[Federal Register Volume 63, Number 77 (Wednesday, April 22, 1998)]
[Proposed Rules]
[Pages 19864-19873]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-10373]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-251698-96]
RIN 1545-AU77


S Corporation Subsidiaries

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations relating to the 
treatment of corporate subsidiaries of S corporations. The proposed 
regulations interpret the rules added to the Internal Revenue Code by 
section 1308 of the Small Business Job Protection Act of 1996. The 
proposed regulations affect S corporations and their subsidiaries.

DATES: Written comments must be received by July 21, 1998.

ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-251698-96), room 
5228, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered between the 
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-251698-96), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., 
Washington, DC. Alternatively, taxpayers may submit comments 
electronically via the Internet by selecting the ``Tax Regs'' option on 
the IRS Home Page, or by submitting comments directly to the IRS 
Internet site at http://www.irs.ustreas.gov/prod/tax__regs/
comments.html.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Deanna L. 
Walton, (202) 622-3050 (Subchapter S) or Lee A. Dean, (202) 622-7540 
(Subchapter C); concerning submissions, Michael Slaughter, (202) 622-
7190 (not toll-free numbers).


[[Page 19865]]



SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)).
    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, T:FP, Washington, DC 20224. 
Comments on the collections of information should be received by June 
22, 1998. Comments are specifically requested concerning: Whether the 
proposed collections of information are necessary for the proper 
performance of the functions of the Internal Revenue Service, including 
whether the collections will have a practical utility;
    The accuracy of the estimated burden associated with the proposed 
collections of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collections of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collections of information in these proposed regulations are in 
Secs. 1.1361-3(a)(1), 1.1361-3(b)(1), 1.1361-5(a)(2), and 1.1362-8. The 
collections of information are required to determine the manner in 
which a corporate subsidiary of an S corporation will be treated under 
the Internal Revenue Code.
    These collections of information are required to obtain a benefit. 
The likely respondents and/or recordkeepers are small businesses or 
organizations, businesses or other for-profit institutions, and farms.
    Estimated total annual reporting/recordkeeping burden: 10,110 
hours.
    Estimated average annual burden per respondent/recordkeeper: 57 
minutes.
    Estimated number of respondents/recordkeepers: 10,660.
    Estimated annual frequency of responses: On occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a 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

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) relating to S corporations and their 
subsidiaries under sections 1361 and 1362 of the Internal Revenue Code 
(Code). Section 1308 of the Small Business Job Protection Act of 1996, 
Public Law 104-188, 110 Stat. 1755 (the Act), modified section 1361 of 
the Code to permit an S corporation: (1) To own 80 percent or more of 
the stock of a C corporation, and (2) to elect to treat a wholly owned 
subsidiary as a qualified subchapter S subsidiary (QSSS). In Notice 97-
4 (1997-2 I.R.B. 24), the IRS announced its intention to issue 
regulations under section 1308 of the Act and requested comments on 
certain issues. Section 1601 of the Taxpayer Relief Act of 1997, Public 
Law 105-34, 111 Stat. 788 (the 1997 Act), made a technical correction 
to section 1361 to provide regulatory authority regarding the 
consequences of an election to be a QSSS.

Explanation of Provisions

Overview

    Prior law prohibited an S corporation from owning 80 percent or 
more of the stock of another corporation. The Act repealed section 
1362(b)(2)(A) of the Internal Revenue Code (Code), thereby allowing an 
S corporation to own 80 percent or more of the stock of a C 
corporation. The Act also added section 1504(b)(8) to the Code to 
prevent an S corporation from joining in the filing of a consolidated 
return with its affiliated C corporations. A C corporation subsidiary 
of an S corporation, however, may file a consolidated return with its 
affiliated C corporations. See H.R. Conf. Rep. No. 737, 104th Cong., 2d 
Sess. 224 (1996).
    New section 1361(b)(3)(B) defines the term qualified subchapter S 
subsidiary as any domestic corporation that is not an ineligible 
corporation if, (1) an S corporation holds 100 percent of the stock of 
the corporation, and (2) that S corporation elects to treat the 
subsidiary as a QSSS. Except as otherwise provided in regulations, a 
corporation for which a QSSS election is made is not treated as a 
separate corporation, and all assets, liabilities, and items of income, 
deduction, and credit of the QSSS are treated as assets, liabilities, 
and items of income, deduction, and credit of the parent S corporation. 
The legislative history accompanying section 1361(b)(3) indicates that, 
when the parent corporation makes the election, the subsidiary is 
deemed to have liquidated under sections 332 and 337 immediately before 
the election is effective. See S. Rep. No. 281, 104th Cong., 2d Sess. 
53 (1996); H.R. Rep. No. 586, 104th Cong., 2d Sess. 89 (1996). However, 
the legislative history accompanying the technical correction made by 
the 1997 Act indicates that regulations may provide exceptions to that 
general rule. See S. Rep. No. 33, 105th Cong., 1st Sess. 320 (1997).
    Section 1361(b)(3)(C) provides that any QSSS that ceases to meet 
the requirements of section 1361(b)(3)(B) will be treated as a new 
corporation acquiring all of its assets (and assuming all of its 
liabilities) immediately before the cessation from its S corporation 
parent in exchange for the subsidiary's stock. Section 1361(b)(3)(D) 
provides that a QSSS whose election has terminated (or a successor 
corporation) may not make an S election or have a QSSS election made 
with respect to it before its fifth taxable year that begins after the 
first taxable year for which the termination is effective, unless the 
Secretary consents to the election.
    Under current and prior law, the S election of a corporation with 
subchapter C corporation earnings and profits terminated if that S 
corporation received passive investment income, including dividends, in 
excess of 25 percent of gross receipts for three consecutive years. 
Section 1362(d)(3)(E) modifies that general rule by excluding dividends 
from passive investment income to the extent that the dividends are 
attributable to the active conduct of a trade or business of a C 
corporation in which the S corporation has an 80 percent or greater 
ownership interest. Neither the Act nor the legislative history 
provides rules for determining the attribution of dividends to an 
active trade or business.

