[Federal Register Volume 60, Number 133 (Wednesday, July 12, 1995)]
[Proposed Rules]
[Pages 35881-35887]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-16653]



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

[[Page 35882]]


DEPARTMENT OF THE TREASURY
Internal Revenue Service

26 CFR Parts 1 and 18

[PS-268-82]
RIN 1545-AE94


Definitions Under Subchapter S of the Internal Revenue Code

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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

SUMMARY: This document contains proposed regulations for S corporations 
and their shareholders relating to the definitions and the special rule 
provided in section 1377 of the Internal Revenue Code of 1986. The 
proposed regulations reflect changes to the law made by the Subchapter 
S Revision Act of 1982. The proposed regulations are necessary to 
provide guidance needed by taxpayers to comply with the law.

DATES: Written comments and requests for a public hearing must be 
received by October 10, 1995.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (PS-268-82), room 5228, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. In the alternative, submissions may be hand delivered between 
the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (PS-268-82), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW., 
Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Brian J. 
O'Connor, (202) 622-3060; concerning submissions and the hearing, 
Michael Slaughter, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act (44 U.S.C. 
3504(h)). Comments on the collections of information should be sent to 
the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 
20224.
    A collection of information is required under Sec. 1.1377-1(b). 
This information is required by the IRS to verify the event giving rise 
to the making of an election under section 1377(a)(2) by an S 
corporation. The likely respondents and/or recordkeepers will be S 
corporations and shareholders of S corporations.
    Estimated total annual reporting burden: 1,000 hours.
    The estimated annual burden per respondent varies from .2 hour to 
.5 hour, depending on individual circumstances, with an estimated 
average of .25 hour.
    Estimated number of respondents: 4,000.
    Estimated annual frequency of responses: 1.

Background

    This document proposes amendments to the Income Tax Regulations (26 
CFR part 1) under section 1377 of the Internal Revenue Code (Code). 
Section 18.1377-1 was issued by TD 7872 (48 FR 3590). The proposed 
regulations would conform the regulations to the addition of section 
1377 to the Code by section 2 of the Subchapter S Revision Act of 1982, 
Pub. L. 97-354 (1982-2 C.B. 702, 710).

Explanation of Provisions

Shareholder's Pro Rata Share of Items of Income, Loss, Deduction, and 
Credit

    Section 1366(a)(1) requires a shareholder of an S corporation to 
take into account the shareholder's pro rata share of the corporation's 
items of income, loss, deduction, and credit. The proposed regulations 
provide that, except in the case of an election under section 
1377(a)(2), each shareholder's pro rata share of an item for a taxable 
year is the sum of the amounts determined with respect to the 
shareholder by assigning an equal portion of the item to each day of 
the S corporation's taxable year, and then dividing that portion pro 
rata among the shares outstanding on that day.
    The proposed regulations contain several special rules for 
determining a shareholder's pro rata share. First, solely for purposes 
of determining a shareholder's pro rata share of an item, an S 
corporation's taxable year does not include any day on which the 
corporation has no shareholders. This rule ensures that the full amount 
of all items of the S corporation will be allocated to the 
corporation's shareholders. Second, a shareholder who disposes of stock 
of an S corporation is treated as the shareholder for the day of the 
disposition. Finally, a shareholder who dies is treated as the 
shareholder for the day of the shareholder's death.

