that the proposed regulations would have on 
small entities. This certification is based on the fact that the amount 
of time necessary to report the required information will be minimal in 
that it requires ETSCs to provide information already required to be 
collected by previously existing statutory and regulatory requirements. 
Accordingly, the Secretary certifies that these regulations will not 
have a significant economic impact on a substantial number of small 
entities.
    Pursuant to section 7805(f), the notice of proposed rulemaking 
preceding this regulation was submitted to the Chief Counsel for the 
Office of Advocacy of the Small Business Administration for comment on 
its impact on small businesses. No comments were received from the 
Chief Counsel for the Office of Advocacy of the Small Business 
Administration.

II. Paperwork Reduction Act

    These final regulations do not require collection of any new or 
additional information pursuant to the Paperwork Reduction Act (44 
U.S.C. 3501 et seq.). Nevertheless, the Treasury Department and the IRS 
provided such an analysis in the notice of proposed rulemaking 
preceding these final regulations. See 84 FR 60011.

III. Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 requires 
that agencies assess anticipated costs and benefits and take certain 
other actions before issuing a final rule that includes any Federal 
mandate that may result in expenditures in any one year by a state, 
local, or tribal government, in the aggregate, or by the private 
sector, of $100 million in 1995 dollars, updated annually for 
inflation. In 2020, that threshold is approximately $156 million. This 
final rule does not include any mandate that may result in expenditures 
by state, local, or tribal governments, or by the private sector in 
excess of that threshold.

IV. Executive Order 13132: Federalism

    Executive Order 13132 (entitled ``Federalism'') prohibits an agency 
from publishing any rule that has federalism implications if the rule 
either imposes substantial, direct compliance costs on state and local 
governments, and is not required by statute, or preempts state law, 
unless the agency meets the consultation and funding requirements of 
section 6 of the Executive Order. This final rule does not have 
federalism implications and does not impose substantial, direct 
compliance costs on state and local governments or preempt state law 
within the meaning of the Executive Order.

Drafting Information

    The principal authors of these final regulations are Margaret Burow 
and Michael Gould of the Office of Associate Chief Counsel 
(Passthroughs and Special Industries) and Aglaia Ovtchinnikova of the 
Office of Associate Chief Counsel (Corporate). However, other personnel 
from the Treasury Department and the IRS participated in the 
development of the final regulations.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding an 
entry in numerical order for Sec.  1.481-6 to read in part as follows:

    Authority:  26 U.S.C. 7805 * * *
* * * * *
    Section 1.481-6 is also issued under 26 U.S.C. 481.
* * * * *


Sec.  1.316-2  [Amended]

0
Par. 2. Section 1.316-2 is amended by removing ``consist only of money 
and'' from the second sentence of paragraph (b).


Sec.  1.481-5  [Redesignated as Sec.  1.481-6]

0
Par. 3. Section 1.481-5 is redesignated as Sec.  1.481-6.


0
Par. 4. New Sec.  1.481-5 is added to read as follows:


Sec.  1.481-5  Eligible terminated S corporation.

    (a) Scope. Section 481(d)(2) of the Internal Revenue Code (Code) 
and this section provide rules relating to the qualification of a 
corporation as an eligible terminated S corporation (ETSC). Paragraph 
(b) of this section sets forth the requirements a corporation must meet 
to qualify as an ETSC. Paragraph (c) of this section describes certain 
transfers and other events that are disregarded for purposes of 
determining whether a corporation qualifies as an ETSC, as well as the 
treatment of revocations for which the effective date is the first day 
of the taxable year during which the revocation is made. Paragraph (d) 
of this section contains examples illustrating the rules of this 
section.
    (b) ETSC qualification. For a C corporation to qualify as an ETSC, 
it must satisfy the following requirements:
    (1) The corporation must have been an S corporation on December 21, 
2017;
    (2) During the 2-year period beginning on December 22, 2017, the 
corporation

[[Page 66477]]