QSSS Formation

    Under the proposed regulations, an S corporation makes a QSSS 
election with respect to an eligible subsidiary by filing a form to be 
developed by the IRS prior to the time these regulations become final. 
This proposes to change the temporary election procedure provided in 
Notice 97-4, which provides that a parent S corporation files a 
completed Form 966, Corporate Dissolution and

[[Page 19866]]

Liquidation (with some modifications), to make a QSSS election. Until 
these proposed regulations are finalized, taxpayers should continue to 
use the temporary election procedure in Notice 97-4 to make QSSS 
elections.
    The proposed regulations also provide that the effective date of a 
QSSS election may be up to 2 months and 15 days prior to the day the 
QSSS election is made. This is a slight change from the 75 day 
retroactive period provided in Notice 97-4, but is consistent with the 
general time period for making S elections. Unlike the S election, 
however, a QSSS election does not need to be made within 2 months and 
15 days of the beginning of a taxable year. A similar retroactive 
period is provided for revocations of QSSS status. In addition, a 
taxpayer may choose a prospective effective date for a QSSS election or 
revocation, so long as the date selected is not more than 12 months 
after the date the election or revocation is made.
    The proposed regulations provide that, when an S corporation makes 
a valid QSSS election with respect to a subsidiary, the subsidiary is 
deemed to have liquidated into the parent. The tax treatment of this 
liquidation, alone or in the context of any larger transaction (for 
example, a transaction that also includes the acquisition of the 
subsidiary's stock), is generally determined under all relevant 
provisions of the Code and general principles of tax law, including the 
step transaction doctrine. However, a special transition rule applies 
to certain elections effective prior to the date that is 60 days after 
publication of final regulations in the Federal Register. The 
transition rule indicates the recognition of special concerns that may 
have arisen as a result of transactions entered into by taxpayers 
relying on the legislative history to the Act and without applying the 
step transaction doctrine to the acquisition of the subsidiary's stock 
followed by a QSSS election. The IRS requests comments concerning other 
transactions occurring during the transitional period for which relief 
from the effect of application of the step transaction doctrine may be 
warranted.
    Special rules may apply when a QSSS election is made following the 
transfer of one S corporation's stock to another S corporation. For 
example, if an S corporation acquires the stock of another S 
corporation in a transaction in which the acquiring S corporation's 
basis in the stock received is determined by reference to the 
transferor's basis and makes a QSSS election with respect to the other 
corporation effective on the day of acquisition, any losses disallowed 
under section 1366(d) with respect to a former shareholder of the QSSS 
will be available to that shareholder as a shareholder of the acquiring 
S corporation. Furthermore, when stock in an S corporation is 
transferred to another S corporation and a QSSS election is made with 
respect to the subsidiary effective on the day of acquisition, the S 
election of the former corporation terminates at the same moment as the 
QSSS election becomes effective. This rule ensures that the former S 
corporation is not treated as a C corporation for any period solely 
because of the transfer.
    Generally, the proposed regulations treat the liquidation as 
occurring at the close of the day before the QSSS election is 
effective. Under this rule, if a parent corporation makes an S election 
effective on the same date as a QSSS election with respect to a 
subsidiary, the deemed liquidation occurs at a time when the parent 
corporation is still a C corporation. A QSSS election satisfies the 
requirement of adopting a plan of liquidation under section 332.
    Following the deemed liquidation, the QSSS is not treated as a 
separate corporation (except as otherwise provided in the regulations), 
and all assets, liabilities, and items of income, deduction, and credit 
are treated as those of the S corporation. Accordingly, all such items 
must be reported on the S corporation's return required to be filed 
under section 6037. A special rule applies for the calculation of these 
items where either an S corporation or its QSSS is a bank (as defined 
in section 581). This special rule was first announced in Notice 97-5 
(1997-2 I.R.B. 25). Until these proposed regulations are finalized, 
taxpayers should continue to follow Notice 97-5.

QSSS Termination

    The QSSS status of a corporation continues until it terminates. The 
regulations specify the date of termination for specific terminating 
events. Section 1361(b)(3)(D) provides that, if a QSSS election 
terminates, the corporation is treated as a new corporation acquiring 
all of its assets (and assuming all of its liabilities) from the S 
corporation in exchange for stock of the new corporation immediately 
before the termination. The tax treatment of this transaction or of a 
larger transaction that includes this transaction will be determined 
under the Code and general principles of tax law, including the step 
transaction doctrine. Examples are provided to illustrate situations in 
which the formation of the new corporation will qualify as a 
nonrecognition transaction under section 351. The proposed regulations 
also provide that, under certain circumstances, relief may be available 
under the standards established under section 1362(f) for the 
inadvertent termination of an S election.
    Section 1361(b)(3)(D) provides that a corporation whose QSSS 
election has terminated (or a successor corporation) may not make an S 
election or have a QSSS election made with respect to it for five 
taxable years following the termination without the consent of the 
Secretary. The proposed regulations provide that, without requesting 
the Secretary's consent, a corporation may make an election to be 
treated as an S corporation or may have a QSSS election made with 
respect to it before the expiration of the five-year period under 
certain circumstances. Consent is not required if an otherwise valid S 
election or QSSS election is made for the former QSSS (or its successor 
corporation) effective immediately following the disposition of its 
stock. Thus, the proposed regulations allow corporations to move freely 
between QSSS and S corporation status, provided there is no intervening 
period for which the corporation is treated as a C corporation.

C Corporation Subsidiaries

    The proposed regulations also provide rules relating to certain C 
corporation subsidiaries held by S corporations. Under section 
1362(d)(3)(E), dividends received by an S corporation from a C 
corporation in which the S corporation has an 80 percent or greater 
ownership interest are not treated as passive investment income for 
purposes of sections 1362 and 1375 to the extent the dividends are 
attributable to the earnings and profits of the C corporation derived 
from the active conduct of a trade or business. The proposed 
regulations provide guidance for attributing dividends to the active 
conduct of a trade or business. Special rules apply to dividends 
distributed by the common parent of a consolidated group.
    Under the proposed regulations, earnings and profits of a C 
corporation derived from the active conduct of a trade or business are 
the earnings and profits of the corporation derived from activities 
that would not produce passive investment income under section 
1362(d)(3) if the C corporation were an S corporation. The proposed 
regulations provide a safe harbor under which the corporation may 
determine the amount of the active earnings and profits by comparing 
the corporation's gross receipts derived from non-passive

[[Page 19867]]

investment income-producing activities with the corporation's total 
gross receipts in the year the earnings and profits are produced. If 
less than 10 percent of the C corporation's earnings and profits for a 
taxable year are derived from activities that would produce passive 
investment income, all earnings and profits produced by the corporation 
during the taxable year are considered active earnings and profits.
    The proposed regulations also provide that a C corporation may 
treat all earnings and profits accumulated by the corporation prior to 
the time an S corporation held stock meeting the requirements of 
section 1504(a)(2) as active earnings and profits in the same 
proportion as the C corporation's active earnings and profits for the 
three taxable years ending prior to the time when the S corporation 
acquired 80 percent of the C corporation bear to the C corporation's 
total earnings and profits for those three taxable years. Provisions 
also address the allocation of distributions from current or 
accumulated earnings and profits.

Proposed Effective Date

    The regulations are proposed to be effective on the date that final 
regulations are published in the Federal Register. However, the IRS is 
considering whether certain provisions should be made retroactive. The 
IRS requests comments concerning whether certain provisions should be 
made effective for taxable years beginning on or after January 1, 1997.