Election To Treat Taxable Year as Separate Taxable Years

    Under section 1377(a)(2), if a shareholder's interest in an S 
corporation is terminated during the taxable year and all persons who 
are shareholders during the taxable year agree, the corporation may 
elect (terminating election) to apply section 1377(a)(1) as if the 
taxable year of the S corporation consisted of two taxable years, the 
first of which ends on the date of the termination. The proposed 
regulations provide rules concerning the time and manner of making a 
terminating election and, therefore, it is proposed that Sec. 18.1377-1 
(which provides temporary rules concerning the time and manner of 
making a terminating election) be removed. The proposed regulations 
also provide that the terminating election is irrevocable and is 
effective only for the terminating event for which it is made.
    The proposed regulations clarify that a terminating election may be 
made only if a shareholder's entire interest as a shareholder in the S 
corporation is terminated. A shareholder's entire interest as a 
shareholder is terminated under the proposed regulations on the 
occurrence of any event through which a shareholder's entire stock 
ownership in the S corporation ceases, including a sale, exchange, or 
other disposition of all of the stock held by the shareholder; a gift 
under section 102(a) of all the shareholder's stock; a spousal transfer 
under section 1041(a) of all the shareholder's stock; a redemption, as 
defined in section 317(b), of all of the shareholder's stock, 
regardless of the tax treatment of the redemption under section 302; 
and the death of the shareholder. A shareholder's entire interest in an 
S corporation is not terminated under the proposed regulations if the 
shareholder retains ownership of any stock that would result in the 
shareholder continuing to be considered a shareholder of the 
corporation for purposes of section 1362(a)(2). Thus, in determining 
whether a shareholder's entire interest in an S corporation has been 
terminated, any options held by the shareholder (other than options 
that are treated as stock under Sec. 1.1361-1(l)(4)(iii)) and any 
interest in the S corporation held by the shareholder as a creditor, 
employee, director, or in any other non-shareholder capacity are 
disregarded.
    The proposed regulations also describe the effects of a terminating 
election. Under the proposed regulations, an S corporation that makes a 
terminating election must treat its taxable year as two separate 
taxable 

[[Page 35883]]
years for purposes of computing and allocating to each shareholder 
items of income (including tax-exempt income), loss, deduction, and 
credit; making adjustments to the accumulated adjustments account 
(AAA), earnings and profits, and basis; and determining the tax effect 
of a distribution to the shareholders. This treatment is required to 
give full effect to treating the taxable year as two separate taxable 
years. The proposed regulations also require the S corporation to 
assign items of income, loss, deduction, and credit to each deemed 
separate taxable year using the corporation's normal method of 
accounting as determined under section 446(a). The proposed regulations 
provide that a terminating election does not affect the due date of the 
S corporation's tax return for the taxable year or the time when the 
shareholders must include their pro rata allocations of items from the 
S corporation. The proposed regulations also provide that a terminating 
election by an S corporation that is a partner in a partnership is 
treated as a sale or exchange of the corporation's entire interest in 
the partnership for purposes of section 706(c) (closing of the 
partnership's taxable year) if the taxable year of the partnership ends 
after the shareholder's interest is terminated and within the full 
taxable year of the S corporation for which the terminating election is 
made. This rule conforms terminating elections with the rule for S 
termination years. See Sec. 1.1362-3(c)(1).
    The proposed regulations coordinate the application of the 
terminating election under section 1377(a)(2) with the election under 
section 1362(e)(3) (election to have items assigned to each short 
taxable year of an S termination year under normal accounting rules 
rather than pro rata) and the election under Sec. 1.1368-1(g)(2) 
(election to terminate the taxable year when there is a qualifying 
disposition). Under the proposed regulations, if a transfer results in 
a termination of the shareholder's entire interest as a shareholder and 
the transfer also constitutes a qualifying disposition under 
Sec. 1.1368-1(g)(2)(i), the terminating election rules under these 
proposed regulations take precedence and a qualifying disposition 
election cannot be made. If a termination of a shareholder's entire 
interest results in a termination under section 1362(d)(2) of the 
corporation's election to be an S corporation, however, the proposed 
regulations provide that the corporation may not make a terminating 
election. When a corporation's election to be an S corporation 
terminates, the portion of the corporation's taxable year ending at the 
close of the day preceding the day for which the terminating event is 
effective is treated as an S short year, and the remainder is treated 
as a C short year. Thus, because the day upon which a terminating event 
occurs is the first day of a C short year, as of that date there is no 
S corporation taxable year that may be divided into two separate years 
under section 1377(a)(2). Under section 1362(e)(2), the income or loss 
for the entire S termination year is allocated on a pro rata basis 
between the S and C short years. However, if the corporation makes an 
election under section 1362(e)(3), the corporation allocates income and 
loss to each short taxable year under the corporation's normal tax 
accounting rules. Thus, when a corporation makes an election under 
section 1362(e)(3), a shareholder of an S corporation may achieve a 
result similar to the result of an election under section 1377(a)(2) 
and these proposed regulations (which also require an allocation of 
income and loss to each short taxable year under normal accounting 
rules).
Post-Termination Transition Period

