[Federal Register Volume 69, Number 122 (Friday, June 25, 2004)]
[Proposed Rules]
[Pages 35544-35547]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-14391]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-131486-03]
RIN 1545-BC29


Adjustment To Net Unrealized Built-in Gain

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations under section 1374 
that provide for an adjustment to the amount that may be subject to tax 
under section 1374 in certain cases in which an S corporation acquires 
assets from a C corporation in an acquisition to which section 
1374(d)(8) applies. These proposed regulations provide guidance to 
certain S corporations that acquire assets from a C corporation in a 
carryover basis transaction.

DATES: Written or electronic comments must be received by September 23, 
2004.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-131486-03), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
131486-03), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the IRS 
Internet site at http://www.irs.gov/regs or via the Federal eRulemaking 
Portal at http://www.regulations.gov (IRS--REG-131486-03). The public 
hearing will be held in the IRS Auditorium, Internal Revenue Building, 
1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Jennifer Sledge, (202) 622-7750; concerning submissions of comments, 
Treena Garrett, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background and Explanation of Provisions

    Section 1374 of the Internal Revenue Code of 1986 (Code) generally 
imposes a corporate level tax on the income or gain of an S corporation 
that formerly was a C corporation to the extent the income or gain is 
attributable to the period during which the corporation was a C 
corporation. Congress amended

[[Page 35545]]