Special Analyses

    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. 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. It is 
hereby certified that the collections of information contained in these 
regulations will not have a significant economic impact on a 
substantial number of small businesses. This certification is based on 
the fact that the economic burden imposed on taxpayers by the 
collections of information and recordkeeping requirements of these 
regulations is insignificant. For example, the estimated average annual 
burden per respondent is less than one hour. Furthermore, most 
taxpayers will only have to respond to the requests for information 
contained in Secs. 1.1361-3(b)(1) and 1.1361-5(a)(2) one time in the 
life of the corporation. Therefore, a Regulatory Flexibility Analysis 
under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not 
required.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (preferably a 
signed original and eight (8) copies) that are timely submitted to the 
IRS. All comments will be available for public inspection and copying.
    A public hearing will be scheduled in the Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC. The IRS 
recognizes that persons outside the Washington, DC, area also may wish 
to testify at the public hearing through teleconferencing. Requests to 
include teleconferencing sites must be received by June 22, 1998. If 
the IRS receives sufficient indications of interest to warrant 
teleconferencing to a particular city, and if the IRS has 
teleconferencing facilities available in that city on the date the 
public hearing is to be scheduled, the IRS will try to accommodate the 
requests.
    The IRS will publish the time and date of the public hearing and 
the locations of any teleconferencing sites in an announcement in the 
Federal Register.

Drafting Information

    The principal authors of these proposed regulations are Deanna L. 
Walton, Office of the Assistant Chief Counsel (Passthroughs and Special 
Industries); and Lee A. Dean, Office of the Assistant Chief Counsel 
(Corporate). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be 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 * * *
    Par. 2. Amend Sec. 1.1361-0 as follows:
    1. Revise the introductory text.
    2. Remove the entry for Sec. 1.1361-1(d)(3).
    3. Add entries for Secs. 1.1361-2, 1.1361-3, 1.1361-4, .1361-5, and 
1.1361-6.
    The revisions and additions read as follows:

Section 1.1361-0  Table of Contents

    This section lists captions contained in Secs. 1.1361-1, 1.1361-2, 
1.1361-3, 1.1361-4, 1.1361-5, and 1.1361-6.
* * * * *

Section 1.1361-2  Definitions Relating to S Corporation 
Subsidiaries

    (a) In general.
    (b) Stock treated as held by S corporation.
    (c) Examples.

Secton 1.1361-3  QSSS Election

    (a) Time and manner of making election.
    (1) In general.
    (2) Time of making election.
    (3) Effective date of election.
    (4) Example.
    (5) Extension of time for making a QSSS election.
    (b) Revocation of QSSS election.
    (1) Manner of revoking QSSS election.
    (2) Effective date of revocation.
    (3) Revocation after termination.

Section 1.1361-4  Effect of QSSS Election.

    (a) Separate existence ignored.
    (1) In general.
    (2) Liquidation of subsidiary.
    (3) Treatment of banks.
    (i) In general.
    (ii) Examples.
    (4) Treatment of stock of QSSS.
    (5) Transitional relief.
    (i) General rule.
    (ii) Examples.
    (b) Timing of the liquidation.
    (1) In general.
    (2) Acquisitions.
    (3) Coordination with section 338 election.
    (c) Carryover of disallowed losses and deductions.
    (d) Examples.

Section 1.1361-5  Termination of QSSS Election

    (a) In general.
    (1) Effective date.
    (2) Information to be provided upon termination of QSSS election 
by failure to qualify as a QSSS.
    (3) Examples.
    (b) Effect of termination of QSSS election.
    (1) Formation of new corporation.
    (2) Carryover of disallowed losses and deductions.
    (3) Examples.
    (c) Inadvertent terminations.
    (d) Election after QSSS termination.
    (1) In general.
    (2) Exception.
    (3) Examples.

Section 1.1361-6  Effective Date

    Par. 3. Amend Sec. 1.1361-1 as follows:
    1. Revise paragraph (b)(1)(i).
    2. Remove paragraph (d)(1)(i).
    3. Redesignate paragraphs (d)(1)(ii), (d)(1)(iii), (d)(1)(iv), and 
(d)(1)(v) as paragraphs (d)(1)(i), (d)(1)(ii), (d)(1)(iii), and 
(d)(1)(iv), respectively.
    4. Revise newly designated paragraph (d)(1)(i).

[[Page 19868]]

    5. Remove paragraph (d)(3).
    6. Revise the first sentence of paragraph (e)(1).
    The revisions read as follows:


Sec. 1.1361-1  S corporation defined.

* * * * *
    (b) * * *
    (1) * * *
    (i) More than 75 shareholders (35 for taxable years beginning 
before January 1, 1997);
* * * * *
    (d) * * *
    (1) * * *
    (i) For taxable years beginning on or after January 1, 1997, a 
financial institution that uses the reserve method of accounting for 
bad debts described in section 585 (for taxable years beginning prior 
to January 1, 1997, a financial institution to which section 585 
applies (or would apply but for section 585(c)) or to which section 593 
applies);
* * * * *
    (e) * * *
    (1) General rule. A corporation does not qualify as a small 
business corporation if it has more than 75 shareholders (35 for 
taxable years beginning prior to January 1, 1997). * * *
* * * * *
    Par. 4. Add Secs. 1.1361-2, 1.1361-3, 1.1361-4, 1.1361-5, and 
1.1361-6 to read as follows:


Sec. 1.1361-2  Definitions relating to S corporation subsidiaries.

    (a) In general. The term qualified subchapter S subsidiary (QSSS) 
means any domestic corporation that is not an ineligible corporation 
(as defined in section 1361(b)(2) and the regulations thereunder), if--
    (1) 100 percent of the stock of such corporation is held by an S 
corporation; and
    (2) The S corporation properly elects to treat the subsidiary as a 
QSSS under Sec. 1.1361-3.
    (b) Stock treated as held by S corporation. For purposes of 
satisfying the 100 percent stock ownership requirement in section 
1361(b)(3)(B)(i) and paragraph (a)(1) of this section, stock of a 
corporation is treated as held by an S corporation if the S corporation 
is the owner of that stock for federal income tax purposes.
    (c) Examples. The following examples illustrate the application of 
this section:

    Example 1. X, an S corporation, owns 100 percent of Y, a 
corporation for which a valid QSSS election is in effect for the 
taxable year. Y owns 100 percent of Z, a corporation otherwise 
eligible for QSSS status. X may elect to treat Z as a QSSS under 
section 1361(b)(3)(B)(ii).
    Example 2. Assume the same facts as in Example 1, except that Y 
is a business entity that is disregarded as an entity separate from 
its owner under Sec. 301.7701-2(c)(2) of this chapter. X may elect 
to treat Z as a QSSS.
    Example 3. Assume the same facts as in Example 1, except that Y 
owns 50 percent of Z, and X owns the other 50 percent. X may elect 
to treat Z as a QSSS.
    Example 4. Assume the same facts as in Example 1, except that Y 
is a C corporation. Although Y is a domestic corporation that is 
otherwise eligible to be a QSSS, no QSSS election has been made for 
Y. Thus, X is not treated as holding the stock of Z. Consequently, X 
may not elect to treat Z as a QSSS.