    Section 1377(b) provides that the term post-termination transition 
period (PTTP) for purposes of subchapter S of chapter 1 of the Code 
means: (1) The period beginning on the day after the last day of the 
corporation's last taxable year as an S corporation and ending on the 
later of the day which is 1 year after such last day, or the due date 
for filing the return for the last taxable year as an S corporation 
(including extensions); and (2) the 120-day period beginning on the 
date of a determination that the corporation's election under section 
1362(a) had terminated for a previous taxable year. The PTTP is 
relevant for purposes of section 1366(d)(3) (carryover of disallowed 
losses after the last taxable year for which a corporation is an S 
corporation) and section 1371(e) (distributions of money by a 
corporation with respect to its stock after termination of S 
corporation status).
    The proposed regulations clarify that a PTTP arises following the 
termination under section 1362(d) of a corporation's S election. For 
example, a PTTP arises in the case of a C corporation that acquires the 
assets of an S corporation in a transaction to which section 381(a)(2) 
applies. However, if an S corporation acquires the assets of another S 
corporation in a transaction to which section 381(a)(2) applies, a PTTP 
does not arise. Instead, under Sec. 1.1368-2(d)(2), the acquiring S 
corporation succeeds to and merges its AAA with the AAA of the 
distributor or transferor S corporation.
    The proposed regulations clarify that the last day of a 
corporation's last taxable year as an S corporation is the last day of 
the short S taxable year under section 1362(e)(1)(A) or the date of 
transfer in the event that a C corporation acquires the assets of an S 
corporation in a transaction to which section 381(a)(2) applies. The 
proposed regulations also provide that the special treatment under 
section 1371(e)(1) is available only to those shareholders who were 
shareholders in the S corporation at the time of the termination.
    The proposed regulations provide additional guidance on the 
definition of a determination for purposes of ascertaining when a PTTP 
begins under section 1377(b)(1)(B). Under the proposed regulations, a 
determination includes a written agreement between an S corporation and 
the Commissioner that the corporation failed to qualify as an S 
corporation. The agreement must be signed by the appropriate district 
director and an authorized officer of the corporation. In addition, if 
there is no written agreement, a determination results from the 
expiration of the period specified in section 6226 for filing a 
petition for readjustment of a final S corporation administrative 
adjustment finding that the corporation failed to qualify as an S 
corporation, provided that no petition is filed prior to the expiration 
of the period. For corporations not subject to the audit and assessment 
provisions of subchapter C of chapter 63 of subtitle A (dealing with 
the tax treatment of partnership items) a determination results from 
the expiration of the period for filing a petition under section 6213 
for the shareholder's taxable year for which the Commissioner has made 
a finding that the corporation failed to qualify as an S corporation, 
provided that no petition was timely filed before the expiration of the 
period.

Effective Date

    The regulations under section 1377 are proposed to apply to taxable 
years of an S corporation beginning after the date of publication as 
final regulations in the Federal Register.

Special Analysis

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It also has been determined 
that section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) and the Regulatory 

[[Page 35884]]
Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, 
and, therefore, a Regulatory Flexibility Analysis is not required. 
Pursuant to section 7805(f) of the Internal Revenue Code, this notice 
of proposed rulemaking will be submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on its impact 
on small business.

Comments and Requests for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying. A public 
hearing may be scheduled if requested in writing by a person that 
timely submits written comments. If a public hearing is scheduled, 
notice of the date, time, and place for the hearing will be published 
in the Federal Register.

Drafting Information

    The principal author of these regulations is Brian J. O'Connor, 
Office of Assistant Chief Counsel (Passthroughs and Special 
Industries). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Parts 1 and 18

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 18 are proposed to be amended as 
follows:

PART 1--INCOME TAXES

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

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

    Section 1.1377-1 also issued under 26 U.S.C. 1377 (a)(2) and 
(c).

    Par. 2. Sections 1.1377-0, 1.1377-1, 1.1377-2, and 1.1377-3 are 
added under the heading ``Small Business Corporations and Their 
Shareholders'' to read as follows:


Sec. 1.1377-0  Table of contents.
    The following table of contents is provided to facilitate the use 
of Secs. 1.1377-1 through 1.1377-3:

Sec. 1.1377-1  Pro rata share.

    (a) Computation of pro rata shares.
    (1) In general.
    (2) Special rules.
    (i) Days without shareholders.
    (ii) Determining shareholder for day of stock disposition.
    (b) Election to terminate year.
    (1) In general.
    (2) Effect of the terminating election.
    (i) In general.
    (ii) Due date of S corporation return.
    (iii) Taxable year of inclusion by shareholder.
    (iv) S Corporation that is a partner in a partnership.
    (3) Determination of whether an S shareholder's entire interest 
has terminated.
    (4) Time and manner of making terminating election.
    (i) In general.
    (ii) Shareholders required to consent.
    (iii) More than one terminating election.
    (c) Examples.