must have made a valid revocation of its S election under section 
1362(d)(1) and the regulatory provisions in this part under section 
1362 of the Code (revocation); and
    (3) Except as provided in paragraph (c) of this section, the owners 
of the shares of stock of the corporation must be the same (and in 
identical proportions) on both:
    (i) December 22, 2017; and
    (ii) The day on which the revocation is made.
    (c) Special rules--(1) Certain disregarded events. The following 
events are disregarded for purposes of determining whether the 
requirement in paragraph (b)(3) of this section is satisfied:
    (i) Transfers of stock between a shareholder and that shareholder's 
trust treated as wholly owned by that shareholder under subpart E of 
subchapter J of chapter 1 of the Code;
    (ii) Transfers of stock between a shareholder and an entity owned 
by that shareholder that is disregarded as separate from its owner 
under Sec.  301.7701-2(c)(2)(i) of the Procedure and Administration 
Regulations;
    (iii) An election by a shareholder trust to be treated as part of a 
decedent's estate under section 645 of the Code or the termination of 
an election under that section;
    (iv) A change in the status of a shareholder trust from one type of 
eligible S corporation shareholder trust described in section 
1361(c)(2)(A) of the Code to another type of eligible S corporation 
shareholder trust; for example, a trust to which the shares of stock 
were transferred pursuant to the terms of a will (testamentary trust) 
described in section 1361(c)(2)(A)(iii) that elects to become an 
electing small business trust described in section 1361(c)(2)(A)(v) and 
(e); and
    (v) A transaction that includes more than one of the events 
described in this paragraph (c)(1).
    (2) Certain revocations. For purposes of paragraphs (b)(2) and 
(b)(3)(ii) of this section, a revocation with an effective date that is 
the first day of the taxable year during which the revocation is made 
pursuant to section 1362(d)(1)(C)(i) may be treated as having been made 
on the day the revocation was made or on the effective date of the 
revocation.
    (d) Examples. Paragraphs (d)(1) through (3) of this section 
(Examples 1 through 3) illustrate the rules of this section. For 
purposes of paragraphs (d)(1) through (3) of this section (Examples 1 
through 3), as of December 1, 2017, X is a calendar year S corporation 
with 100 shares of stock outstanding that is owned equally by unrelated 
individuals A and B. Pursuant to section 1362(d)(1) and Sec. Sec.  
1.1362-2 and 1.1362-6, X made a valid revocation of its S election on 
March 15, 2019, effective on January 1, 2019. X treats the revocation 
as having been made on March 15, 2019, for purposes of paragraphs 
(b)(2) and (b)(3)(ii). At all times, X has a single class of stock 
outstanding. Paragraphs (d)(1) through (3) of this section (Examples 1 
through 3) describe all relevant transactions involving the X stock 
from December 1, 2017, until March 15, 2019.
    (1) Example 1--(i) Facts. On June 5, 2018, A contributed 20 of its 
shares of X stock to Y, a wholly owned limited liability company that 
is disregarded as an entity separate from A pursuant to Sec.  301.7701-
2(c)(2)(i). On June 14, 2018, A contributed all of its interest in Y to 
Trust, which was a revocable trust treated as a wholly owned grantor 
trust of A pursuant to sections 671 and 676 of the Code. On December 
27, 2018, B sold 10 shares of its X stock to C, an unrelated person.
    (ii) Analysis. X is an ETSC if it satisfies the requirements of 
paragraph (b) of this section.
    (A) S corporation. X was an S corporation on December 21, 2017. 
Therefore, X satisfies the requirement of paragraph (b)(1) of this 
section.
    (B) Date of revocation. X made a valid revocation of its S election 
pursuant to section 1362(d)(1) on March 15, 2019, which is during the 
two-year period specified in paragraph (b)(2) of this section. 
Therefore, X satisfies the requirement of paragraph (b)(2) of this 
section.
    (C) Ownership. For purposes of the requirement in paragraph (b)(3) 
of this section, the relevant dates are: December 22, 2017, and March 
15, 2019 (the date X made a revocation of its S corporation status).
    (1) A's ownership interest. As of December 22, 2017, A owned 50 
shares of the outstanding shares of X stock. On June 5, 2018, A 
contributed 20 of its shares of X stock to Y (Transfer). On June 14, 
2018, A contributed all of its interest in Y to Trust (Contribution). 
Both the Transfer and the Contribution are disregarded for purposes of 
determining whether the requirement of paragraph (b)(3) of this section 
is satisfied. See paragraphs (c)(2) and (1) of this section, 
respectively. Therefore, A owns 50 shares of the outstanding stock of X 
on March 15, 2019.
    (2) B's ownership interest. As of December 22, 2017, B owned 50 
shares of the outstanding shares of X stock. On December 27, 2018, B 
sold 10 shares to C. Therefore, B owns 40 shares of the outstanding 
stock of X on March 15, 2019.
    (3) C's ownership interest. As of December 22, 2017, C owned no 
shares of X stock. On December 27, 2018, C purchased 10 shares from B. 
Therefore, C owns 10 shares of the outstanding stock of X on March 15, 
2019.
    (4) Failure to satisfy the requirement in paragraph (b)(3) of this 
section. As described in paragraphs (d)(1)(ii)(C)(2) and (3) of this 
section, B's and C's interest in X were not in the same proportions on 
December 22, 2017, and March 15, 2019. Therefore, X does not satisfy 
the requirement of paragraph (b)(3) of this section and does not 
qualify as an ETSC.
    (iii) Restoration of interests prior to end of PTTP. If C 
transferred its shares of X stock back to B on February 1, 2019, then 
on December 22, 2017, and March 15, 2019, A and B will have owned 50 
shares of the outstanding stock of X. Under these facts, X satisfies 
the requirement of paragraph (b)(3) of this section and qualifies as an 
ETSC.
    (2) Example 2--(i) Facts. The facts are the same as in paragraph 
(d)(1)(i) of this section, except that B sold 10 shares of its X stock 
to C on December 18, 2017, in addition to the sale of 10 shares of X 
stock on December 27, 2018.
    (ii) Analysis. The analysis in paragraph (d)(1)(ii)(A) and (B) of 
this section remains the same regarding the requirements of paragraph 
(b)(1) and (2) of this section. With respect to the requirement of 
paragraph (b)(3) of this section, on December 22, 2017, A owned 50%, B 
owned 40%, and C owned 10% of the outstanding stock of X. As in 
paragraph (d)(1)(ii)(C)(1) of this section, the Transfer and the 
Contribution are disregarded for purposes of determining whether the 
requirement of paragraph (b)(3) of this section is satisfied. 
Therefore, on March 15, 2019, A owned 50% (50 shares), B owned 30% (30 
shares), and C owned 20% (20 shares) of the outstanding shares of X. 
Even though A, B, and C owned shares of X on December 22, 2017, B's and 
C's proportionate ownership interest of X stock was not the same on 
December 22, 2017, and March 15, 2019. Therefore, X does not satisfy 
the requirement of paragraph (b)(3) of this section and does not 
qualify as an ETSC.
    (3) Example 3--(i) Facts. The facts are the same as in paragraph 
(d)(1)(i) of this section, except that X made a valid revocation of its 
S election on November 1, 2019, effective on January 1, 2020.
    (ii) Analysis. The analysis in paragraph (d)(1)(ii)(A) through (C) 
of this section remains the same regarding the requirements of 
paragraph (b)(1)

[[Page 66478]]

through (3) of this section, except that the relevant dates are: 
December 22, 2017, and November 1, 2019 (the date X made a revocation 
of its S corporation status). Although the effective date of X's 
revocation of its S election (January 1, 2020) occurs after the 
conclusion of the two-year period specified in paragraph (b)(2) of this 
section, it is irrelevant for purposes of determining whether the 
requirements of paragraph (b)(2) and (3) of this section are satisfied.


0
Par. 5. Newly redesignated Sec.  1.481-6 is revised to read as follows:


Sec.  1.481-6  Effective dates; applicability dates.

    (a) Sections 1.481-1, 1.481-2, 1.481-3, and 1.481-4 are effective 
for Consent Agreements signed on or after December 27, 1994. For 
Consent Agreements signed before December 27, 1994, see Sec. Sec.  
1.481-1, 1.481-2, 1.481-3, 1.481-4, and 1.481-5 as contained in 26 CFR 
part 1, revised as of April 1, 1995.
    (b) Section 1.481-5 applies to taxable years beginning October 20, 
2020. However, a corporation may choose to apply the rules in 
Sec. Sec.  1.481-5, 1.1371-1, and 1.1371-2 in their entirety to taxable 
years beginning on or before October 20, 2020. If a corporation makes 
the choice described in the previous sentence, the corporation must 
continue to apply the rules in Sec. Sec.  1.481-5, 1.1371-1, and 
1.1371-2 in their entirety for the corporation's subsequent taxable 
years.


0
Par. 6. Section 1.1362-2 is amended by adding paragraph (a)(2)(iii) to 
read as follows:


Sec.  1.1362-2  Termination of election.

    (a) * * *
    (2) * * *
    (iii) Applicability of section 7503. With respect to a revocation 
made under paragraph (a)(2) of this section, see section 7503 
(addressing time for performance of acts where the last day occurs on a 
Saturday, Sunday, or legal holiday). This paragraph (a)(2)(iii) applies 
to revocations made under paragraph (a)(2) of this section effective 
after October 20, 2020. A corporation may apply this paragraph 
(a)(2)(iii) retroactively to a revocation made by the corporation under 
paragraph (a)(2) of this section effective on or before October 20, 
2020.
* * * * *


0
Par. 6. Sections 1.1371-1 and 1.1371-2 are added to read as follows:


Sec.  1.1371-1  Distributions of money by an eligible terminated S 
corporation.