Sec. 1.1361-3  QSSS election.

    (a) Time and manner of making election--(1) In general. Except as 
provided in section 1361(b)(3)(D) and Sec. 1.1361-5(d) (five-year 
prohibition on re-election), an S corporation may elect to treat an 
eligible subsidiary as a QSSS by filing a completed form to be 
prescribed by the Internal Revenue Service. The election form must be 
signed by a person authorized to sign the S corporation's return 
required to be filed under section 6037 and must be submitted to the 
service center where the subsidiary filed its most recent tax return 
(if applicable). If an S corporation forms a subsidiary and makes a 
valid QSSS election (effective upon the date of the subsidiary's 
formation) for the subsidiary, the election should be submitted to the 
service center where the S corporation filed its most recent return.
    (2) Time of making election. A QSSS election may be made by the S 
corporation parent at any time during the taxable year.
    (3) Effective date of election. A QSSS election will be effective 
on the date specified on the election form or on the date the election 
form is filed if no date is specified. The effective date specified on 
the form can not be more than 2 months and 15 days prior to the date of 
filing and can not be more than 12 months after the date of filing. For 
this purpose, the definition of the term ``month'' found in 
Sec. 1.1362-6(a)(2)(ii)(C) applies. If an election form specifies an 
effective date more than 2 months and 15 days prior to the date on 
which the election form is filed, it will be effective 2 months and 15 
days prior to the date it is filed. If an election form specifies an 
effective date more than 12 months after the date on which the election 
is filed, it will be effective 12 months after the date it is filed. 
The corporation for which the QSSS election is made must meet all the 
requirements of section 1361(b)(3)(B) at the time the election is made 
and for all periods for which the election is to be effective.
    (4) Example. The following example illustrates the application of 
paragraph (a)(3) of this section:

    Example. X has been a calendar year S corporation engaged in a 
trade or business for several years. X acquires the stock of Y, a 
calendar year C corporation, on April 1, 1998. On August 10, 1998, X 
makes an election to treat Y as a QSSS. Unless otherwise specified 
on the election form, the election will be effective as of August 
10, 1998. If specified on the election form, the election may be 
effective on some other date that is not more than 2 months and 15 
days prior to August 10, 1998, and not more than 12 months after 
August 10, 1998.

    (5) Extension of time for making a QSSS election. An extension of 
time to make a QSSS election may be available under the procedures 
applicable under Secs. 301.9100-1 and 301.9100-3 of this chapter.
    (b) Revocation of QSSS election--(1) Manner of revoking QSSS 
election. An S corporation may revoke a QSSS election under section 
1361 by filing a statement with the service center where the S 
corporation's most recent tax return was properly filed. The revocation 
statement must include the names, addresses, and taxpayer 
identification numbers of both the parent S corporation and the QSSS. 
The statement must be signed by a person authorized to sign the S 
corporation's return required to be filed under section 6037.
    (2) Effective date of revocation. The revocation of a QSSS election 
is effective on the date specified on the revocation statement or on 
the date the revocation statement is filed if no date is specified. The 
effective date specified on the revocation statement can not be more 
than 2 months and 15 days prior to the date on which the revocation 
statement is filed and can not be more than 12 months after the date on 
which the revocation statement is filed. If a revocation statement 
specifies an effective date more than 2 months and 15 days prior to the 
date on which the statement is filed, it will be effective 2 months and 
15 days prior to the date it is filed. If a revocation statement 
specifies an effective date more than 12 months after the date on which 
the statement is filed, it will be effective 12 months after the date 
it is filed.
    (3) Revocation after termination. A revocation may not be made 
after the occurrence of an event that renders the subsidiary ineligible 
for QSSS status under section 1361(b)(3)(B).


Sec. 1.1361-4  Effect of QSSS election.

    (a) Separate existence ignored--(1) In general. Except as otherwise 
provided in paragraph (a)(3) of this section, for federal tax 
purposes--

[[Page 19869]]

    (i) A corporation which is a QSSS shall not be treated as a 
separate corporation; and
    (ii) All assets, liabilities, and items of income, deduction, and 
credit of a QSSS shall be treated as assets, liabilities, and items of 
income, deduction, and credit of the S corporation.
    (2) Liquidation of subsidiary. If an S corporation makes a valid 
QSSS election with respect to a subsidiary, the subsidiary is deemed to 
have liquidated into the S corporation. Except as provided in paragraph 
(a)(5) of this section, the tax treatment of the liquidation or of a 
larger transaction that includes the liquidation will be determined 
under the Internal Revenue Code and general principles of tax law, 
including the step transaction doctrine. Thus, for example, if an S 
corporation forms a subsidiary and makes a valid QSSS election 
(effective upon the date of the subsidiary's formation) for the 
subsidiary, there will be no deemed liquidation of the new subsidiary. 
Instead, the corporation will be deemed to be a QSSS from its 
inception. For purposes of section 332, the making of a QSSS election 
satisfies the requirement of adopting a plan of liquidation.
    (3) Treatment of banks--(i) In general. If an S corporation is a 
bank, or if an S corporation makes a valid QSSS election for a 
subsidiary that is a bank, any special rules applicable to banks under 
the Internal Revenue Code continue to apply separately to the bank 
parent or bank subsidiary as if the deemed liquidation of any QSSS 
under paragraph (a)(2) of this section had not occurred. For any QSSS 
that is a bank, however, all assets, liabilities, and items of income, 
deduction, and credit of the QSSS, as determined in accordance with the 
special bank rules, are treated as assets, liabilities, and items of 
income, deduction, and credit of the S corporation. For purposes of 
this paragraph (a)(3)(i), the term ``bank'' has the same meaning as in 
section 581.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (a)(3):

    Example 1. X, an S corporation, is a bank as defined in section 
581. X owns 100 percent of Y and Z, corporations for which valid 
QSSS elections are in effect. Y is a bank as defined in section 581, 
and Z is not a financial institution. Pursuant to paragraph 
(a)(3)(i) of this section, any special rules applicable to banks 
under the Internal Revenue Code continue to apply separately to X 
and Y and do not apply to Z. Thus, for example, section 265(b), 
which provides special rules for interest expense deductions of 
banks, applies separately to X and Y. That is, X and Y each must 
make a separate determination under section 265(b) of interest 
expense allocable to tax-exempt interest, and no deduction is 
allowed for that interest expense.
    Example 2. X, an S corporation, is a bank holding company and 
thus is not a bank as defined in section 581. X owns 100 percent of 
Y, a corporation for which a valid QSSS election is in effect. Y is 
a bank as defined in section 581. Pursuant to paragraph (a)(3)(i) of 
this section, any special rules applicable to banks under the 
Internal Revenue Code continue to apply to Y and do not apply to X. 
However, all of Y's assets, liabilities, and items of income, 
deduction, and credit, as determined in accordance with the special 
bank rules, are treated as those of X. Thus, for example, section 
582(c), which provides special rules for sales and exchanges of debt 
by banks, applies only to sales and exchanges by Y. However, any 
gain or loss on such a transaction by Y that is considered ordinary 
income or ordinary loss pursuant to section 582(c) is treated as 
ordinary income or ordinary loss of X.