Sec. 1.1377-2  Post-termination transition period.

    (a) In general.
    (b) When a post-termination transition period arises.
    (c) Last day of last taxable year.
    (d) Determination defined.
    (e) Time of determination.
    (1) Court decision.
    (2) Closing agreement.
    (3) Written agreement.
    (4) Implied agreement.

Sec. 1.1377-3  Effective date.


Sec. 1.1377-1  Pro rata share.

    (a) Computation of pro rata shares--(1) In general. For purposes of 
subchapter S of chapter 1 of the Code and this section, each 
shareholder's pro rata share of any S corporation item described in 
section 1366(a) for any taxable year is the sum of the amounts 
determined with respect to the shareholder by assigning an equal 
portion of the item to each day of the S corporation's taxable year, 
and then dividing that portion pro rata among the shares outstanding on 
that day. See paragraph (b) of this section for rules pertaining to the 
computation of each shareholder's pro rata share when an election is 
made under section 1377(a)(2) to treat the taxable year of an S 
corporation as if it consisted of two taxable years in the case of a 
termination of a shareholder's entire interest in the corporation.
    (2) Special rules--(i) Days without shareholders. Solely for 
purposes of determining a shareholder's pro rata share of an item for a 
taxable year under section 1377(a) and this section, an S corporation's 
taxable year does not include any day on which the corporation has no 
shareholders.
    (ii) Determining shareholder for day of stock disposition. A 
shareholder who disposes of stock in an S corporation is treated as the 
shareholder for the day of the disposition. A shareholder who dies is 
treated as the shareholder for the day of the shareholder's death.
    (b) Election to terminate year--(1) In general. If a shareholder's 
entire interest in an S corporation is terminated during the S 
corporation's taxable year and all persons who are shareholders during 
the taxable year agree (as prescribed in paragraph (b)(4) of this 
section), the S corporation may elect under section 1377(a)(2) and this 
paragraph (b) (terminating election) to treat its taxable year as if it 
consisted of two separate taxable years, the first of which ends at the 
close of the day on which the shareholder's entire interest in the S 
corporation is terminated. If the event resulting in the termination of 
the shareholder's entire interest also constitutes a qualifying 
disposition as described in Sec. 1.1368-1(g)(2), the election under 
Sec. 1.1368-1(g)(2) cannot be made. An S corporation may not make a 
terminating election if the cessation of a shareholder's interest 
occurs in a transaction which results in a termination under section 
1362(d)(2) of the corporation's election to be an S corporation. (See 
section 1362(e)(3) for an election to have items assigned to each short 
taxable year under normal tax accounting rules in the case of a 
termination of a corporation's election to be an S corporation.) A 
terminating election is irrevocable and is effective only for the 
terminating event for which it is made.
    (2) Effect of the terminating election--(i) In general. An S 
corporation that makes a terminating election for a taxable year must 
treat the taxable year as separate taxable years for purposes of 
allocating items of income (including tax-exempt income), loss, 
deduction, and credit; making adjustments to the accumulated 
adjustments account, earnings and profits, and basis; and determining 
the tax effect of a distribution to the shareholders. An S corporation 
that makes a terminating election must assign items of income 
(including tax-exempt income), loss, deduction, and credit to each 
deemed separate taxable year using its normal method of accounting as 
determined under section 446(a).
    (ii) Due date of S corporation return. A terminating election does 
not affect the due date of the S corporation's return required to be 
filed under section 6037(a) for a taxable year (determined without 
regard to a terminating election).
    (iii) Taxable year of inclusion by shareholder. A terminating 
election does not affect the taxable year in which a shareholder 
(including any shareholder whose entire interest in the corporation has 
terminated during the 