    (a) Scope and definitions--(1) Scope. This section provides rules 
relating to qualified distributions and distributions to which section 
301 of the Internal Revenue Code (Code) applies during each taxable 
year of the ETSC period, including the taxable year in which the ETSC 
period ends. If an ETSC does not make any qualified distributions 
during a taxable year, then no distribution by the ETSC is governed by 
section 1371(f) of the Code or this section. Paragraph (a)(2) of this 
section contains definitions that apply for purposes of this section. 
Paragraph (b) of this section contains rules regarding the 
characterization of a qualified distribution. Paragraph (c) of this 
section contains rules regarding the characterization of any excess 
qualified distribution and non-qualified distribution during each 
taxable year of the ETSC period, including the taxable year in which 
the ETSC period ends. Paragraph (d) of this section contains examples 
illustrating the rules of this section. Paragraph (e) of this section 
contains the applicability date of this section.
    (2) Definitions. The following definitions apply for purposes of 
this section--
    (i) AAA. The term AAA means the accumulated adjustments account, 
within the meaning of section 1368(e)(1)(A) of the Code and Sec.  
1.1368-2(a)(1).
    (ii) AAA ratio. Except as provided in this paragraph or paragraph 
(b)(3)(iv) of this section, the term AAA ratio means the fraction of 
which the numerator is historical AAA and the denominator is the sum of 
historical AAA and historical AE&P. Notwithstanding the preceding 
sentence, if the AE&P of the ETSC is less than or equal to zero as of 
the beginning of a taxable year, then the AAA ratio is one for such 
year and for all subsequent taxable years of the ETSC period.
    (iii) AE&P. The term AE&P means earnings and profits described in 
section 316(a)(1) of the Code.
    (iv) AE&P ratio. Except as provided in this paragraph or paragraph 
(b)(3)(iv) of this section, the term AE&P ratio means the fraction of 
which the numerator is historical AE&P, and the denominator is the sum 
of historical AAA and historical AE&P. Notwithstanding the preceding 
sentence, if the AE&P of the ETSC is less than or equal to zero as of 
the beginning of a taxable year, then the AE&P ratio is zero for such 
year and all subsequent taxable years of the ETSC period.
    (v) CE&P. The term CE&P means earnings and profits that are 
described in section 316(a)(2).
    (vi) ETSC. The term ETSC means an eligible terminated S 
corporation, within the meaning of section 481(d) of the Code and Sec.  
1.481-5.
    (vii) ETSC period. In general, the term ETSC period means any 
taxable year, or portion thereof, of an ETSC beginning on the first day 
after the post-termination period within the meaning of section 
1377(b)(1)(A) of the Code and ending on the date on which the ETSC's 
AAA balance is zero. Additionally, an ETSC does not have an ETSC period 
if the ETSC's AAA balance is not greater than zero at the end of its 
post-termination transition period. See Sec.  1.1371-2 for rules 
governing the impact of a post-termination period, within the meaning 
of section 1377(b)(1)(B), on the ETSC period.
    (viii) Excess qualified distribution. The term excess qualified 
distribution means the portion of a qualified distribution that is not 
characterized pursuant to paragraph (b)(2) or (3) of this section.
    (ix) Historical AAA. The term historical AAA means the AAA of the 
ETSC as of the beginning of the day on which the revocation of an 
election under section 1362(a) of the Code is effective pursuant to 
section 1362(d)(1).
    (x) Historical AE&P. The term historical AE&P means the AE&P of the 
ETSC as of the beginning of the day on which the revocation of an 
election under section 1362(a) is effective pursuant to section 
1362(d)(1). For purposes of the preceding sentence, if the ETSC's 
historical AE&P is less than zero, then the historical AE&P is treated 
as zero.
    (xi) Non-qualified distribution. The term non-qualified 
distribution means a distribution that is not a qualified distribution 
and to which section 301 applies.
    (xii) Qualified distribution. The term qualified distribution means 
a distribution of money by an ETSC during the ETSC period to which, 
absent the application of section 1371(f) and this section, section 301 
would apply. However, if paragraph (d)(2)(i) of this section applies to 
the ETSC, then a qualified distribution to a non-legacy shareholder is 
treated as a non-qualified distribution.
    (b) Characterization of qualified distribution--(1) In general. 
Paragraph (b)(2) of this section provides rules regarding the 
determination of the amount of a qualified distribution that is sourced 
from AAA and the corollary effects of such a characterization. 
Paragraph (b)(3) of this section provides rules regarding the 
determination of the amount of a qualified distribution that is sourced 
from AE&P and the corollary

[[Page 66479]]

effects of such a characterization. Paragraph (b)(4) of this section 
provides rules regarding the characterization of an excess qualified 
distribution as a separate qualified distribution. The rules in 
paragraphs (b)(2) through (4) of this section are applied before the 
application of paragraph (c) of this section.
    (2) Distribution of AAA--(i) Amount. The portion of a qualified 
distribution that is sourced from an ETSC's AAA is equal to the lesser 
of:
    (A) The product of the qualified distribution and the AAA ratio; 
and
    (B) The ETSC's AAA immediately before the qualified distribution.
    (ii) Reduction or elimination of ETSC's AAA. The ETSC's AAA is 
reduced by the amount of the distribution described in paragraph 
(b)(2)(i) of this section. If, with respect to a qualified 
distribution, the amount described in paragraph (b)(2)(i)(A) of this 
section equals or exceeds the amount described in paragraph 
(b)(2)(i)(B) of this section, then the rules in this paragraph (b) do 
not apply to any subsequent distributions by the ETSC. Instead, the 
subsequent distributions are treated in the manner provided in 
paragraph (c) of this section.
    (iii) Effect on the shareholder. The amount described in paragraph 
(b)(2)(i) of this section is applied against and reduces the 
shareholder's adjusted basis of the shares of stock with respect to 
which the distribution is made under the principles of section 
301(c)(2). If the application of the amount described in paragraph 
(b)(2)(i) of this section would result in a reduction of basis that 
exceeds the shareholder's adjusted basis of any share of stock with 
respect to which the distribution is made, such excess is treated as 
gain from the sale or exchange of property. The reduction of the 
shareholder's basis described in this paragraph with respect to a 
qualified distribution occurs prior to the application of paragraph (c) 
of this section to the excess qualified distribution, if any, with 
respect to such qualified distribution.
    (3) Distribution of AE&P--(i) Amount. This paragraph (b)(3) applies 
if an ETSC's AE&P ratio is greater than zero. If this paragraph (b)(3) 
applies, the portion of a qualified distribution that is sourced from 
the ETSC's AE&P is equal to the lesser of:
    (A) The product of the qualified distribution and the AE&P ratio; 
and
    (B) The ETSC's AE&P immediately before the qualified distribution. 
For purposes of the preceding sentence, if the ETSC's AE&P immediately 
before the qualified distribution is less than zero, then the ETSC's 
AE&P is treated as zero.
    (ii) Effect on ETSC's AE&P. The ETSC's AE&P is reduced, as 
described in section 312(a)(1), by the amount of the distribution 
described in paragraph (b)(3)(i) of this section. The AE&P reduction 
described in this paragraph occurs prior to the application of 
paragraph (c) of this section, even if a distribution to which 
paragraph (c) of this section applies (regarding excess qualified 
distributions and non-qualified distributions) occurs earlier in time 
than the qualified distribution to which this paragraph applies.
    (iii) Effect on the shareholder. The amount of the qualified 
distribution that is sourced from the ETSC's AE&P described in 
paragraph (b)(3)(i) of this section is included in the gross income of 
the shareholder as a dividend under section 301(c)(1).
    (iv) Adjustment to the AAA ratio and the AE&P ratio. After the 
application of paragraph (b)(3)(ii) of this section, if the ETSC's AE&P 
is zero and the ETSC's AAA is greater than zero, then the ETSC's AAA 
ratio is one and the ETSC's AE&P ratio is zero for all subsequent 
qualified distributions during:
    (A) That taxable year; and
    (B) All subsequent taxable years of the ETSC period.
    (4) Excess qualified distribution treated as a separate qualified 
distribution--(i) In general. After the application of paragraph 
(b)(2)(ii) of this section with respect to a qualified distribution, if 
the ETSC has any remaining AAA, then any amount of excess qualified 
distribution, with respect to such qualified distribution, is treated 
as a separate qualified distribution and is analyzed pursuant to 
paragraph (b) of this section.
    (ii) No change in characterization of previously characterized 
portion of qualified distribution. Paragraph (b)(4)(i) will not change 
the characterization of any portion of a qualified distribution that 
was previously characterized pursuant to paragraphs (b)(2) and (3) of 
this section and will reflect the application of paragraphs (b)(2) and 
(3) of this section to the portion of the qualified distribution 
previously characterized.
    (c) Characterization of excess qualified distribution and non-
qualified distributions. After the application of paragraph (b), the 
excess qualified distributions, if any, and non-qualified 
distributions, if any, are treated in the manner provided in sections 
301(c) and 316.
    (d) Examples. Paragraphs (d)(1) through (5) of this section 
(Examples 1 through 5) illustrate the rules of this section. For 
purposes of paragraphs (d)(1) through (5) of this section (Examples 1 
through 5), X is a calendar year S corporation with a single share of 
stock outstanding. A, an individual, purchased its share of X stock 
prior to December 22, 2017, and, except as otherwise indicated, never 
contributed any amounts to X's capital. A remained the sole shareholder 
of X when X made a valid revocation on March 15, 2018, pursuant to 
section 1362(d)(1) and Sec. Sec.  1.1362-2 and 1.1362-6, of its S 
election and when that revocation became effective on January 1, 2018. 
X qualified as an ETSC pursuant to Sec.  1.481-5(b) and its ETSC period 
began on January 1, 2019. Additionally, X did not make any 
distributions during its post-termination transition period, within the 
meaning of section 1377(b)(1)(A). Furthermore, A remains the sole 
shareholder of X at the time of the distribution(s) described.
    (1) Example 1: Historical AE&P is zero--(i) Facts. At the beginning 
of January 1, 2018, X had AAA of $100 and AE&P of $0. During 2018, X 
had $300 of CE&P and made no distributions. At the beginning of January 
1, 2019, X has AAA of $100 and AE&P of $300, and A's adjusted basis in 
its share of X stock is $460. During 2019, the only distribution that X 
makes is a $60 distribution of money to A on December 27. X's CE&P 
during 2019 is $150, without diminution by reason of any distributions 
made during the taxable year.
    (ii) Analysis--(A) Calculation of AAA ratio and AE&P ratio. 
Pursuant to paragraphs (a)(2)(ix) and (x) of this section, 
respectively, X's historical AAA and X's historical AE&P are determined 
as of the beginning of January 1, 2018, the beginning of the day on 
which the revocation of X's election under section 1362(a) is effective 
pursuant to section 1362(d)(1). Accordingly, X's historical AAA is $100 
and X's historical AE&P is $0. Therefore, X's AAA ratio is 1 ($100/
($100 + $0)), and X's AE&P ratio is zero ($0/($100 + $0)).
    (B) Characterization of distribution. Pursuant to paragraph 
(a)(2)(xii) of this section, the $60 distribution on December 27, 2019, 
is a qualified distribution because it is a distribution of money by an 
ETSC during the ETSC period to which section 301 would apply absent the 
application of section 1371(f) and this section.
    (C) Analysis of qualified distribution--(1) Distribution of AAA. 
Pursuant to paragraph (b)(2)(i) of this section, the portion of the 
qualified distribution that is sourced from AAA is equal to the lesser 
of: The product of the qualified distribution and the AAA ratio