    (4) Treatment of stock of QSSS. Except for purposes of section 
1361(b)(3)(B)(i) and Sec. 1.1361-2(a)(1), the stock of a QSSS shall be 
disregarded for all federal tax purposes.
    (5) Transitional relief--(i) General rule. If an S corporation and 
another corporation (the related corporation) are persons specified in 
section 267(b) prior to an acquisition by the S corporation of some or 
all of the stock of the related corporation followed by a QSSS election 
for the related corporation, the step transaction doctrine will not 
apply to determine the tax consequences of the acquisition. This 
paragraph (a)(5) shall apply to QSSS elections effective prior to the 
date that is 60 days after publication of final regulations in the 
Federal Register.
    (ii) Examples. The following examples illustrate the application of 
this paragraph (a)(5):

    Example 1. Individual A owns 100 percent of the stock of X, an S 
corporation. X owns 79 percent of the stock of Y, a solvent 
corporation, and A owns the remaining 21 percent. On May 4, 1998, A 
contributes its Y stock to X in exchange for X stock. X makes a QSSS 
election with respect to Y effective immediately following the 
transfer. The liquidation described in paragraph (a)(2) of this 
section is respected as an independent step separate from the stock 
acquisition, and the tax consequences of the liquidation are 
determined under sections 332 and 337. The contribution by A of the 
Y stock qualifies under section 351, and no gain or loss is 
recognized by A, X, or Y.
    Example 2. Individual A owns 100 percent of the stock of two 
solvent S corporations, X and Y. On May 4, 1998, A contributes the 
stock of Y to X. X makes a QSSS election with respect to Y 
immediately following the transfer. The liquidation described in 
paragraph (a)(2) of this section is respected as an independent step 
separate from the stock acquisition, and the tax consequences of the 
liquidation are determined under sections 332 and 337. The 
contribution by A of the Y stock to X qualifies under section 351, 
and no gain or loss is recognized by A, X, or Y. Y is not treated as 
a C corporation for any period solely because of the transfer of its 
stock to X, an ineligible shareholder. See Sec. 1.1362-2(b)(4).

    (b) Timing of the liquidation--(1) In general. Except as otherwise 
provided in paragraphs (b)(2) or (b)(3) of this section, the 
liquidation described in paragraph (a)(2) of this section occurs at the 
close of the day before the QSSS election is effective. Thus, for 
example, if a C corporation elects to be treated as an S corporation 
and makes a QSSS election (effective the same date as the S election) 
with respect to a subsidiary, the liquidation occurs immediately before 
the S election becomes effective, while the S electing parent is still 
a C corporation.
    (2) Acquisitions. If an S corporation does not own 100 percent of 
the stock of the subsidiary on the day before the QSSS election is 
effective, the liquidation described in paragraph (a)(2) of this 
section occurs immediately after the time at which the S corporation 
first owns 100 percent of the stock.
    (3) Coordination with section 338 election. An S corporation that 
makes a qualified stock purchase of a target may make an election under 
section 338 with respect to the acquisition if it meets the 
requirements for the election, and may make a QSSS election with 
respect to the target. If an S corporation makes an election under 
section 338 with respect to a subsidiary acquired in a qualified stock 
purchase, a QSSS election made with respect to that subsidiary is not 
effective before the day after the acquisition date (within the meaning 
of section 338(h)(2)). If the QSSS election is effective on the day 
after the acquisition date, the liquidation under paragraph (a)(2) of 
this section occurs immediately after the deemed asset purchase by the 
new target corporation under section 338. If an S corporation makes an 
election under section 338 (without a section 338(h)(10) election) with 
respect to a target, the target must file a final or deemed sale return 
as a C corporation reflecting the deemed sale. See Sec. 1.338-1(e).
    (c) Carryover of disallowed losses and deductions. If an S 
corporation (S1) acquires the stock of another S corporation (S2) in a 
transaction in which the basis of the S2 stock is determined in whole 
or in part by reference to the transferor's basis, and S1 makes a QSSS 
election with respect to S2 effective on the day of the acquisition, 
any loss or deduction disallowed under section 1366(d) with respect to 
a former shareholder of S2 is

[[Page 19870]]

available to that shareholder as a shareholder of S1. Thus, a loss or 
deduction of a shareholder of S2 disallowed prior to or during the 
taxable year of the transaction is treated as incurred by S1 with 
respect to that shareholder if the shareholder is a shareholder of S1 
after the transaction.
    (d) Examples. The following examples illustrate the application of 
this section:

    Example 1. X, an S corporation, owns 100 percent of the stock of 
Y, a C corporation. On June 2, 1998, X makes a valid QSSS election 
for Y, effective June 2, 1998. Assume that, under general principles 
of tax law, including the step transaction doctrine, X's acquisition 
of the Y stock and the subsequent QSSS election would not be treated 
as related. The liquidation described in paragraph (a)(2) of this 
section occurs at the close of the day on June 1, 1998, the day 
before the QSSS election is effective, and the plan of liquidation 
is considered adopted on that date. Y's taxable year and separate 
existence for federal tax purposes end at the close of June 1, 1998.
    Example 2. X, a C corporation, owns 100 percent of the stock of 
Y, another C corporation. On December 31, 1998, X makes an election 
under section 1362 to be treated as an S corporation and a valid 
QSSS election for Y, both effective January 1, 1999. Assume that, 
under general principles of tax law, including the step transaction 
doctrine, X's acquisition of the Y stock and the subsequent QSSS 
election would not be treated as related. The liquidation described 
in paragraph (a)(2) of this section occurs at the close of December 
31, 1998, the day before the QSSS election is effective. The QSSS 
election for Y is effective on the same day that X's S election is 
effective, and the deemed liquidation is treated as occurring before 
the S election is effective, when X is still a C corporation. Y's 
taxable year ends at the close of December 31, 1998. See 
Sec. 1.381(b)-1.
    Example 3. On June 1, 1998, X, an S corporation, acquires 100 
percent of the stock of Y, an existing S corporation, for cash in a 
transaction meeting the requirements of a qualified stock purchase 
(QSP) under section 338. X immediately makes a QSSS election for Y 
effective June 2, 1998, and also makes a joint election under 
section 338(h)(10) with the shareholder of Y. Under section 338(a) 
and Sec. 1.338(h)(10)-1, Y is treated as having sold all of its 
assets at the close of the acquisition date, June 1, 1998. Y is 
treated as a new corporation which purchased all of those assets as 
of the beginning of June 2, 1998, the day after the acquisition 
date. Section 338(a)(2). The QSSS election is effective on June 2, 
1998, and the liquidation under paragraph (a)(2) of this section 
occurs immediately after the deemed asset purchase by the new 
corporation.
    Example 4. X, an S corporation, owns 100 percent of Y, a 
corporation for which a QSSS election is in effect. On May 12, 1998, 
a date on which the QSSS election is in effect, X issues Y a $10,000 
note under state law that matures in ten years with a market rate of 
interest. Y is not treated as a separate corporation, and X's 
issuance of the note to Y on May 12, 1998, is disregarded for 
federal tax purposes.
    Example 5. X, an S corporation, owns 100 percent of the stock of 
Y, a C corporation. At a time when Y is indebted to X in an amount 
which exceeds the fair market value of Y's assets, X makes a QSSS 
election effective on the date it is filed with respect to Y. The 
liquidation described in paragraph (a)(2) of this section does not 
qualify under sections 332 and 337 and, thus, Y recognizes gain or 
loss on the assets distributed, subject to the limitations of 
section 267.