[[Page 35885]]
corporation's taxable year) must take into account the shareholder's 
pro rata share of the S corporation's items of income, loss, deduction, 
and credit.
    (iv) S corporation that is a partner in a partnership. A 
terminating election by an S corporation that is a partner in a 
partnership is treated as a sale or exchange of the corporation's 
entire interest in the partnership for purposes of section 706(c) 
(relating to closing the partnership taxable year), if the taxable year 
of the partnership ends after the shareholder's interest is terminated 
and within the taxable year of the S corporation (determined without 
regard to any terminating election) for which the terminating election 
is made.
    (3) Determination of whether an S shareholder's entire interest has 
terminated. For purposes of section 1377(a)(2) and paragraph (b) of 
this section, a shareholder's entire interest in an S corporation is 
terminated on the occurrence of any event through which a shareholder's 
entire stock ownership in the S corporation ceases, including a sale, 
exchange, or other disposition of all of the stock held by the 
shareholder; a gift under section 102(a) of all the shareholder's 
stock; a spousal transfer under section 1041(a) of all the 
shareholder's stock; a redemption, as defined in section 317(b), of all 
the shareholder's stock, regardless of the tax treatment of the 
redemption under section 302; and the death of the shareholder. A 
shareholder's entire interest in an S corporation is not terminated if 
the shareholder retains ownership of any stock that would result in the 
shareholder continuing to be considered a shareholder of the 
corporation for purposes of section 1362(a)(2). Thus, in determining 
whether a shareholder's entire interest in an S corporation has been 
terminated, any options held by the shareholder (other than options 
that are treated as stock under Sec. 1.1361-1(l)(4)(iii)) and any 
interest held by the shareholder as a creditor, employee, director, or 
in any other non-shareholder capacity are disregarded. (See 
Sec. 1.1361-1(l)(4)(iii) for circumstances under which an option is 
treated as stock of the corporation and, therefore, the holder of the 
option is treated as owning a stock interest in the corporation.)
    (4) Time and manner of making terminating election--(i) In general. 
An S corporation makes a terminating election by attaching a statement 
to its timely filed original or amended return required to be filed 
under section 6037(a) (that is, a Form 1120S) for the taxable year 
during which a shareholder's entire interest is terminated. A single 
election statement may be filed by the S corporation for all 
terminating elections for the taxable year. The election statement must 
include--
    (A) A declaration by the S corporation that it is electing under 
section 1377(a)(2) and Sec. 1.1377-1(b) to treat the taxable year as if 
it consisted of two separate taxable years;
    (B) Information setting forth when and how the shareholder's entire 
interest was terminated (for example, a sale or gift);
    (C) The signature on behalf of the S corporation of an authorized 
officer of the corporation under penalties of perjury; and
    (D) A notice of consent, signed by each person who is a shareholder 
in the S corporation during the taxable year (determined without regard 
to the terminating election), including any shareholder whose entire 
interest terminates during the taxable year, in which each shareholder 
consents to the S corporation making the terminating election.
    (ii) Shareholders required to consent. For purposes of paragraph 
(b)(4)(i)(D) of this section, a shareholder of the S corporation for 
the taxable year is a shareholder as described in section 1362(a)(2). 
For example, the person who under Sec. 1.1362-6(b)(2) must consent to a 
corporation's S election in certain special cases is the person who 
must consent to the terminating election. In addition, an executor or 
administrator of an estate of a deceased shareholder may consent to the 
terminating election on behalf of the deceased shareholder.
    (iii) More than one terminating election. A shareholder whose 
entire interest in an S corporation is terminated in an event for which 
a terminating election was made is not required to consent to a 
terminating election made with respect to a subsequent termination 
within the same taxable year of the entire interest of another 
shareholder.
    (c) Examples. The following examples illustrate the provisions of 
this section.