[[Page 66480]]

($60 x 1, or $60), and X's AAA immediately before the qualified 
distribution ($100). Therefore, $60 is sourced from AAA. Pursuant to 
paragraph (b)(2)(ii) of this section, after the distribution, X's AAA 
is reduced by $60 to $40. Pursuant to paragraph (b)(2)(iii) of this 
section, A's basis in its X stock is reduced by $60 to $400.
    (2) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this 
section, the portion of the distribution that is sourced from AE&P is 
equal to the lesser of: The product of the qualified distribution and 
the AE&P ratio ($60 x 0, or $0), and X's AE&P immediately before the 
qualified distribution ($300). Therefore, $0 is sourced from AE&P.
    (2) Example 2: Qualified distributions with both historical AAA and 
historical AE&P--(i) Facts. At the beginning of January 1, 2018, X had 
AAA of $200 and AE&P of $100. During 2018, X had $0 of CE&P and made no 
distributions. At the beginning of January 1, 2019, X has AAA of $200 
and AE&P of $100, and A's adjusted basis in its share of X stock is 
$500. During 2019, X makes a $90 distribution of money on February 9 
and a $150 distribution of money on June 5. X's CE&P during 2019 is 
$500, without diminution by reason of any distributions made during the 
taxable year.
    (ii) Analysis--(A) Calculation of AAA ratio and AE&P ratio. 
Pursuant to paragraphs (a)(2)(ix) and (x) of this section, 
respectively, X's historical AAA and X's historical AE&P are determined 
as of the beginning of January 1, 2018, the beginning of the day on 
which the revocation of X's election under section 1362(a) is effective 
pursuant to section 1362(d)(1). Accordingly, X's historical AAA is $200 
and X's historical AE&P is $100. Therefore, X's AAA ratio is 0.67 
($200/($200 + $100)), and X's AE&P ratio is 0.33 ($100/($200 + $100)).
    (B) Characterization of distributions. Pursuant to paragraph 
(a)(2)(xii) of this section, the $90 distribution on February 9, 2019, 
and the $150 distribution on June 5, 2019, are both qualified 
distributions because they are distributions of money by an ETSC during 
the ETSC period to which section 301 would apply absent the application 
of section 1371(f) and this section.
    (C) Analysis of qualified distributions--(1) February 9, 2019 
distribution--(i) Distribution of AAA. Pursuant to paragraph (b)(2)(i) 
of this section, the portion of the qualified distribution that is 
sourced from AAA is equal to the lesser of: The product of the 
qualified distribution and the AAA ratio ($90 x 0.67, or $60), and X's 
AAA immediately before the qualified distribution ($200). Therefore, 
$60 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this 
section, after the distribution, X's AAA is reduced by $60 to $140. 
Pursuant to paragraph (b)(2)(iii) of this section, A's basis in its X 
stock is reduced by $60 to $440.
    (ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this 
section, the portion of the distribution that is sourced from AE&P is 
equal to the lesser of: the product of the qualified distribution and 
the AE&P ratio ($90 x 0.33, or $30), and X's AE&P immediately before 
the qualified distribution ($100). Therefore, $30 is sourced from AE&P. 
Pursuant to paragraph (b)(3)(ii) of this section, after the 
distribution, X's AE&P is reduced by $30 to $70. Pursuant to paragraph 
(b)(3)(iii) of this section, the $30 distribution is characterized as a 
dividend.
    (2) June 5, 2019 distribution--(i) Distribution of AAA. Pursuant to 
paragraph (b)(2)(i) of this section, the portion of the qualified 
distribution that is sourced from AAA is equal to the lesser of: The 
product of the qualified distribution and the AAA ratio ($150 x 0.67, 
or $100), and X's AAA immediately before the qualified distribution 
($140). Therefore, $100 is sourced from AAA. Pursuant to paragraph 
(b)(2)(ii) of this section, after the distribution, X's AAA is reduced 
by $100 to $40. Pursuant to paragraph (b)(2)(iii) of this section, A's 
basis in its X stock is reduced by $100 to $340.
    (ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this 
section, the portion of the distribution that is sourced from AE&P is 
equal to the lesser of: The product of the qualified distribution and 
the AE&P ratio ($150 x 0.33, or $50), and X's AE&P immediately before 
the qualified distribution ($70). Therefore, $50 is sourced from AE&P. 
Pursuant to paragraph (b)(3)(ii) of this section, after the 
distribution, X's AE&P is reduced by $50 to $20. Pursuant to paragraph 
(b)(3)(iii) of this section, the $50 distribution is characterized as a 
dividend.
    (3) Example 3: Limitation on amount characterized as AAA--(i) 
Facts. At the beginning of January 1, 2018, X had AAA of $100 and AE&P 
of $300. During 2018, X had $280 of CE&P and made no distributions. At 
the beginning of January 1, 2019, X has AAA of $100 and AE&P of $580, 
and A's adjusted basis in its share of X stock is $450. During 2019, 
the only distribution that X makes is a $500 distribution of money to A 
on October 5. X's CE&P during 2019 is $150, without diminution by 
reason of any distributions made during the taxable year.
    (ii) Analysis--(A) Calculation of AAA ratio and AE&P ratio. 
Pursuant to paragraphs (a)(2)(ix) and (x) of this section, 
respectively, X's historical AAA and X's historical AE&P are determined 
as of the beginning of January 1, 2018, the beginning of the day on 
which the revocation of X's election under section 1362(a) is effective 
pursuant to section 1362(d)(1). Accordingly, X's historical AAA is $100 
and X's historical AE&P is $300. Therefore, X's AAA ratio is 0.25 
($100/($100 + $300)), and X's AE&P ratio is 0.75 ($300/($100 + $300)).
    (B) Characterization of distribution. Pursuant to paragraph 
(a)(2)(xii) of this section, the $500 distribution on October 5, 2019, 
is a qualified distribution because it is a distribution of money by an 
ETSC during the ETSC period to which section 301 would apply absent the 
application of section 1371(f) and this section.
    (C) Analysis of qualified distribution--(1) Distribution of AAA. 
Pursuant to paragraph (b)(2)(i) of this section, the portion of the 
qualified distribution that is sourced from AAA is equal to the lesser 
of: The product of the qualified distribution and the AAA ratio ($500 x 
0.25, or $125), and X's AAA immediately before the qualified 
distribution ($100). Therefore, $100 is sourced from AAA. Pursuant to 
paragraph (b)(2)(ii) of this section, after the distribution, X's AAA 
is reduced by $100 to $0. Pursuant to paragraph (b)(2)(iii) of this 
section, A's basis in its X stock is reduced by $100 to $350.
    (2) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this 
section, the portion of the distribution that is sourced from AE&P is 
equal to the lesser of: the product of the qualified distribution and 
the AE&P ratio ($500 x 0.75, or $375), and X's AE&P immediately before 
the qualified distribution ($580). Therefore, $375 is sourced from 
AE&P. Pursuant to paragraph (b)(3)(ii) of this section, after the 
distribution, X's AE&P is reduced by $375 to $205. Pursuant to 
paragraph (b)(3)(iii) of this section, the $375 distribution is 
characterized as a dividend.
    (D) Effect of qualified distribution on ETSC period. Pursuant to 
paragraph (a)(2)(vii) of this section, X's ETSC period ends because X's 
AAA balance is zero following the October 5, 2019 distribution.
    (E) Analysis of excess qualified distribution--(1) Amount of excess 
qualified distribution. Pursuant to paragraph (a)(2)(viii) of this 
section, the amount of the excess qualified distribution is $25, the 
portion of the