Sec. 1.1361-5  Termination of QSSS election.

    (a) In general--(1) Effective date. The termination of a QSSS 
election is effective--
    (i) On the effective date contained in the revocation statement if 
a QSSS election is revoked under Sec. 1.1361-3(b);
    (ii) At the close of the last day of the parent's last taxable year 
as an S corporation if the parent's S election terminates under 
Sec. 1.1362-2; or
    (iii) At the close of the day on which an event (other than an 
event described in paragraph (a)(1)(ii) of this section) occurs that 
renders the subsidiary ineligible for QSSS status under section 
1361(b)(3)(B).
    (2) Information to be provided upon termination of QSSS election by 
failure to qualify as a QSSS. If a QSSS election terminates because an 
event renders the subsidiary ineligible for QSSS status, the S 
corporation must attach to its return for the taxable year in which the 
termination occurs a notification that a QSSS election has terminated, 
the date of the termination, and the names, addresses, and employer 
identification numbers of both the parent corporation and the QSSS.
    (3) Examples. The following examples illustrate the application of 
this paragraph (a):

    Example 1. Termination because parent's S election terminates. 
X, an S corporation, owns 100 percent of Y. A QSSS election is in 
effect with respect to Y for 1998. Effective on January 1, 1999, X 
revokes its S election. Because X is no longer an S corporation, Y 
no longer qualifies as a QSSS at the close of December 31, 1998.
    Example 2. Termination due to transfer of QSSS stock. X, an S 
corporation, owns 100 percent of Y. A QSSS election is in effect 
with respect to Y for 1998. On December 10, 1998, X sells one share 
of Y stock to A, an individual. Because X no longer owns 100 percent 
of the stock of Y, Y no longer qualifies as a QSSS. Accordingly, the 
QSSS election made with respect to Y terminates at the close of 
December 10, 1998.
    Example 3. No termination on stock transfer between QSSS and 
parent. X, an S corporation, owns 100 percent of the stock of Y and 
Y owns 100 percent of the stock of Z. QSSS elections are in effect 
with respect to both Y and Z. Y transfers all of its Z stock to X. 
Because X is treated as owning the stock of Z both before and after 
the transfer of stock solely for purposes of determining whether the 
requirements of section 1361(b)(3)(B)(i) and Sec. 1.1361-2(a)(1) 
have been satisfied, the transfer of Z stock does not terminate Z's 
QSSS election. Because the stock of Z is disregarded for all other 
federal tax purposes, no gain is recognized under section 311.

    (b) Effect of termination of QSSS election--(1) Formation of new 
corporation. If a QSSS election terminates under paragraph (a) of this 
section, the former QSSS is treated as a new corporation acquiring all 
of its assets (and assuming all of its liabilities) immediately before 
the termination from the S corporation parent in exchange for stock of 
the new corporation. The tax treatment of this transaction or of a 
larger transaction that includes this transaction will be determined 
under the Internal Revenue Code and general principles of tax law, 
including the step transaction doctrine.
    (2) Carryover of disallowed losses and deductions. If a QSSS 
terminates because the S corporation distributes the QSSS stock to some 
or all of the S corporation's shareholders in a transaction to which 
section 368(a)(1)(D) applies by reason of section 355 (or so much of 
section 356 as relates to section 355), any loss or deduction 
disallowed under section 1366(d) with respect to a shareholder of the S 
corporation immediately before the distribution is allocated between 
the S corporation and the former QSSS with respect to the shareholder. 
The amount of the disallowed loss or deduction allocated to the S 
corporation is an amount that bears the same ratio to each item of 
disallowed loss or deduction as the value of the shareholder's stock in 
the S corporation bears to the total value of the shareholder's stock 
in both the S corporation and the former QSSS, in each case as 
determined immediately after the distribution.
    (3) Examples. The following examples illustrate the application of 
this paragraph (b):

    Example 1. X, an S corporation, owns 100 percent of the stock of 
Y, a corporation for which a QSSS election is in effect. X sells 21 
percent of the Y stock to Z, an unrelated corporation, for cash, 
thereby terminating the QSSS election. Y is treated as a new 
corporation acquiring all of its assets (and assuming all of its 
liabilities) in exchange for Y stock immediately before the 
termination from the S corporation. The deemed exchange by X of 
assets for Y stock does not qualify under section 351 because X is 
not in control of Y within the meaning of section 368(c) immediately 
after the transfer as a result of the sale of stock to Z. Therefore, 
X must recognize gain, if any, on the assets transferred to Y in 
exchange for its stock. X's losses, if any, on the assets 
transferred are subject to the limitations of section 267.

[[Page 19871]]

    Example 2. Assume the same facts as in Example 1, except that, 
instead of purchasing Y stock, Z contributes to Y an operating asset 
in exchange for 21 percent of the Y stock. Y is treated as a new 
corporation acquiring all of its assets (and assuming all of its 
liabilities) in exchange for Y stock immediately before the 
termination. Because X and Z are co-transferors that control the 
transferee immediately after the transfer, the transaction qualifies 
under section 351.
    Example 3. X, an S corporation, owns 100 percent of the stock of 
Y, a corporation for which a QSSS election is in effect. X 
distributes all of the Y stock pro rata to its shareholders, and the 
distribution terminates the QSSS election. The transaction can 
qualify as a distribution to which sections 368(a)(1)(D) and 355 
apply if the transaction otherwise satisfies the requirements of 
those sections.
    Example 4. X, an S corporation, owns 100 percent of the stock of 
Y, a corporation for which a QSSS election is in effect. X 
subsequently revokes the QSSS election. Y is treated as a new 
corporation acquiring all of its assets (and assuming all of its 
liabilities) immediately before the revocation from its S 
corporation parent in a deemed exchange for Y stock. On a subsequent 
date, X sells 21 percent of the stock of Y to Z, an unrelated 
corporation, for cash. Assume that under general principles of tax 
law including the step transaction doctrine, the sale is not taken 
into account in determining whether X is in control of Y immediately 
after the deemed exchange of assets for stock. The deemed exchange 
by X of assets for Y stock and the deemed assumption by Y of its 
liabilities qualify under section 351 because, for purposes of that 
section, X is in control of Y within the meaning of section 368(c) 
immediately after the transfer.

