[Federal Register Volume 61, Number 198 (Thursday, October 10, 1996)]
[Rules and Regulations]
[Pages 53062-53066]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-25945]



[[Page 53062]]

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DEPARTMENT OF THE TREASURY
26 CFR Parts 1 and 602

[TD 8684]
RIN 1545-AM98


Treatment of Gain From the Disposition of Interest in Certain 
Natural Resource Recapture Property by S Corporations and Their 
Shareholders

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the tax 
treatment by S corporations and their shareholders of gain from the 
disposition by an S corporation (and a corporation that was formerly an 
S corporation) of certain natural resource recapture property (section 
1254 property after enactment of the Tax Reform Act of 1986 and oil, 
gas, or geothermal property before enactment of the Tax Reform Act of 
1986), and also rules relating to the disposition of stock in an S 
corporation that holds certain natural resource recapture property. 
Changes to the applicable tax law were made by the Tax Reform Act of 
1986, and the Subchapter S Revision Act of 1982. The regulations 
provide the public with guidance in complying with the changed tax 
laws.

EFFECTIVE DATE: October 10, 1996.

FOR FURTHER INFORMATION CONTACT: James A. Quinn, 202-622-3060 (not a 
toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under 
control number 1545-1493. This information is required by the IRS to 
establish that a portion of the gain recognized upon a sale or exchange 
of S corporation stock is not attributable to a shareholder's section 
1254 costs so as to qualify for the exception contained in Sec. 1.1254-
4(c)(2)(i)(A).
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number.
    The estimated annual burden per respondent varies from .5 hour to 
1.5 hours, depending on individual circumstances, with an estimated 
average of 1 hour.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington, 
DC 20224, and 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.
    Books or records relating to this collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    On December 21, 1995, the IRS published in the Federal Register a 
notice of proposed rulemaking (60 FR 66238) providing rules for 
applying the provisions of section 1254 to the disposition of natural 
resource recapture property by an S corporation (and a corporation that 
was formerly an S corporation) and the disposition of S corporation 
stock. No written comments responding to this notice were received. No 
public hearing was held because no hearing was requested. The proposed 
regulations are adopted without any substantive change by this Treasury 
decision. However, in the course of preparing the final regulations for 
publication, the IRS and Treasury Department have determined that 
Secs. 1.1254-2 and 1.1254-3 are in need of minor technical 
clarifications. Accordingly, Secs. 1.1254-2 and 1.1254-3 are clarified 
as discussed below.

Clarification of Secs. 1.1254-2 and 1.1254-3

    Section 1.1254-2(d)(1) is amended to state that Sec. 1.1254-2(d)(1) 
is applied without regard to Sec. 1.1254-1(b)(2)(vii). This amendment 
clarifies that section 1254 costs must be recaptured in a like-kind 
exchange or involuntary conversion that involves the acquisition of 
property that is not natural resource recapture property. The amendment 
makes clear that the treatment of like- kind exchanges and involuntary 
conversions involving natural resource recapture property is similar to 
the treatment of these transactions involving section 1245 property. 
See Secs. 1.1245-3(a)(3), 1.1245-4(d)(1), 1.1245-4(d)(2), Example 2, 
and 1.1245-5(a)(2), Example.
    Section 1.1254-3(b)(1) provides that if natural resource recapture 
property is transferred in certain transactions the amount of section 
1254 costs with respect to the property in the hands of the transferee 
equals the amount of section 1254 costs with respect to the property in 
the hands of the transferor minus the amount of any gain taken into 
account as ordinary income under section 1254(a)(1) by the transferor 
upon the disposition. The intent of this rule is that in these 
transactions the section 1254 costs with respect to the property are to 
be transferred to the transferee but reduced by any gain taken into 
account as ordinary income. However, in the case of an S corporation or 
partnership transferor, the section 1254 costs have generally been 
allocated among the shareholders or partners. Consequently, 
Sec. 1.1254-3(b)(1) is clarified to provide that in the case of an S 
corporation transferor the section 1254 costs include the section 1254 
costs of the shareholders minus any gain taken into account by the 
shareholders as ordinary income. A similar clarification is added for 
partnership transferors.
    Similarly, Sec. 1.1254-3(d) is clarified for like-kind exchanges 
and involuntary conversions to provide that in the case of an S 
corporation the section 1254 costs include the section 1254 costs of 
the shareholders minus any gain taken into account by the shareholders 
as ordinary income. A similar clarification is added for a partnership.