[[Page 66481]]

qualified distribution ($500) not characterized pursuant to paragraph 
(b)(2) or (3) of this section ($100 AAA distribution + $375 AE&P 
distribution).
    (2) Characterization of excess qualified distribution. Paragraph 
(b)(4) of this section does not apply to the excess qualified 
distribution because X's AAA balance is zero after the application of 
paragraph (b)(2)(ii) of this section (see paragraph (d)(3)(ii)(C)(1) of 
this section). Pursuant to paragraph (c) of this section, section 
301(c) applies to the excess qualified distribution. Pursuant to 
sections 301(c)(1) and 316, the $25 excess qualified distribution is 
sourced from CE&P.
    (iii) Subsequent contribution. The facts are the same as paragraph 
(d)(3)(i) of this section, except that at the time of the October 5, 
2019 distribution, A's adjusted basis in its X stock is $90. Further, 
on December 27, 2019, A contributes $100 to X in a transaction 
described in section 351(a). The analysis in paragraph (d)(3)(ii) of 
this section remains the same, except that, unlike the second to last 
sentence of paragraph (d)(3)(ii)(C)(1) of this section, A's basis in 
its X stock is reduced by $90 to $0 and pursuant to paragraph 
(b)(2)(iii) of this section, $10 is treated as gain from the sale or 
exchange of property. Additionally, as a result of the December 27, 
2019 contribution of $100, A's basis in its X stock is increased by 
$100, so that at the end of 2019, A's basis in its X stock is $100.
    (4) Example 4: Limitation on the amount characterized as AE&P--(i) 
Facts. At the beginning of January 1, 2018, X had AAA of $100 and AE&P 
of $100. During 2018, X had CE&P of $(75) and made no distributions. At 
the beginning of January 1, 2019, X has AAA of $100 and AE&P of $25, 
and A's adjusted basis in its share of X stock is $500. During 2019, 
the only distributions that X makes are a $100 distribution of money to 
A on July 9 and a $40 distribution of money to A on September 27. X's 
CE&P during 2019 is $20, without diminution by reason of any 
distributions made during the taxable year.
    (ii) Analysis--(A) Calculation of AAA ratio and AE&P ratio. 
Pursuant to paragraphs (a)(2)(ix) and (x) of this section, 
respectively, X's historical AAA and X's historical AE&P are determined 
as of the beginning of January 1, 2018, the beginning of the day on 
which the revocation of X's election under section 1362(a) is effective 
pursuant to section 1362(d)(1). Accordingly, X's historical AAA is $100 
and X's historical AE&P is $100. Therefore, X's AAA ratio is 0.5 ($100/
($100 + $100)), and X's AE&P ratio is 0.5 ($100/($100 + $100)).
    (B) Analysis of July 9, 2019 distribution--(1) Characterization of 
distribution. Pursuant to paragraph (a)(2)(xii) of this section, the 
$100 distribution on July 9, 2019, is a qualified distribution because 
it is a distribution of money by an ETSC during the ETSC period to 
which section 301 would apply absent the application of section 1371(f) 
and this section.
    (2) Analysis of qualified distribution--(i) Distribution of AAA. 
Pursuant to paragraph (b)(2)(i) of this section, the portion of the 
distribution that is sourced from AAA is equal to the lesser of: The 
product of the qualified distribution and the AAA ratio ($100 x 0.5, or 
$50), and X's AAA immediately before the qualified distribution ($100). 
Therefore, $50 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of 
this section, after the distribution, X's AAA is reduced by $50 to $50. 
Pursuant to paragraph (b)(2)(iii) of this section, A's basis in its X 
stock is reduced by $50 to $450.
    (ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this 
section, the portion of the distribution that is sourced from AE&P is 
equal to the lesser of: The product of the qualified distribution and 
the AE&P ratio ($100 x 0.5, or $50), and X's AE&P immediately before 
the qualified distribution ($25). Therefore, $25 is sourced from AE&P. 
Pursuant to paragraph (b)(3)(ii) of this section, after the 
distribution, X's AE&P is reduced by $25 to $0. Pursuant to paragraph 
(b)(3)(iii) of this section, $25 of the distribution is characterized 
as a dividend.
    (3) Recalculation of AAA and AE&P ratios. Pursuant to paragraph 
(b)(3)(iv) of this section, because the July 9, 2019 distribution 
caused X's AE&P to be reduced to zero, the AAA ratio is one and the 
AE&P ratio is zero for all subsequent qualified distributions during 
the 2019 taxable year and subsequent taxable years of the ETSC period.
    (4) Excess qualified distribution--(i) Amount of excess qualified 
distribution. Pursuant to paragraph (a)(2)(viii) of this section, the 
amount of the excess qualified distribution is $25, the amount of the 
qualified distribution ($100) not characterized pursuant to paragraph 
(b)(2) or (3) of this section ($50 AAA distribution + $25 AE&P 
distribution).
    (ii) Characterization of excess qualified distribution as a 
separate qualified distribution. Pursuant to paragraph (b)(4) of this 
section, because X has AAA remaining after characterizing the qualified 
distribution (see paragraph (d)(4)(ii)(B)(2)(i) of this section), the 
$25 excess qualified distribution is treated as a separate qualified 
distribution and is analyzed pursuant to paragraph (b) of this section.
    (iii) Analysis of excess qualified distribution that is treated as 
a separate qualified distribution. Pursuant to paragraph (b)(2)(i) of 
this section, the portion of the distribution that is sourced from AAA 
is equal to the lesser of: The product of the excess qualified 
distribution and the AAA ratio ($25 x 1, or $25), and X's AAA 
immediately before the excess qualified distribution ($50). Therefore, 
$25 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this 
section, after the distribution, X's AAA is reduced by $25 to $25. 
Pursuant to paragraph (b)(2)(iii) of this section, A's basis in its X 
stock is reduced by $25 to $425. Pursuant to paragraph (b)(3)(i) of 
this section, because X's AE&P ratio is zero, paragraph (b)(3) of this 
section does not apply.
    (C) Analysis of September 27, 2019 distribution--(1) 
Characterization of the distribution. Pursuant to paragraph (a)(2)(xii) 
of this section, the $40 distribution on September 27, 2019, is a 
qualified distribution because it is a distribution of money by an ETSC 
during the ETSC period to which section 301 would apply absent the 
application of section 1371(f) and this section.
    (2) Analysis of qualified distribution--(i) Distribution of AAA. 
Pursuant to paragraph (b)(2)(i) of this section, the portion of the 
distribution that is sourced from AAA is equal to the lesser of: The 
product of the qualified distribution and the AAA ratio ($40 x 1, or 
$40), and X's AAA immediately before the qualified distribution ($25) 
(see paragraph (d)(4)(ii)(B)(4)(iii) of this section). Therefore, $25 
is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section, 
after the distribution, X's AAA is reduced by $25 to $0. Pursuant to 
paragraph (b)(2)(iii) of this section, A's basis in its X stock is 
reduced by $25 to $400.
    (ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this 
section, because X's AE&P ratio is zero, paragraph (b)(3) of this 
section does not apply.
    (3) Excess qualified distribution--(i) Amount of excess qualified 
distribution. Pursuant to paragraph (a)(2)(viii) of this section, the 
amount of the excess qualified distribution is $15, the portion of the 
qualified distribution ($40) not characterized pursuant to paragraph 
(b)(2) or (3) of this section ($25 AAA distribution + $0 AE&P 
distribution).
    (ii) Excess qualified distribution not characterized as a separate 
qualified distribution. Pursuant to paragraph (b)(4) of this section, 
because X has