    (c) Inadvertent terminations. Relief from the consequences of an 
inadvertent termination of a QSSS election may be available under the 
standards established by the Commissioner for the inadvertent 
termination of an S election under Sec. 1.1362-4.
    (d) Election after QSSS termination--(1) In general. Absent the 
Commissioner's consent, and except as provided in paragraph (d)(2) of 
this section, a corporation whose QSSS election has terminated under 
paragraph (a) of this section (or a successor corporation as defined in 
Sec. 1.1362-5(b)) may not make an S election under section 1362 or have 
a QSSS election under section 1361(b)(3)(B)(ii) made with respect to it 
for five taxable years (as described in section 1361(b)(3)(D)). The 
Commissioner may permit an S election by the corporation or a new QSSS 
election with respect to the corporation before the 5-year period 
expires. The corporation requesting consent to make the election has 
the burden of establishing that, under the relevant facts and 
circumstances, the Commissioner should consent to a new election.
    (2) Exception. If a corporation's QSSS election terminates by 
reason of a disposition of the corporation's stock, the corporation 
may, without requesting the Commissioner's consent, make an S election 
or have a QSSS election made with respect to it before the expiration 
of the five-year period described in section 1361(b)(3)(D) and 
paragraph (d)(1) of this section, provided that--
    (i) Immediately following the disposition of its stock, the 
corporation (or its successor corporation) is otherwise eligible to 
make an S election or have a QSSS election made for it; and
    (ii) The relevant election is made effective immediately following 
the disposition of the stock of the corporation.
    (3) Examples. The following examples illustrate the application of 
this paragraph (d):

    Example 1. Termination upon distribution of QSSS stock to 
shareholders of parent. X, an S corporation, owns Y, a QSSS. X 
distributes all of its Y stock to X's shareholders. The distribution 
terminates the QSSS election because Y no longer satisfies the 
requirements of a QSSS. Assuming Y is otherwise eligible to be 
treated as an S corporation, Y's shareholders may elect to treat Y 
as an S corporation effective on the date of the stock distribution 
without requesting the Commissioner's consent.
    Example 2. Sale of 100 percent of QSSS stock. X, an S 
corporation, owns Y, a QSSS. X sells 100 percent of the stock of Y 
to Z, an unrelated S corporation. Z may elect to treat Y as a QSSS 
effective on the date of purchase without requesting the 
Commissioner's consent.


Sec. 1.1361-6  Effective date.

    Except as provided in Sec. 1.1361-4(a)(5)(i), the provisions of 
Secs. 1.1361-2 through 1.1361-5 apply to taxable years beginning on or 
after the date that final regulations are published in the Federal 
Register.
    Par. 5. Amend Sec. 1.1362-0 as follows:
    1. Add an entry for Sec. 1.1362-2(b)(4).
    2. Add entries for Sec. 1.1362-8.
    The additions read as follows:


Sec. 1.1362-0  Table of contents.

* * * * *

Section 1.1362-2  Termination of Election

* * * * *
    (b) * * *
    (4) Termination when stock transferred to another S corporation.
* * * * *

Section 1.1362-8  Dividends Received From Affiliated Subsidiaries

    (a) In general.
    (b) Determination of active or passive earnings and profits.
    (1) In general.
    (2) Lower tier subsidiaries.
    (3) De minimis exception.
    (4) Special rules for earnings and profits accumulated by a C 
corporation prior to 80 percent acquisition.
    (5) Gross receipts safe harbor.
    (c) Allocating distributions to active or passive earnings and 
profits.
    (1) Distributions from current earnings and profits.
    (2) Distributions from accumulated earnings and profits.
    (3) Adjustments to active earnings and profits.
    (4) Special rules for consolidated groups.
    (d) Examples.
    (e) Effective date.

    Par. 6. Amend Sec. 1.1362-2 as follows:
    1. Amend paragraph (b)(1) by adding a sentence to the end of the 
paragraph.
    2. Add paragraph (b)(4).
    3. Amend paragraph (c)(5)(ii)(C) by adding a sentence to the end of 
the paragraph.
    The additions read as follows:


Sec. 1.1362-2  Termination of election.

* * * * *
    (b) * * *
    (1) * * * See paragraph (b)(4) of this section for a special rule 
applying to the termination of an S election caused by the transfer of 
the corporation's stock to another S corporation.
* * * * *
    (4) Termination when stock transferred to another S corporation. If 
all of the stock of an S corporation (S1) is transferred to another S 
corporation (S2) and a QSSS election for S1 is made effective as of the 
day of the transfer, S1's S election terminates at the same time as the 
deemed liquidation under Sec. 1.1361-4(a)(2). Accordingly, S1 is not 
treated as a C corporation for any period solely because of the 
transfer of S1 stock to S2, an ineligible S corporation shareholder. 
See, however, Sec. 1.338-1(e)(3) if an election under section 338 
(without an election under section 338(h)(10)) is made. This paragraph 
(b)(4) is effective on the date final regulations are published in the 
Federal Register.
    (c) * * *
    (5) * * *
    (ii) * * *
    (C) * * * See Sec. 1.1362-8 for special rules regarding the 
treatment of dividends received by an S corporation from a C 
corporation in which the S corporation holds stock meeting the 
requirements of section 1504(a)(2).
* * * * *
    Par. 7. Add Sec. 1.1362-8 to read as follows:


Sec. 1.1362-8  Dividends received from affiliated subsidiaries.