Effective Date

    Section 1.1254-4 applies to dispositions of natural resource 
recapture property by an S corporation (and a corporation that was 
formerly an S corporation) and dispositions of S corporation stock 
occurring on or after October 10, 1996. The clarifications to 
Secs. 1.1254-2 and 1.1254-3 are effective for dispositions of property 
occurring on or after October 10, 1996.

Special Analyses

    It has been determined that this Treasury decision 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) 
does not apply to these regulations, and because the notice of proposed 
rulemaking preceding the regulations was issued prior to March 29, 
1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, the notice of proposed 
rulemaking preceding these regulations was submitted to the Small 
Business Administration for comment on its impact on small business.

Drafting Information

    The principal author of these regulations is James A. Quinn of the

[[Page 53063]]

Office of Assistant Chief Counsel (Passthroughs and Special 
Industries), IRS. However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

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

    Authority: 26 U.S.C. 7805 * * * Section 1.1254-4 also issued 
under 26 U.S.C. 1254(b). * * *

    Par. 2. Section 1.1254-0 is amended by revising the entry for 
Sec. 1.1254-4 to read as follows:


Sec. 1.1254-0  Table of contents for section 1254 recapture rules.

* * * * *

Sec. 1.1254-4  Special rules for S corporations and their 
shareholders.

    (a) In general.
    (b) Determination of gain treated as ordinary income under 
section 1254 upon a disposition of natural resource recapture 
property by an S corporation.
    (1) General rule.
    (2) Examples.
    (c) Character of gain recognized by a shareholder upon a sale or 
exchange of S corporation stock.
    (1) General rule.
    (2) Exceptions.
    (3) Examples.
    (d) Section 1254 costs of a shareholder.
    (e) Section 1254 costs of an acquiring shareholder after certain 
acquisitions.
    (1) Basis determined under section 1012.
    (2) Basis determined under section 1014(a).
    (3) Basis determined under section 1014(b)(9).
    (4) Gifts and section 1041 transfers.
    (f) Special rules for a corporation that was formerly an S 
corporation or formerly a C corporation.
    (1) Section 1254 costs of an S corporation that was formerly a C 
corporation.
    (2) Examples.
    (3) Section 1254 costs of a C corporation that was formerly an S 
corporation.
    (g) Determination of a shareholder's section 1254 costs upon 
certain stock transactions
    (1) Issuance of stock.
    (2) Natural resource recapture property acquired in exchange for 
stock.
    (3) Treatment of nonvested stock.
    (4) Exception.
    (5) Aggregate of S corporation shareholders' section 1254 costs 
with respect to natural resource recapture property held by the S 
corporation
    (6) Examples.
* * * * *
    Par. 3. Section 1.1254-2 is amended by revising paragraph 
(d)(1)(ii) to read as follows:


Sec. 1.1254-2  Exceptions and limitations.

* * * * *
    (d) * * * (1) * * *
    (ii) The fair market value of property acquired that is not natural 
resource recapture property (determined without regard to Sec. 1.1254-
1(b)(2)(vii)) and is not taken into account under paragraph (d)(1)(i) 
of this section (that is, qualifying property under section 1031 or 
1033 that is not natural resource recapture property).
* * * * *
    Par. 4. Section 1.1254-3 is amended by revising paragraphs 
(b)(1)(i), (b)(1)(ii), (d)(1)(i) and (d)(1)(ii) to read as follows:


Sec. 1.1254-3  Section 1254 costs immediately after certain 
acquisitions.