[[Page 66482]]

AAA of $0 after characterizing the qualified distribution (see 
paragraph (d)(4)(ii)(C)(2)(i) of this section), the $15 excess 
qualified distribution is not treated as a separate qualified 
distribution.
    (iii) Analysis of excess qualified distribution that is not treated 
as a separate qualified distribution. Pursuant to paragraph (c) of this 
section, section 301(c) applies to the excess qualified distribution. 
Pursuant to sections 301(c)(1) and 316, the $15 excess qualified 
distribution is sourced from CE&P.
    (5) Example 5: Distributions include non-qualified distributions--
(i) Facts. At the beginning of January 1, 2018, X had AAA of $100 and 
AE&P of $100. During 2018, X had $0 of CE&P and made no distributions. 
At the beginning of January 1, 2019, X has AAA of $100 and AE&P of 
$100, and A's adjusted basis in its X stock is $200. During 2019, X 
makes a $100 distribution of money on June 14; a $300 distribution of 
property on November 9; and a $200 distribution of money on December 
18. X's CE&P during 2019 is $160, without diminution by reason of any 
distributions made during the taxable year.
    (ii) Analysis--(A) Calculation of AAA ratio and AE&P ratio. 
Pursuant to paragraphs (a)(2)(ix) and (x) of this section, 
respectively, X's historical AAA is $100 and X's historical AE&P is 
$100. Therefore, X's AAA ratio is 0.5 ($100/($100 + $100)), and X's 
AE&P ratio is 0.5 ($100/($100 + $100)).
    (B) Characterization of distributions. Pursuant to paragraph 
(a)(2)(xii) of this section, the $100 distribution on June 14, 2019, 
and the $200 distribution on December 18, 2019, are both qualified 
distributions because they are distributions of money by an ETSC during 
the ETSC period to which section 301 would apply absent the application 
of section 1371(f) and this section. Pursuant to paragraph (a)(2)(xi) 
of this section, the $300 distribution of property on November 9, 2019, 
is a non-qualified distribution. Pursuant to paragraph (b)(1) of this 
section, the rules of paragraph (b)(2) through (b)(4) of this section 
apply to the qualified distributions before the rules of paragraph (c) 
of this section apply to the non-qualified distribution and any excess 
qualified distributions.
    (C) Analysis of qualified distributions--(1) June 14, 2019 
distribution--(i) Distribution of AAA. Pursuant to paragraph (b)(2)(i) 
of this section, the portion of the distribution that is sourced from 
AAA is equal to the lesser of: The product of the qualified 
distribution and the AAA ratio ($100 x 0.5, or $50), and X's AAA 
immediately before the qualified distribution ($100). Therefore, $50 is 
sourced from AAA. Pursuant to paragraph (b)(2)(ii) of this section, 
after the distribution, X's AAA is reduced by $50 to $50. Pursuant to 
paragraph (b)(2)(iii) of this section, on June 14, 2019, A's basis in 
its X stock is reduced by $50 to $150.
    (ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this 
section, the portion of the distribution that is sourced from AE&P is 
equal to the lesser of: The product of the qualified distribution and 
the AE&P ratio ($100 x 0.5, or $50), and X's AE&P immediately before 
the qualified distribution ($100). Therefore, $50 is sourced from AE&P. 
Pursuant to paragraph (b)(3)(ii) of this section, after the 
distribution, X's AE&P is reduced by $50 to $50. Pursuant to paragraph 
(b)(3)(iii) of this section, the $50 distribution is characterized as a 
dividend.
    (iii) Amount of excess qualified distribution. The amount of the 
excess qualified distribution is $0, the amount of the qualified 
distribution ($100) not characterized pursuant to paragraph (b)(2) or 
(3) of this section ($50 AAA distribution + $50 AE&P distribution).
    (2) December 18, 2019 distribution--(i) Distribution of AAA. 
Pursuant to paragraph (b)(2)(i) of this section, the portion of the 
distribution that is sourced from AAA is equal to the lesser of: The 
product of the qualified distribution and the AAA ratio ($200 x 0.5, or 
$100), and X's AAA immediately before the qualified distribution ($50). 
Therefore, $50 is sourced from AAA. Pursuant to paragraph (b)(2)(ii) of 
this section, after the distribution, X's AAA is reduced by $50 to $0. 
Pursuant to paragraph (b)(2)(iii) of this section, A must determine its 
basis as of December 18, 2019, in order to determine the consequences 
of receiving the $50 AAA distribution. Because the non-qualified 
distribution on November 9, 2019, which precedes the December 18, 2019 
qualified distribution, could have the effect of reducing A's basis, 
any effect on A's basis from that non-qualified distribution must be 
analyzed prior to determining the effect of the December 18, 2019 
distribution of AAA on A's basis. See paragraphs (d)(5)(ii)(D)(3) and 
(4) of this section. Pursuant to paragraph (a)(2)(vii) of this section, 
X's ETSC period ends because X's AAA balance is zero following the 
December 18, 2019 distribution.
    (ii) Distribution of AE&P. Pursuant to paragraph (b)(3)(i) of this 
section, the portion of the distribution that is sourced from AE&P is 
equal to the lesser of: The product of the qualified distribution and 
the AE&P ratio ($200 x 0.5, or $100), and X's AE&P immediately before 
the qualified distribution ($50). Therefore, $50 is sourced from AE&P. 
Pursuant to paragraph (b)(3)(ii) of this section, after the 
distribution, X's AE&P is reduced by $50 to $0. Pursuant to paragraph 
(b)(3)(iii) of this section, the $50 distribution is characterized as a 
dividend.
    (iii) Amount of excess qualified distribution. The amount of the 
excess qualified distribution is $100, the amount of the qualified 
distribution ($200) not characterized pursuant to paragraph (b)(2) or 
(3) of this section ($50 AAA distribution + $50 AE&P distribution).
    (D) Analysis of non-qualified and excess qualified distributions--
(1) In general. The $300 non-qualified distribution on November 9, 
2019, and the $100 excess qualified distribution on December 18, 2019, 
are treated in the manner provided in section 301(c).
    (2) Allocation of CE&P. Pursuant to section 316 and Sec.  1.316-2, 
X's CE&P is allocated proportionately among the excess qualified and 
the non-qualified distributions. Therefore, the portion of X's CE&P 
that is allocated to the November 9, 2019 distribution and the December 
18, 2019 distribution is $120 ($160 CE&P x ($300 distribution/$400 
total excess qualified and non-qualified distributions during 2019) and 
$40 ($160 CE&P x ($100 distribution/$400 total excess qualified and 
non-qualified distributions during 2019), respectively.
    (3) November 9, 2019 distribution. Pursuant to paragraph 
(d)(5)(ii)(D)(2) of this section, $120 of the $300 distribution is 
characterized as a distribution of CE&P. Pursuant to paragraph 
(d)(5)(ii)(C)(2)(ii) of this section, the amount of X's AE&P available 
to allocate the November 9, 2019 distribution is $0. Therefore, the 
remaining $180 is characterized pursuant to section 301(c)(2) and (3). 
Pursuant to paragraph (d)(5)(ii)(C)(1)(i) of this section, A's basis in 
its X stock prior to the November 9, 2019 distribution is $150. 
Therefore, $150 is applied against basis pursuant to section 301(c)(2) 
(reducing A's basis to $0) and $30 is treated as gain from the sale or 
exchange of property pursuant to section 301(c)(3).
    (4) December 18, 2019 distribution--(i) Consequences of AAA 
distribution. As of December 18, 2019, A's basis in its X stock is $0. 
See paragraph (d)(5)(ii)(D)(3) of this section. Pursuant to paragraph 
(d)(5)(ii)(C)(2)(i) of this section, $50 of the distribution is 
characterized as a distribution of AAA. Because the amount of the 
distribution of AAA ($50) exceeds A's basis in its X