    Example 1. General rule. (i) On January 2, 1997, X, a calendar 
year corporation, is incorporated. On January 4, 1997, X acquires 
assets. On January 6, 1997, X issues 100 shares of common stock to 
each of A and B and files an election to be an S corporation 
effective for its 1997 taxable year. During its 1997 taxable year, X 
has nonseparately computed income (as defined in section 1366(a)(2)) 
of $720,000.
    (ii) Each shareholder's pro rata share of X's nonseparately 
computed income for 1997 is determined by assigning an equal portion 
of the income to each day of X's taxable year on which X had 
shareholders. In the present case, there are only 360 days on which 
X had shareholders because X had no shareholders until January 6, 
1997. Thus, $2,000 of nonseparately computed income is assigned to 
each day that X had shareholders ($720,000/360 days=$2,000 per day). 
The amount assigned to each day is multiplied by the percentage of 
shares held by the shareholder on that day. Because A and B each 
owned 50 percent of the shares of stock outstanding on each day that 
X had shareholders, each shareholder's daily pro rata share of X's 
nonseparately computed income is $1,000 ($2,000 per day x 50%). 
Finally, the amounts of each shareholder's daily pro rata shares are 
aggregated to produce the shareholder's pro rata share of X's 
nonseparately computed income for 1997. During 1997, A and B each 
held X stock for 360 days. Thus, each shareholder's pro rata share 
of X's nonseparately computed income for 1997 is $360,000 ($1,000 
per day x 360 days).
    Example 2. Shareholder's pro rata share in the case of a partial 
disposition of stock. (i) X, a newly incorporated calendar year 
corporation, issues 100 shares of common stock on January 6, 1997, 
to each of A and B and files an election to be an S corporation for 
its 1997 taxable year. On July 24, 1997, B sells 50 shares of X 
stock to C. Thus, in 1997, A owned 50 percent of the outstanding 
shares of X on each day of X's 1997 taxable year on which X had 
shareholders, B owned 50 percent on each day from January 6, 1997, 
to July 24, 1997 (200 days), and 25 percent from July 25, 1997, to 
December 31, 1997 (160 days), and C owned 25 percent from July 25, 
1997, to December 31, 1997 (160 days).
    (ii) Because B's entire interest in X is not terminated when B 
sells 50 shares to C on July 24, 1997, X cannot make a terminating 
election under section 1377(a)(2) and paragraph (b) of this section 
for B's sale of 50 shares to C. Although B's sale of 50 shares to C 
is a qualifying disposition under Sec. 1.1368-1(g)(2)(i), X does not 
make an election to terminate its taxable year under Sec. 1.1368-
1(g)(2). During its 1997 taxable year, X has nonseparately computed 
income of $720,000.
    (iii) For each day in X's 1997 taxable year, A's daily pro rata 
share of X's nonseparately computed income is $1,000 ($720,000/360 
days x 50%). Thus, A's pro rata share of X's nonseparately computed 
income for 1997 is $360,000 ($1,000 x 360 days). B's daily pro rata 
share of X's nonseparately computed income is $1,000 ($720,000/
360 x 50%) for the first 200 days of X's taxable year on which X has 
shareholders, and $500 ($720,000/360 x 25%) for the following 160 
days in 1997. Thus, B's pro rata share of X's nonseparately computed 
income for 1997 is $280,000 (($1,000 x 200 days) + ($500 x 160 
days)). C's daily pro rata share of X's nonseparately computed 
income is $500 ($720,000/360 x 25%) for 160 days in 1997. Thus, C's 
pro rata share of X's nonseparately computed income for 1997 is 
$80,000 ($500 x 160 days).
    Example 3. Shareholder's pro rata share when an S corporation 
makes a terminating election under section 1377(a)(2). (i) On 
January 6, 1997, X, a newly incorporated calendar year corporation, 
issues 100 shares of common stock to each of A and B and files an 
election to be treated as an S corporation for its 1997 taxable 
year. On July 24, 1997, 