* * * * *
    (b) * * * (1) * * *
    (i) The amount of section 1254 costs with respect to the natural 
resource recapture property in the hands of the transferor immediately 
before the disposition (and in the case of an S corporation or 
partnership transferor, the section 1254 costs of the shareholders or 
partners with respect to the natural resource recapture property); 
minus
    (ii) The amount of any gain taken into account as ordinary income 
under section 1254(a)(1) by the transferor upon the disposition (and in 
the case of an S corporation or partnership transferor, any such gain 
taken into account as ordinary income by the shareholders or partners).
* * * * *
    (d) * * *
    (1) * * *
    (i) The amount of section 1254 costs with respect to the natural 
resource recapture property disposed of (including the section 1254 
costs of the shareholders of an S corporation or of the partners of a 
partnership with respect to the natural resource recapture property); 
minus
    (ii) The amount of any gain taken into account as ordinary income 
under section 1254(a)(1) by the transferor upon the disposition (and in 
the case of an S corporation or partnership transferor, any such gain 
taken into account as ordinary income by the shareholders or partners).
* * * * *
    Par. 5. Section 1.1254-4 is amended by adding text to read as 
follows:


Sec. 1.1254-4  Special rules for S corporations and their shareholders.

    (a) In general. This section provides rules for applying the 
provisions of section 1254 to S corporations and their shareholders 
upon the disposition by an S corporation (and a corporation that was 
formerly an S corporation) of natural resource recapture property and 
upon the disposition by a shareholder of stock of an S corporation that 
holds natural resource recapture property.
    (b) Determination of gain treated as ordinary income under section 
1254 upon a disposition of natural resource recapture property by an S 
corporation--(1) General rule. Upon a disposition of natural resource 
recapture property by an S corporation, the amount of gain treated as 
ordinary income under section 1254 is determined at the shareholder 
level. Each shareholder must recognize as ordinary income under section 
1254 the lesser of--
    (i) The shareholder's section 1254 costs with respect to the 
property disposed of; or
    (ii) The shareholder's share of the amount, if any, by which the 
amount realized on the sale, exchange, or involuntary conversion, or 
the fair market value of the property upon any other disposition 
(including a distribution), exceeds the adjusted basis of the property.
    (2) Examples. The following examples illustrate the provisions of 
paragraph (b)(1) of this section:

    Example 1. Disposition of natural resource recapture property 
other than oil and gas property. A and B are equal shareholders in 
X, an S corporation. On January 1, 1997, X acquires for $90,000 an 
undeveloped mineral property, its sole property. During 1997, X 
expends and deducts $100,000 in developing the property. On January 
15, 1998, X sells the property for $250,000 when X's basis in the 
property is $90,000. Thus, X recognizes gain of $160,000 on the 
sale. A and B's share of the $160,000 gain recognized is $80,000 
each. Each shareholder has $50,000 of section 1254 costs with 
respect to the property. Under these circumstances, A and B each are 
required to recognize $50,000 of the $80,000 of gain on the sale of 
the property as ordinary income under section 1254.
    Example 2. Disposition of oil and gas property the adjusted 
basis of which is allocated to the shareholders under section 
613A(c)(11). C and D are equal shareholders in Y, an S corporation. 
On January 1, 1997, Y acquires for $150,000 an undeveloped oil and 
gas property, its sole property. During 1997, Y expends in 
developing the property

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$40,000 in intangible drilling costs which it elects to expense 
under section 263(c). On January 15, 1998, Y sells the property for 
$200,000. C and D's share of the $200,000 amount realized on the 
sale is $100,000 each. C and D each have a basis of $75,000 in the 
property and $20,000 of section 1254 costs with respect to the 
property. Under these circumstances, C and D each are required to 
recognize $20,000 of the $25,000 gain on the sale of the property as 
ordinary income under section 1254.