[[Page 66483]]

stock ($0), pursuant to paragraph (b)(2)(iii) of this section, on 
December 18, 2019, $50 is treated as gain from the sale or exchange of 
property.
    (ii) Characterization of excess qualified distribution. Pursuant to 
paragraph (d)(5)(ii)(C)(2)(iii) of this section, $100 of the December 
18, 2019 distribution is an excess qualified distribution. Paragraph 
(b)(4) of this section does not apply to the excess qualified 
distribution because X's AAA balance is zero after the application of 
paragraph (b)(2)(ii) of this section (see paragraph (d)(5)(ii)(C)(2)(i) 
of this section. Pursuant to paragraph (c) of this section, section 
301(c) applies to the excess qualified distribution. Pursuant to 
paragraph (d)(5)(ii)(D)(2) of this section, $40 of the $100 excess 
qualified distribution is characterized as a distribution of CE&P. 
Pursuant to paragraph (d)(5)(ii)(D)(3) of this section, X's AE&P as the 
time of the December 18, 2019 distribution is $0. Therefore, the 
remaining $60 is characterized pursuant to section 301(c)(2) and (3). 
Pursuant to paragraph (d)(5)(ii)(D)(4)(i) of this section, A's basis in 
its X stock prior to characterization of the excess qualified 
distribution is $0. Therefore, $60 is treated as gain from the sale or 
exchange of property pursuant to section 301(c)(3).
    (e) Applicability date. This section applies to taxable years 
beginning after October 20, 2020. However, a corporation may choose to 
apply the rules in Sec. Sec.  1.481-5, 1.1371-1, and 1.1371-2 in their 
entirety to taxable years beginning on or before October 20, 2020. If a 
corporation makes the choice described in the previous sentence, all 
shareholders of the corporation must report consistently, and the 
corporation must continue to apply the rules in Sec. Sec.  1.481-5, 
1.1371-1, and 1.1371-2 in their entirety for the corporation's 
subsequent taxable years.


Sec.  1.1371-2  Impact of Audit PTTP on ETSC Period.