[[Page 35886]]
B sells B's entire 100 shares of X corporation stock to C. During its 
1997 taxable year, X has nonseparately computed income of $720,000. 
X makes an election under section 1377(a)(2) and paragraph (b) of 
this section for the termination of B's entire interest arising from 
B's sale of 100 shares to C. As a result of the election, each 
shareholder's pro rata share is determined as if X's taxable year 
consisted of two separate taxable years, the first of which ends on 
July 24, 1997, the date B's entire interest in X terminates.
    (ii) Under X's normal method of accounting, $200,000 of the 
$720,000 of nonseparately computed income is allocable to the period 
of January 6, 1997, through July 24, 1997 (the first deemed taxable 
year), and the remaining $520,000 is allocable to the period of July 
25, 1997, through December 31, 1997 (the second deemed taxable 
year).
    (iii) The pro rata share of the $200,000 of nonseparately 
computed income for each of A and B for the first deemed taxable 
year is determined by assigning the $200,000 of nonseparately 
computed income to each day of the first deemed taxable year 
($200,000/200 days=$1,000 per day). Thus, for each day of the first 
deemed taxable year, $1,000 is allocated between A and B based on 
their proportionate stock ownership. Because A and B each held 50% 
of X's authorized and issued shares on each day of the first deemed 
taxable year, the daily pro rata share for each of A and B for each 
day of the first deemed taxable year is $500 ($1,000 per day x 50%). 
Thus, each shareholder's pro rata share of the $200,000 of 
nonseparately computed income for the first deemed taxable year is 
$100,000 ($500 per day x 200 days). A and B must report these 
amounts for their respective taxable years with or within which X's 
full taxable year ends (December 31, 1997).
    (iv) The pro rata share of the $520,000 of nonseparately 
computed income for each of A and C for the second deemed taxable 
year is determined by assigning the $520,000 of nonseparately 
computed income to each day of the second deemed taxable year 
($520,000/160 days=$3,250 per day). Thus, for each day of the second 
deemed taxable year, $3,250 is allocated between A and C based on 
their proportionate ownership. Because A and C each held 50% of X's 
authorized and issued shares on each day of the second deemed 
taxable year, the daily pro rata shares for each of A and C for each 
day of the second deemed taxable year is $1,625 ($3,250 per 
day x 50%). Therefore, each shareholder's pro rata share of the 
$520,000 nonseparately computed income is $260,000 ($1,625 per 
day x 160 days). A and C must report these amounts for their 
respective taxable years with or within which X's full taxable year 
ends (December 31, 1997).
    Example 4. Interaction between the terminating election under 
section 1377(a)(2) and section 1362(e). (i) On January 1, 1997, X, a 
calendar year S corporation, has two shareholders, A and B, owning 
60 shares and 40 shares, respectively. On June 29, 1997, B sells B's 
40 shares to C. On July 20, 1997, C sells C's 40 shares to P, a 
partnership, causing a termination under section 1362(d)(2) of X's 
election to be an S corporation. X makes an election under section 
1377(a)(2) and paragraph (b) of this section with regard to the 
termination of B's entire interest on June 29, 1997. Because the 
termination on July 20, 1997, of C's entire interest results in a 
termination of X's election to be an S corporation, X cannot make a 
terminating election under section 1377(a)(2) and paragraph (b) of 
this section with regard to C's sale of 40 shares to P. However, X 
makes an election under section 1362(e)(3) to assign items to each 
short taxable year of the S termination year under X's normal method 
of accounting. X has nonseparately computed income of $530,000 for 
its 1997 taxable year.
    (ii) As a result of the election under section 1362(e)(3), the 
portion of X's taxable year ending at the close of the day prior to 
the termination of X's S corporation election (January 1, 1997, 
through July 19, 1997) is treated as a short taxable year for which 
X is an S corporation, and the portion of the year beginning on the 
day the termination is effective (July 20, 1997, through December 
31, 1997) is treated as a short taxable year for which X is a C 
corporation. Under X's normal method of accounting, $200,000 of the 
$530,000 of X's taxable income is allocable to the S short year and 
the remaining $330,000 is allocable to the C short year. Of the 
$200,000 allocable to the S short year, $90,000 is allocable to the 
first deemed taxable year (January 1, 1997, through June 29, 1997) 
(180 days), and $110,000 is allocable to the second deemed taxable 
year (June 30, 1997, through July 19, 1997) (20 days) under X's 
normal method of accounting.
    (iii) Each shareholder's pro rata share of X's income for the 
first deemed taxable year within the S short year is determined as 
follows. Because A owns 60% of the stock outstanding during the 
first deemed taxable year, A's pro rata share for that period is 
$54,000 ($90,000/180 days in the period x 60% x 180 days). B's pro 
rata share for that period, reflecting B's 40% ownership, is $36,000 
($90,000/180 days in the period x 40% x 180 days). A and B must 
report these amounts for their respective taxable years with or 
within which the S termination year ends (December 31, 1997).
    (iv) Each shareholder's pro rata share of X's income for the 
second deemed taxable year within the S short year is determined as 
follows. Because A owns 60% of the stock outstanding during the 
second deemed taxable year, A's pro rata share for that period is 
$66,000 ($110,000/20 days in the period x 60% x 20 days). C's pro 
rata share for that period, reflecting C's 40% ownership, is $44,000 
($110,000/20 days in the period x 40% x 20 days). A and C must 
report these amounts for their respective taxable years with or 
within which the S termination year ends (December 31, 1997).


Sec. 1.1377-2  Post-termination transition period.