    (c) Character of gain recognized by a shareholder upon a sale or 
exchange of S corporation stock--(1) General rule. Except as provided 
in paragraph (c)(2) of this section, if an S corporation shareholder 
recognizes gain upon a sale or exchange of stock in the S corporation 
(determined without regard to section 1254), the gain is treated as 
ordinary income under section 1254 to the extent of the shareholder's 
section 1254 costs (with respect to the shares sold or exchanged).
    (2) Exceptions--(i) Gain not attributable to section 1254 costs--
(A) General rule. Paragraph (c)(1) of this section does not apply to 
any portion of the gain recognized on the sale or exchange of the stock 
that the taxpayer establishes is not attributable to section 1254 
costs. The portion of the gain recognized that is not attributable to 
section 1254 costs is that portion of the gain recognized that exceeds 
the amount of ordinary income that the shareholder would have 
recognized under section 1254 (with respect to the shares sold or 
exchanged) if, immediately prior to the sale or exchange of the stock, 
the corporation had sold at fair market value all of the corporation's 
property the disposition of which would result in the recognition by 
the shareholder of ordinary income under section 1254.
    (B) Substantiation. To establish that a portion of the gain 
recognized is not attributable to a shareholder's section 1254 costs so 
as to qualify for the exception contained in paragraph (c)(2)(i)(A) of 
this section, the shareholder must attach to the shareholder's tax 
return a statement detailing the shareholder's share of the fair market 
value and basis, and the shareholder's section 1254 costs, for each of 
the S corporation's natural resource recapture properties held 
immediately before the sale or exchange of stock.
    (ii) Transactions entered into as part of a plan to avoid 
recognition of ordinary income under section 1254. In the case of a 
contribution of property prior to a sale or exchange of stock pursuant 
to a plan a principal purpose of which is to avoid recognition of 
ordinary income under section 1254, paragraph (c)(1) of this section 
does not apply. Instead, the amount recognized as ordinary income under 
section 1254 is the amount of ordinary income the selling or exchanging 
shareholder would have recognized under section 1254 (with respect to 
the shares sold or exchanged) had the S corporation sold its natural 
resource recapture property the disposition of which would have 
resulted in the recognition of ordinary income under section 1254. The 
amount recognized as ordinary income under the preceding sentence 
reduces the amount realized on the sale or exchange of the stock.
    This reduced amount realized is used in determining any gain or 
loss on the sale or exchange.
    (3) Examples. The following examples illustrate the provisions of 
this paragraph (c):

    Example 1. Application of general rule upon a sale of S 
corporation stock. C and D are equal shareholders in Y, an S 
corporation. As of January 1, 1997, Y holds two mining properties: 
Blackacre, with an adjusted basis of $5,000 and a fair market value 
of $35,000, and Whiteacre, with an adjusted basis of $20,000 and a 
fair market value of $15,000. Y also holds securities with a basis 
of $5,000 and a fair market value of $10,000. On January 1, 1997, D 
sells 50 percent of D's Y stock to E for $15,000. As of the date of 
the sale, D's adjusted basis in the Y stock sold is $7,500, and D 
has $18,000 of section 1254 costs with respect to Blackacre and 
$12,000 of section 1254 costs with respect to Whiteacre. Under this 
paragraph (c), the gain recognized by D upon the sale of Y stock is 
treated as ordinary income to the extent of D's section 1254 costs 
with respect to the stock sold, unless D establishes that a portion 
of such excess is not attributable to D's section 1254 costs. 
However, because D would recognize $7,500 in ordinary income under 
section 1254 with respect to the stock sold if Y sold Blackacre (the 
only asset the disposition of which would result in ordinary income 
to D under section 1254), the $7,500 of gain recognized by D upon 
the sale of D's Y stock is attributable to D's section 1254 costs. 
Therefore, upon the sale of stock to E, D recognizes $7,500 of 
ordinary income under this paragraph (c).
    Example 2. Sale of S corporation stock where gain is not 
entirely attributable to section 1254 costs. Assume the same facts 
as in Example 1, except that Blackacre has a fair market value of 
$25,000, and the securities have a fair market value of $20,000. 
Immediately prior to the sale of stock to E, if Y had sold Blackacre 
(its only asset the disposition of which would result in the 
recognition of ordinary income to D under section 1254), D would 
recognize $5,000 in ordinary income with respect to the stock sold 
under section 1254. D attaches a statement to D's tax return for 
1997 detailing D's share of the fair market values and bases, and 
D's section 1254 costs with respect to Blackacre and Whiteacre. 
Therefore, upon the sale of stock to E, of the $7,500 gain 
recognized by D, $5,000 is ordinary income under this paragraph (c).
    Example 3. Contribution of property prior to sale of S 
corporation stock as part of a plan to avoid recognition of ordinary 
income under section 1254. H owns all of the stock of Z, an S 
corporation. As of January 1, 1997, H has $3,000 of section 1254 
costs with respect to property P, which is natural resource 
recapture property and Z's only asset. Property P has an adjusted 
basis of $5,000 and a fair market value of $8,000. H has a basis of 
$5,000 in Z stock, which has a fair market value of $8,000. On 
January 1, 1997, H contributes securities to Z which have a basis of 
$7,000 and a fair market value of $4,000. On April 15, 1997, H sells 
all of the Z stock to J for $12,000. On that date, H's adjusted 
basis in the Z stock is also $12,000. Based on all the facts and 
circumstances, the sale of stock is part of a plan (along with the 
contribution by H of the securities to Z) that has a principal 
purpose to avoid recognition of ordinary income under section 1254. 
Consequently, under paragraph (c)(2)(ii) of this section, H must 
recognize $3,000 as ordinary income under section 1254, the amount 
of ordinary income that H would recognize as ordinary income under 
section 1254 if property P were sold at fair market value. In 
addition, H reduces the amount realized on the sale of the stock 
($12,000) by $3,000. As a result, H also recognizes a $3,000 capital 
loss on the sale of the stock ($9,000 amount realized less $12,000 
adjusted basis).