    (a) Definitions. For purposes of this section, the definitions used 
in Sec.  1.1371-1(a)(2) are applicable. Additionally, the following 
definitions apply for purposes of this section--
    (1) Audit PTTP. The term audit PTTP means a post-termination 
transition period described in section 1377(b)(1)(B) of the Internal 
Revenue Code (Code).
    (2) Initial PTTP. The term initial PTTP means a post-termination 
transition period described in section 1377(b)(1)(A).
    (3) Intervening audit PTTP. The term intervening audit PTTP means 
an audit PTTP arising during the ETSC period.
    (b) In general. If an intervening audit PTTP arises, the ETSC 
period immediately stops. Immediately following the end of the 
intervening audit PTTP, the ETSC period resumes if the ETSC's AAA 
balance is greater than zero. Otherwise, any subsequent distributions 
by the ETSC are treated in the manner provided in section 301(c) of the 
Code.
    (c) Examples. Paragraphs (c)(1) and (2) of this section (Examples 1 
and 2) illustrate the rules of this section. For purposes of paragraphs 
(c)(1) and (2) of this section (Examples 1 and 2), X is a calendar year 
S corporation. A, an individual, purchased all of the outstanding 
shares of X in a single transaction at the same price per share prior 
to December 22, 2017, and was the sole shareholder of X at all times. 
Pursuant to section 1362(d)(1) of the Code and Sec. Sec.  1.1362-2 and 
1.1362-6, X made a valid revocation of its S election on March 15, 
2019, that became effective on January 1, 2019. No amount distributed 
by X is an extraordinary dividend within the meaning of section 1059.
    (1) Example 1: No ETSC period following initial PTTP--(i) Facts. At 
the beginning of January 1, 2019, X had AAA of $49,000 and AE&P of 
$2,000, and A's adjusted basis in its shares of X stock was $50,000. 
During 2019, the only distribution that X made was a $49,000 
distribution of money to A on March 13, 2019. X's CE&P during 2019 was 
$0, without regard to any diminution by reason of any distributions 
made during the taxable year.
    (ii) Analysis--(A) Distribution during initial PTTP. Pursuant to 
sections 1371(e) and 1377(b)(1)(A), the $49,000 distribution of money 
on March 13, 2019, is characterized as a distribution of AAA because it 
was made during the initial PTTP.
    (B) Effect on corporation. Pursuant to Sec.  1.1368-2(a)(3)(iii), 
X's AAA is reduced by $49,000 to $0. Following the initial PTTP, even 
if X satisfies the requirements of section 481(d)(2) of the Code and 
Sec.  1.481-5(b) to be an ETSC, X does not have an ETSC period because 
its AAA balance is zero at the end of its initial PTTP. Therefore, 
section 1371(f) of the Code and Sec.  1.1371-1 will not apply to any 
subsequent distributions by X.
    (C) Effect on shareholder. Pursuant to section 1371(e)(1), A 
reduces its basis in its X stock by $49,000 to $1,000.
    (2) Example 2: Intervening audit PTTP--(i) Facts. The facts are the 
same as the facts in paragraph (c)(1) of this section. On May 20, 2020, 
which is after X's initial PTTP, the IRS begins an audit of X's 2018 
return. During the audit it is agreed that X overstated its advertising 
expense deduction by $10,000. On July 6, 2020, A signs a closing 
agreement whereby X's overstatement results in an additional tax on A's 
2018 individual return. As a result, at the beginning of January 1, 
2019, X had AAA of $59,000 ($49,000 + $10,000) and AE&P of $2,000. 
Additionally, at the beginning of January 1, 2019, A's adjusted basis 
in its shares of X stock was $60,000 ($50,000 + $10,000). During 2020, 
the only distribution X makes is a $6,000 distribution of money to A on 
September 1, 2020. X's CE&P during 2020 was $0, without regard to any 
diminution by reason of any distributions made during the taxable year.
    (ii) Analysis--(A) Analysis of March 13, 2019 distribution. The 
treatment of the March 13, 2019, distribution is the same as described 
in paragraph (c)(1)(ii)(A) of this section, because the amount of the 
distribution ($49,000) does not exceed X's AAA balance at the beginning 
of January 1, 2019 ($59,000), and so the entirety of the $49,000 
distribution is properly characterized as a distribution of AAA.
    (1) Effect on corporation. As described in paragraph (c)(1)(ii)(B) 
of this section, X's AAA ($59,000 at the beginning of January 1, 2019) 
is reduced by $49,000 to $10,000. At the conclusion of X's initial PTTP 
(ending on December 31, 2019), X's AAA balance is $10,000. Pursuant to 
Sec.  1.1371-1(a)(2)(vii), X has an ETSC period. Therefore, section 
1371(f) and Sec.  1.1371-1 will apply to any subsequent qualified 
distributions by X.
    (2) Effect on shareholder. As described in paragraph (c)(1)(ii)(C) 
of this section, A reduces its basis in its X stock ($60,000 at the 
beginning of January 1, 2019) by $49,000 to $11,000.
    (B) Intervening audit PTTP. Pursuant to section 1377(b)(1)(B), X 
enters an intervening audit PTTP that begins on July 6, 2020, and ends 
on November 2, 2020. The application of section 1371(f) and Sec.  
1.1371-1 to distributions during the intervening audit PTTP is stopped. 
Instead, sections 1371(e) and 1377(b)(1)(B) and Sec. Sec.  1.1371-2 and 
1.1377-2 apply for the duration of the intervening audit PTTP. During 
the intervening audit PTTP, the only distribution X made is a $6,000 
distribution of money to A on September 1, 2020. Pursuant to sections 
1371(e) and 1377(b)(1)(B), the $6,000 distribution is characterized as 
a distribution of AAA because it was made during the intervening audit 
PTTP.

[[Page 66484]]

    (1) Effect on corporation. Pursuant to Sec.  1.1368-2(a)(3)(iii), 
X's AAA is reduced by $6,000 to $4,000. Beginning on November 3, 2020, 
pursuant to Sec.  1.1371-1(a)(2)(vii), X's ETSC period resumes (after 
the intervening audit PTTP's conclusion) because its AAA balance is 
greater than zero.
    (2) Effect on shareholder. Pursuant to section 1371(e)(1), A 
reduces its basis in its X stock by $6,000 to $5,000.
    (C) ETSC period. Beginning on November 3, 2020, X's ETSC period 
resumes, and distributions of money are subject to section 1371(f) and 
Sec.  1.1371-1 until X's AAA balance is zero. For purposes of 
calculating each of X's AAA and AE&P ratios, X's historical AAA is 
$59,000 (at the beginning of January 1, 2019, which includes the 
$10,000 increase as a result of the July 6, 2020, closing agreement).
    (d) Applicability date. This section applies to taxable years 
beginning after October 20, 2020. However, a corporation may choose to 
apply the rules in Sec. Sec.  1.481-5, 1.1371-1, and 1.1371-2 in their 
entirety to taxable years that began on or before October 20, 2020. If 
a corporation makes the choice described in the previous sentence, all 
shareholders of the corporation must report consistently, and the 
corporation must continue to apply the rules in Sec. Sec.  1.481-5, 
1.1371-1, and 1.1371-2 in their entirety for the corporation's 
subsequent taxable years.


Sec.  1.1377-2   [Amended]

0
Par. 7. Section 1.1377-2 is amended by removing the last sentence of 
paragraph (b).


0
Par. 8. Section 1.1377-3 is revised to read as follows:


Sec.  1.1377-3  Applicability dates.

    (a) In general. Except as otherwise provided in this section, 
Sec. Sec.  1.1377-1 and 1.1377-2 apply to taxable years of an S 
corporation beginning after December 31, 1996.
    (b) Certain conversions. Section 1.1377-1(a)(2)(iii) and (c)(3) 
(Example 3) are applicable for taxable years beginning on and after May 
14, 2002.
    (c) Special treatment of distributions of money during post-
termination transition period--(1) In general. Except as provided in 
paragraph (c)(2) of this section, Sec.  1.1377-2(b) applies to taxable 
years beginning after October 20, 2020. For taxable years beginning on 
or before October 20, 2020, see Sec.  1.1377-2(b) as contained in 26 
CFR part 1, revised April 1, 2020.
    (2) Taxable years beginning on or before October 20, 2020. A 
corporation may choose to apply Sec.  1.1377-2(b) to taxable years 
beginning on or before October 20, 2020 and with respect to which the 
period described in section 6501(a) has not expired. If a corporation 
makes the choice described in the previous sentence, all shareholders 
of the corporation must report consistently, and the corporation must 
adopt Sec. Sec.  1.481-5, 1.1371-1, 1.1371-2, if an ETSC, and 1.1377-
2(b) in their entity and continue to apply those rules in their 
entirety for the corporation's subsequent taxable years.

Sunita Lough,
Deputy Commissioner for Services and Enforcement.
    Approved: September 9, 2020.
David J. Kautter,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2020-21144 Filed 10-19-20; 8:45 am]
BILLING CODE 4830-01-P