    (a) In general. For purposes of subchapter S of chapter 1 of the 
Code and this section, the term post-termination transition period 
means--
    (1) The period beginning on the day after the last day of the 
corporation's last taxable year as an S corporation and ending on the 
later of--
    (i) The day which is 1 year after such last day; or
    (ii) The due date for filing the return for the last taxable year 
as an S corporation (including extensions); and
    (2) The 120-day period beginning on the date of a determination 
that the corporation's election under section 1362(a) had terminated 
for a previous taxable year.
    (b) When a post-termination transition period arises. A post-
termination transition period arises following the termination under 
section 1362(d) of a corporation's S election. For example, a post-
termination transition period arises if a C corporation acquires the 
assets of an S corporation in a transaction to which section 381(a)(2) 
applies. However, if an S corporation acquires the assets of another S 
corporation in a transaction to which section 381(a)(2) applies, a 
post-termination transition period does not arise. (See Sec. 1.1368-
2(d)(2) for the treatment of the acquisition of the assets of an S 
corporation by another S corporation in a transaction to which section 
381(a)(2) applies.) The 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 is available only to 
those shareholders who were shareholders in the S corporation at the 
time of the termination.
    (c) Last day of last taxable year. For purposes of section 
1377(b)(1)(A) and paragraph (a)(1) of this section, the last day of a 
corporation's last taxable year as an S corporation is--
    (1) The last day of the short S taxable year under section 
1362(e)(1)(A); or
    (2) The date of transfer (within the meaning of section 381(a)(2)) 
in the event that a C corporation acquires the assets of an S 
corporation in a transaction to which section 381(a)(2) applies.
    (d) Determination defined. For purposes of section 1377(b)(1)(B) 
and paragraph (a)(2) of this section, the term determination means--
    (1) A court decision rendered by a court of competent jurisdiction;
    (2) A closing agreement entered into between the Secretary and the 
taxpayer pursuant to section 7121;
    (3) A written agreement between the corporation and the 
Commissioner (including a statement acknowledging that the 
corporation's election to be an S corporation terminated under section 
1362(d)) that the corporation failed to qualify as an S corporation;
    (4) For a corporation subject to the audit and assessment 
provisions of subchapter C of chapter 63 of subtitle A, 

[[Page 35887]]
the expiration of the period specified in section 6226 for filing a 
petition for readjustment of a final S corporation administrative 
adjustment finding that the corporation failed to qualify as an S 
corporation, provided that no petition was timely filed before the 
expiration of the period; and
    (5) For a corporation not subject to the audit and assessment 
provisions of subchapter C of chapter 63 of subtitle A, the expiration 
of the period for filing a petition under section 6213 for the 
shareholder's taxable year for which the Commissioner has made a 
finding that the corporation failed to qualify as an S corporation, 
provided that no petition was timely filed before the expiration of the 
period.
    (e) Time of determination--(1) Court decision. A court decision 
becomes a determination on the date the decision becomes final under 
rules applicable to the court rendering the decision.
    (2) Closing agreement. A closing agreement becomes a determination 
on the date of its approval by the Commissioner.
    (3) Written agreement. A written agreement described in paragraph 
(d)(3) of this section becomes a determination when it is signed by the 
district director having jurisdiction over the corporation (or by 
another Service official to whom authority to sign the agreement is 
delegated) and by an officer of the corporation authorized to sign on 
its behalf. Neither the request for a written agreement nor the terms 
of the written agreement suspend the running of any statute of 
limitations.
    (4) Implied agreement. A determination under paragraph (d)(4) or 
(d)(5) of this section becomes effective on the day after the date of 
expiration of the period specified under section 6226 or 6213, 
respectively.


Sec. 1.1377-3  Effective date.

    Sections 1.1377-1 and 1.1377-2 apply to taxable years of an S 
corporation beginning after [the date of publication as final 
regulations in the Federal Register].

PART 18--TEMPORARY INCOME TAX REGULATIONS UNDER THE SUBCHAPTER S 
REVISION ACT OF 1982

    Par. 3. The authority citation for part 18 continues to read as 
follows:

    Authority: 26 U.S.C. 7805 sec. (6)(c)(3)(B)(iii) of the 
Subchapter S Revision Act of 1982.


Sec. 18.1377-1  [Removed]

    Par. 4. Section 18.1377-1 is removed.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 95-16653 Filed 7-11-95; 8:45 am]
BILLING CODE 4830-01-U