    (d) Section 1254 costs of a shareholder. An S corporation 
shareholder's section 1254 costs with respect to any natural resource 
recapture property held by the corporation include all of the 
shareholder's section 1254 costs with respect to the property in the 
hands of the S corporation. See Sec. 1.1254-1(b)(1) for the definition 
of section 1254 costs.
    (e) Section 1254 costs of an acquiring shareholder after certain 
acquisitions--(1) Basis determined under section 1012. If stock in an S 
corporation that holds natural resource recapture property is acquired 
and the acquiring shareholder's basis for the stock is determined 
solely by reference to its cost (within the meaning of section 1012), 
the amount of section 1254 costs with respect to the property held by 
the corporation in the acquiring shareholder's hands is zero on the 
acquisition date.
    (2) Basis determined under section 1014(a). If stock in an S 
corporation that holds natural resource recapture property is acquired 
from a decedent and the acquiring shareholder's basis is determined, by 
reason of the application of section 1014(a), solely by reference to 
the fair market value of the stock on the date of the decedent's death 
or on the applicable date provided in section 2032 (relating to 
alternate valuation date), the amount of section 1254 costs

[[Page 53065]]

with respect to the property held by the corporation in the acquiring 
shareholder's hands is zero on the acquisition date.
    (3) Basis determined under section 1014(b)(9). If stock in an S 
corporation that holds natural resource recapture property is acquired 
before the death of the decedent, the amount of section 1254 costs with 
respect to the property held by the corporation in the acquiring 
shareholder's hands includes the amount, if any, of the section 1254 
costs deducted by the acquiring shareholder before the decedent's 
death, to the extent that the basis of the stock (determined under 
section 1014(a)) is required to be reduced under section 1014(b)(9) 
(relating to adjustments to basis when the property is acquired before 
the death of the decedent).
    (4) Gifts and section 1041 transfers. If stock is acquired in a 
transfer that is a gift, in a transfer that is a part sale or exchange 
and part gift, or in a transfer that is described in section 1041(a), 
the amount of section 1254 costs with respect to the property held by 
the corporation in the acquiring shareholder's hands immediately after 
the transfer is an amount equal to--
    (i) The amount of section 1254 costs with respect to the property 
held by the corporation in the hands of the transferor immediately 
before the transfer; minus
    (ii) The amount of any gain recognized as ordinary income under 
section 1254 by the transferor upon the transfer.
    (f) Special rules for a corporation that was formerly an S 
corporation or formerly a C corporation--(1) Section 1254 costs of an S 
corporation that was formerly a C corporation. In the case of a C 
corporation that holds natural resource recapture property and that 
elects to be an S corporation, each shareholder's section 1254 costs as 
of the beginning of the corporation's first taxable year as an S 
corporation include a pro rata share of the section 1254 costs of the 
corporation as of the close of the last taxable year that the 
corporation was a C corporation.
    (2) Examples. The following examples illustrate the application of 
the provisions of paragraph (f)(1) of this section:

    Example 1. Sale of natural resource recapture property held by 
an S corporation that was formerly a C corporation--(i) Y is a C 
corporation that elects to be an S corporation effective January 1, 
1997. On that date, Y owns Oil Well, which is natural resource 
recapture property and a capital asset. Y has section 1254 costs of 
$20,000 as of the close of the last taxable year that it was a C 
corporation. On January 1, 1997, Oil Well has a value of $200,000 
and a basis of $100,000. Thus, under section 1374, Y's net 
unrealized built-in gain is $100,000. Also on that date, Y's basis 
in Oil Well is allocated to A, Y's sole shareholder, under section 
613A(c)(11) and the section 1254 costs are allocated to A under 
paragraph (f)(1) of this section. In addition, A has a basis in A's 
Y stock of $100,000.
    (ii) On November 1, 1997, Y sells Oil Well for $250,000. During 
1997, Y has taxable income greater than $100,000, and no other 
transactions or items treated as recognized built-in gain or loss. 
Under section 1374, Y has net recognized built-in gain of $100,000. 
Assuming a tax rate of 35 percent on capital gain, Y has a tax of 
$35,000 under section 1374. The tax of $35,000 is treated as a 
capital loss under section 1366(f)(2). A has a realized gain on the 
sale of $150,000 ($250,000 minus $100,000) of which $20,000 is 
recognized as ordinary income under section 1254, and $130,000 is 
recognized as capital gain. Consequently, A recognizes ordinary 
income of $20,000 and net capital gain of $95,000 ($130,000 minus 
$35,000) on the sale.
    Example 2. Sale of stock followed by sale of natural resource 
recapture property held by an S corporation that was formerly a C 
corporation--(i) Assume the same facts as in Example 1(i). On 
November 1, 1997, A sells all of A's Y stock to P for $250,000. A 
has a realized gain on the sale of $150,000 ($250,000 minus 
$100,000) of which $20,000 is recognized as ordinary income under 
section 1254, and $130,000 is recognized as capital gain.
    (ii) On November 2, 1997, Y sells Oil Well for $250,000. During 
1997, Y has taxable income greater than $100,000, and no other 
transactions or items treated as recognized built-in gain or loss. 
Under section 1374, Y has net recognized built-in gain of $100,000. 
Assuming a tax rate of 35 percent on capital gain, Y has a tax of 
$35,000 under section 1374. The tax of $35,000 is treated as a 
capital loss under section 1366(f)(2). P has a realized gain on the 
sale of $150,000 ($250,000 minus $100,000), which is recognized as 
capital gain. Consequently, P recognizes net capital gain of 
$115,000 ($150,000 minus $35,000) on the sale.

    (3) Section 1254 costs of a C corporation that was formerly an S 
corporation. In the case of an S corporation that becomes a C 
corporation, the C corporation's section 1254 costs with respect to any 
natural resource recapture property held by the corporation as of the 
beginning of the corporation's first taxable year as a C corporation 
include the sum of its shareholders' section 1254 costs with respect to 
the property as of the close of the last taxable year that the 
corporation was an S corporation. In the case of an S termination year 
as defined in section 1362(e)(4), the shareholders' section 1254 costs 
are determined as of the close of the S short year as defined in 
section 1362(e)(1)(A). See paragraph (g)(5) of this section for rules 
on determining the aggregate amount of the shareholders' section 1254 
costs.
    (g) Determination of a shareholder's section 1254 costs upon 
certain stock transactions--(1) Issuance of stock. Upon an issuance of 
stock (whether such stock is newly-issued or had been held as treasury 
stock) by an S corporation in a reorganization described in section 368 
or otherwise--
    (i) Each recipient of shares must be allocated a pro rata share 
(determined solely with respect to the shares issued in the 
transaction) of the aggregate of the S corporation shareholders' 
section 1254 costs with respect to natural resource recapture property 
held by the S corporation immediately before the issuance (as 
determined pursuant to paragraph (g)(5) of this section); and
    (ii) Each pre-existing shareholder must reduce his or her section 
1254 costs with respect to natural resource recapture property held by 
the S corporation immediately before the issuance by an amount equal to 
the pre-existing shareholder's section 1254 costs immediately before 
the issuance multiplied by the percentage of stock of the corporation 
issued in the transaction.
    (2) Natural resource recapture property acquired in exchange for 
stock. If natural resource recapture property is transferred to an S 
corporation in exchange for stock of the S corporation (for example, in 
a section 351 transaction, or in a reorganization described in section 
368), the S corporation must allocate to its shareholders a pro rata 
share of the S corporation's section 1254 costs with respect to the 
property immediately after the transaction (as determined under 
Sec. 1.1254-3(b)(1)).
    (3) Treatment of nonvested stock. Stock issued in connection with 
the performance of services that is substantially nonvested (within the 
meaning of Sec. 1.83-3(b)) is treated as issued for purposes of this 
section at the first time it is treated as outstanding stock of the S 
corporation for purposes of section 1361.
    (4) Exception. Paragraph (g)(1) of this section does not apply to 
stock issued in exchange for stock of the same S corporation (as for 
example, in a recapitalization described in section 368(a)(1)(E)).
    (5) Aggregate of S corporation shareholders' section 1254 costs 
with respect to natural resource recapture property held by the S 
corporation--(i) In general. The aggregate of S corporation 
shareholders' section 1254 costs is equal to the sum of each 
shareholder's section 1254 costs. The S corporation must determine each