    (a) In general. For purposes of section 1362(d)(3), if an S 
corporation holds stock in a C corporation meeting the

[[Page 19872]]

requirements of section 1504(a)(2), the term ``passive investment 
income'' does not include dividends from the C corporation to the 
extent those dividends are attributable to the earnings and profits of 
the C corporation derived from the active conduct of a trade or 
business (``active earnings and profits''). For purposes of applying 
section 1362(d)(3), earnings and profits of a C corporation are active 
earnings and profits to the extent that the earnings and profits are 
derived from activities that would not produce passive investment 
income (as defined in section 1362(d)(3)) if the C corporation were an 
S corporation.
    (b) Determination of active or passive earnings and profits--(1) In 
general. An S corporation may use any reasonable method to determine 
the amount of dividends that are not treated as passive investment 
income under section 1362(d)(3)(E). Paragraph (b)(5) of this section 
describes a method of determining the amount of dividends that are not 
treated as passive investment income under section 1362(d)(3)(E) that 
is deemed to be reasonable under all circumstances.
    (2) Lower tier subsidiaries. If a C corporation subsidiary (upper 
tier corporation) holds stock in another C corporation (lower tier 
subsidiary) meeting the requirements of section 1504(a)(2), the upper 
tier corporation's gross receipts attributable to a dividend from the 
lower tier subsidiary are considered to be derived from the active 
conduct of a trade or business to the extent the lower tier 
subsidiary's earnings and profits are attributable to the active 
conduct of a trade or business by the subsidiary under paragraph 
(b)(1), (b)(3), (b)(4), or (b)(5) of this section. For purposes of this 
section, distributions by the lower tier subsidiary will be considered 
attributable to active earnings and profits according to the rule in 
paragraph (c) of this section. This paragraph (b)(2) does not apply to 
any member of a consolidated group (as defined in Sec. 1.1502-1(h)).
    (3) De minimis exception. If less than 10 percent of a C 
corporation's earnings and profits for a taxable year are derived from 
activities that would produce passive investment income if the C 
corporation were an S corporation, all earnings and profits produced by 
the corporation during that taxable year are considered active earnings 
and profits.
    (4) Special rules for earnings and profits accumulated by a C 
corporation prior to 80 percent acquisition. A C corporation may treat 
all earnings and profits accumulated by the corporation in all taxable 
years ending before the S corporation held stock meeting the 
requirements of section 1504(a)(2) as active earnings and profits in 
the same proportion as the C corporation's active earnings and profits 
for the three taxable years ending prior to the time when the S 
corporation acquired 80 percent of the C corporation bears to the C 
corporation's total earnings and profits for those three taxable years.
    (5) Gross receipts safe harbor. A corporation may treat its 
earnings and profits for a year as active earnings and profits in the 
same proportion as the corporation's gross receipts (as defined in 
Sec. 1.1362-2(c)(4)) derived from activities that would not produce 
passive investment income (if the C corporation were an S corporation), 
including those that do not produce passive investment income under 
paragraphs (b)(2) through (b)(4) of this section, bear to the 
corporation's total gross receipts for the year in which the earnings 
and profits are produced.
    (c) Allocating distributions to active or passive earnings and 
profits--(1) Distributions from current earnings and profits. Dividends 
distributed by a C corporation from current earnings and profits are 
attributable to active earnings and profits in the same proportion as 
current active earnings and profits bear to total current earnings and 
profits of the C corporation.
    (2) Distributions from accumulated earnings and profits. Dividends 
distributed by a C corporation out of accumulated earnings and profits 
for a taxable year are attributable to active earnings and profits in 
the same proportion as accumulated active earnings and profits for that 
taxable year bear to total accumulated earnings and profits for that 
taxable year immediately prior to the distribution.
    (3) Adjustments to active earnings and profits. For purposes of 
applying paragraph (c)(1) or (c)(2) of this section to a distribution, 
the active earnings and profits of a corporation shall be reduced by 
the amount of any prior distribution properly treated as attributable 
to active earnings and profits from the same taxable year.
    (4) Special rules for consolidated groups. For purposes of applying 
section 1362(d)(3) and this section to dividends received by an S 
corporation from the common parent of a consolidated group (as defined 
in Sec. 1.1502-1(h)), the following rules apply--
    (i) The current earnings and profits, accumulated earnings and 
profits, and active earnings and profits of the common parent shall be 
determined under the principles of Sec. 1.1502-33 (relating to earnings 
and profits of any member of a consolidated group owning stock of 
another member); and
    (ii) The gross receipts of the common parent shall be the sum of 
the gross receipts of each member of the consolidated group (including 
the common parent), adjusted to eliminate gross receipts from 
intercompany transactions (as defined in Sec. 1.1502-13(b)(1)(i)).
    (d) Examples. The following examples illustrate the principles of 
this section:

    Example 1. (i) X, an S corporation, owns 85 percent of the one 
class of stock of Y. On December 31, 1998, Y declares a dividend of 
$100 ($85 to X), which is equal to Y's current earnings and profits. 
In 1998, Y has total gross receipts of $1,000, $200 of which would 
be passive investment income if Y were an S corporation.
    (ii) One-fifth ($200/$1,000) of Y's gross receipts for 1998 is 
attributable to activities that would produce passive investment 
income. Accordingly, one-fifth of the $100 of earnings and profits 
is passive, and $17 (\1/5\ of $85) of the dividend from Y to X is 
passive investment income.
    Example 2. (i) The facts are the same as in Example 1, except 
that Y owns 90 percent of the stock of Z. Y and Z do not join in the 
filing of a consolidated return. In 1998, Z has gross receipts of 
$15,000, $12,000 of which are derived from activities that would 
produce passive investment income. On December 31, 1998, Z declares 
a dividend of $1,000 ($900 to Y) from current earnings and profits.
    (ii) Four-fifths ($12,000/15,000) of the dividend from Z to Y 
are attributable to passive earnings and profits. Accordingly, $720 
(\4/5\ of $900) of the dividend from Z to Y is considered gross 
receipts from an activity that would produce passive investment 
income. The $900 dividend to Y gives Y a total of $1,900 ($1,000 + 
$900) in gross receipts, $920 ($200 + $720) of which is attributable 
to passive investment income-producing activities. Under these 
facts, $41 ($920/1,900 of $85) of Y's distribution to X is passive 
investment income to X.

    (e) Effective date. This section applies to dividends received in 
taxable years beginning on or after the date that final regulations are 
published in the Federal Register.


Sec. 1.1368-0  [Amended]

    Par. 8. Amend Sec. 1.1368-0 in the entry for Sec. 1.1368-2(d)(2) by 
revising ``Reorganizations'' to read ``Liquidations and 
reorganizations''.


Sec. 1.1368-2  [Amended]

    Par. 9. Amend Sec. 1.1368-2 in paragraph (d)(2) by revising 
``Reorganizations'' to read ``Liquidations and reorganizations'' in the 
heading and by revising ``section 381(a)(2)'' to read ``section 
381(a)'' in the first sentence.
    Par. 10. Amend Sec. 1.1374-8 by adding two sentences to the end of 
paragraph (b) to read as follows:

[[Page 19873]]

Sec. 1.1374-8  Section 1374(d)(8) transactions.

* * * * *
    (b) Separate determination of tax. * * * If a C corporation elects 
to be treated as an S corporation, and also makes a QSSS election under 
section 1361(b)(3) (effective on the same date as the S election) with 
respect to a subsidiary, the assets held by the QSSS at the time of the 
QSSS election will be treated as assets held by the parent when it 
became an S corporation. The preceding sentence applies to QSSS 
elections made after the date final regulations are published in the 
Federal Register.
* * * * *
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
[FR Doc. 98-10373 Filed 4-21-98; 8:45 am]
BILLING CODE 4830-01-U