[[Page 53066]]

shareholder's section 1254 costs under either paragraph (g)(5)(ii) 
(written data) or paragraph (g)(5)(iii) (assumptions) of this section. 
The S corporation may determine the section 1254 costs of some 
shareholders under paragraph (g)(5)(ii) of this section and of others 
under paragraph (g)(5)(iii) of this section.
    (ii) Written data. An S corporation may determine a shareholder's 
section 1254 costs by using written data provided by a shareholder 
showing the shareholder's section 1254 costs with respect to natural 
resource recapture property held by the S corporation unless the S 
corporation knows or has reason to know that the written data is 
inaccurate. If an S corporation does not receive written data upon 
which it may rely, the S corporation must use the assumptions provided 
in paragraph (g)(5)(iii) of this section in determining a shareholder's 
section 1254 costs.
    (iii) Assumptions. An S corporation that does not use written data 
pursuant to paragraph (g)(5)(ii) of this section to determine a 
shareholder's section 1254 costs must use the following assumptions to 
determine the shareholder's section 1254 costs--
    (A) The shareholder deducted his or her share of the amount of 
deductions under sections 263(c), 616, and 617 in the first year in 
which the shareholder could claim a deduction for such amounts, unless 
in the case of expenditures under sections 263(c) or 616 the S 
corporation elected to capitalize such amounts;
    (B) The shareholder was not subject to the following limitations 
with respect to the shareholder's depletion allowance under section 
611, except to the extent a limitation applied at the corporate level: 
the taxable income limitation of section 613(a); the depletable 
quantity limitations of section 613A(c); or the limitations of sections 
613A(d)(2), (3), and (4) (exclusion of retailers and refiners).
    (6) Examples. The following examples illustrate the provisions of 
this paragraph (g):

    Example 1. Transfer of natural resource recapture property to an 
S corporation in a section 351 transaction. As of January 1, 1997, A 
owns all the stock (20 shares) in X, an S corporation. X holds 
property that is not natural resource recapture property that has a 
fair market value of $2,000 and an adjusted basis of $2,000. On 
January 1, 1997, B transfers natural resource recapture property, 
Property P, to X in exchange for 80 shares of X stock in a 
transaction that qualifies under section 351. Property P has a fair 
market value of $8,000 and an adjusted basis of $5,000. Pursuant to 
section 351, B does not recognize gain on the transaction. 
Immediately prior to the transaction, B's section 1254 costs with 
respect to Property P equaled $6,000. Under Sec. 1.1254-2(c)(1), B 
does not recognize any gain under section 1254 on the section 351 
transaction and, under Sec. 1.1254-3(b)(1), X's section 1254 costs 
with respect to Property P immediately after the contribution equal 
$6,000. Under paragraph (g)(2) of this section, each shareholder is 
allocated a pro rata share of X's section 1254 costs. The pro rata 
share of X's section 1254 costs that is allocated to A equals $1,200 
(20 percent interest in X multiplied by X's $6,000 of section 1254 
costs). The pro rata share of X's section 1254 costs that is 
allocated to B equals $4,800 (80 percent interest in X multiplied by 
X's $6,000 of section 1254 costs).
    Example 2. Contribution of money in exchange for stock of an S 
corporation holding natural resource recapture property. As of 
January 1, 1997, A and B each own 50 percent of the stock (50 shares 
each) in X, an S corporation. X holds natural resource recapture 
property, Property P, which has a fair market value of $20,000 and 
an adjusted basis of $14,000. A's and B's section 1254 costs with 
respect to Property P are $4,000 and $1,500, respectively. On 
January 1, 1997, C contributes $20,000 to X in exchange for 100 
shares of X's stock. Under paragraph (g)(1)(i) of this section, X 
must allocate to C a pro rata share of its shareholders' section 
1254 costs. Using the assumptions set forth in paragraph (g)(5)(iii) 
of this section, X determines that A's section 1254 costs with 
respect to natural resource recapture property held by X equal 
$4,500. Using written data provided by B, X determines that B's 
section 1254 costs with respect to Property P equal $1,500. Thus, 
the aggregate of X's shareholders' section 1254 costs equals $6,000. 
C's pro rata share of the $6,000 of section 1254 costs equals $3,000 
(C's 50 percent interest in X multiplied by $6,000). Under paragraph 
(g)(1)(ii) of this section, A's section 1254 costs are reduced by 
$2,000 (A's actual section 1254 costs ($4,000) multiplied by 50 
percent). B's section 1254 costs are reduced by $750 (B's actual 
section 1254 costs ($1,500) multiplied by 50 percent).
    Example 3. Merger involving an S corporation that holds natural 
resource recapture property. X, an S corporation with one 
shareholder, A, holds as its sole asset natural resource recapture 
property that has a fair market value of $120,000 and an adjusted 
basis of $40,000. A has section 1254 costs with respect to the 
property of $60,000. For valid business reasons, X merges into Y, an 
S corporation with one shareholder, B, in a reorganization described 
in section 368(a)(1)(A). Y holds property that is not natural 
resource recapture property that has a fair market value of $120,000 
and basis of $120,000. Under paragraph (c) of this section, A does 
not recognize ordinary income under section 1254 upon the exchange 
of stock in the merger because A did not otherwise recognize gain on 
the merger. Under paragraph (g)(2) of this section, Y must allocate 
to A and B a pro rata share of its $60,000 of section 1254 costs. 
Thus, A and B are each allocated $30,000 of section 1254 costs (50 
percent interest in X, each, multiplied by $60,000).

    Par. 6. Section 1.1254-6 is amended by adding two sentences at the 
end of this section to read as follows:


Sec. 1.1254-6  Effective date of regulations.

    * * * Section 1.1254-4 applies to dispositions of natural resource 
recapture property by an S corporation (and a corporation that was 
formerly an S corporation) and dispositions of S corporation stock 
occurring on or after October 10, 1996. Sections 1.1254-2(d)(1)(ii) and 
1.1254-3(b)(1)(i) and (ii) and (d)(1)(i) and (ii) are effective for 
dispositions of property occurring on or after October 10, 1996.

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

    Par. 7. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 8. In Sec. 602.101, paragraph (c) is amended by adding an 
entry in numerical order to the table to read as follows.


Sec. 602.101  OMB Control numbers.

* * * * *
    (c) * * *

------------------------------------------------------------------------
                                                                Current 
                                                                  OMB   
     CFR part of section where identified and described         control 
                                                                  No.   
------------------------------------------------------------------------
                                                                        
                *         *         *         *         *               
1.1254-4....................................................   1545-1493
                *         *         *         *         *               
------------------------------------------------------------------------

Michael P. Dolan,
Acting Commissioner of Internal Revenue.

    Approved: September 10, 1996.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 96-25945 Filed 10-9-96; 8:45 am]
BILLING CODE 4830-01-U