section 1374 to provide this rule as part of the Tax Reform Act of 
1986, which repealed the General Utilities doctrine. Under the General 
Utilities doctrine, a C corporation, in certain cases, could distribute 
appreciated assets to its shareholders, or sell appreciated assets and 
distribute the sale proceeds in connection with a complete liquidation 
to its shareholders, without recognizing gain. Section 1374 prevents a 
corporation from circumventing General Utilities repeal by converting 
to S corporation status before distributing its appreciated assets to 
its shareholders, or selling its appreciated assets and distributing 
the sale proceeds in connection with a complete liquidation to its 
shareholders.
    Specifically, section 1374 imposes a tax on an S corporation's net 
recognized built-in gain attributable to assets that it held on the 
date it converted from a C corporation to an S corporation for the 10-
year recognition period beginning on the first day the corporation is 
an S corporation. Under section 1374, the total amount subject to tax 
is limited to the S corporation's net unrealized built-in gain (NUBIG), 
which is the ``aggregate net built-in gain of the corporation at the 
time of conversion to S corporation status.'' See H.R. Conf. Rep. No. 
99-841, at II-203 (1986). Section 1374 also imposes a tax on an S 
corporation's net recognized built-in gain attributable to assets that 
it acquired in a carryover basis transaction from a C corporation for 
the 10-year recognition period beginning on the day of the carryover 
basis transaction. The legislative history of section 1374 provides 
that each acquisition of assets from a C corporation is subject to a 
separate determination of the amount of net unrealized built-in gain 
and is subject to a separate 10-year recognition period. See H.R. Rep. 
No. 100-795, at 63 (1988).
    Sections 337(d) and 1374(e) authorize the Secretary of the Treasury 
to prescribe regulations as necessary to carry out the purposes of 
General Utilities repeal generally and section 1374 specifically. The 
Treasury Department and the IRS have promulgated regulations consistent 
with these provisions. See, e.g., Sec. Sec.  1.337(d)-4 through 
1.337(d)-7, 1.1374-1 through 1.1374-10.
    Under Sec.  1.1374-3, an S corporation's NUBIG generally is the 
amount of gain the S corporation would recognize on the conversion date 
if it sold all of its assets at fair market value to an unrelated party 
that assumed all of its liabilities on that date. Consistent with the 
legislative history of section 1374, section 1374(d)(8) and Sec.  
1.1374-8 require a separate determination of the amount subject to tax 
under section 1374 for the pool of assets the S corporation held on the 
date it converted to C status and each pool of assets acquired in a 
carryover basis transaction from a C corporation.
    Under the current rules, therefore, if X, a C corporation, elects 
to be an S corporation when it owns all of the stock of Y, a C 
corporation, X's NUBIG will reflect the built-in gain or built-in loss 
in the Y stock. That built-in gain or built-in loss may be duplicative 
of the built-in gain or built-in loss in Y's assets. If Y later 
transfers its assets to X in a liquidation to which sections 332 and 
337(a) apply, the built-in gain and built-in loss in Y's assets may be 
reflected twice: once in the NUBIG attributable to the assets X owned 
on the date of its conversion (including the stock of Y) and a second 
time in the NUBIG attributable to Y's former assets acquired by X in 
the liquidation of Y. A similar result would obtain if, on the date of 
its conversion to an S corporation, X owned less than 80 percent of the 
stock of Y and later acquired the assets of Y in a reorganization to 
which section 368(a) applies. These results are inconsistent with the 
fact that a liquidation to which sections 332 and 337(a) apply, and the 
acquisition of the assets of a corporation some or all of the stock of 
which is owned by the acquiring corporation in a reorganization under 
section 368(a), generally have the effect of eliminating the built-in 
gain or built-in loss in the redeemed or canceled stock of the 
liquidated or target corporation.
    In the course of developing these proposed regulations, the 
Treasury Department and the IRS considered a number of approaches to 
address the issue raised by the situations described above. In 
particular, the Treasury Department and the IRS considered adopting an 
approach that would provide for a single determination of NUBIG for all 
of the assets of an S corporation and, thus, a single determination of 
the amount subject to tax under section 1374. While this approach may 
have produced results similar to those that would have been produced 
had the S corporation remained a C corporation and acquired the assets 
of another C corporation, it was rejected because such an approach 
appears to be inconsistent with the legislative history of section 
1374, which seems to mandate a separate determination of tax for each 
pool of assets. See H.R. Rep. No. 100-795, at 63.
    Instead, these regulations adopt an approach that adjusts 
(increases or decreases) the NUBIG of the pool of assets that included 
the stock of the liquidated or acquired C corporation to reflect the 
extent to which the built-in gain or built-in loss inherent in the 
redeemed or canceled C corporation stock at the time the pool of assets 
became subject to the tax under section 1374 has been eliminated from 
the corporate tax system in the liquidation or reorganization. These 
proposed regulations provide that, if section 1374(d)(8) applies to an 
S corporation's acquisition of assets, some or all of the stock of the 
C corporation from which such assets were acquired was taken into 
account in the computation of NUBIG for a pool of assets of the S 
corporation, and some or all of such stock is redeemed or canceled in 
such transaction, subject to certain limitations, the NUBIG of the pool 
of assets that included the C corporation stock redeemed or canceled in 
the transaction (other than stock with respect to which a loss under 
section 165 is claimed) is adjusted to eliminate any effect any built-
in gain or built-in loss in the redeemed or canceled C corporation 
stock had on the initial computation of NUBIG for that pool of assets. 
For this purpose, stock that has an adjusted basis that is determined 
(in whole or in part) by reference to the adjusted basis of any other 
asset held by the S corporation as of the first day of the recognition 
period (i.e., stock described in section 1374(d)(6)) is treated as 
taken into account in the computation of the NUBIG for the pool of 
assets of the S corporation.
    Adjustments to NUBIG under these proposed regulations, however, are 
subject to two limitations. First, the NUBIG is only adjusted to 
reflect the amount of the built-in gain or built-in loss that was 
inherent in the redeemed or canceled stock at the time the pool of 
assets became subject to tax under section 1374 that has not resulted 
in recognized built-in gain or recognized built-in loss at any time 
during the recognition period, including on the date of the acquisition 
to which section 1374(d)(8) applies. For example, suppose that on the 
date X, a C corporation, converts to S corporation status, it owns the 
stock of Y, which has a basis of $0 and a value of $100. The gain 
inherent in the Y stock contributes $100 to X's NUBIG. During the 
recognition period and prior to the liquidation of Y, Y distributes $20 
to X in a distribution to which section 301(c)(3) applies. That amount 
is recognized built-in gain under section 1374(d)(3). If Y later 
distributes its assets to X in a distribution to which sections 332 and 
337(a) apply, pursuant to these regulations, X must adjust its

[[Page 35546]]

original NUBIG to reflect the elimination of the Y stock. X will reduce 
that NUBIG by $80, the original built-in gain in such stock ($100) 
minus the recognized built-in gain with respect to such stock during 
the recognition period ($20).
    Second, an adjustment cannot be made if it is duplicative of 
another adjustment to the NUBIG for a pool of assets. This rule is 
intended to prevent more than one adjustment to the NUBIG of a pool of 
assets for the same built-in gain or built-in loss stock.
    Any adjustment to NUBIG under these proposed rules will only affect 
computations of the amount subject to tax under section 1374 for 
taxable years that end on or after the date of the liquidation or 
reorganization. It will not affect computations of the amount subject 
to tax under section 1374 for taxable years that end before the date of 
the liquidation or reorganization.
    The Treasury Department and IRS request comments regarding whether 
the rule proposed in these regulations should be expanded to apply in 
other cases in which the stock basis that was taken into account in the 
computation of NUBIG is eliminated. This may occur, for example, where 
an S corporation owns stock of a C corporation on the date of its 
conversion to an S corporation and later distributes the stock of the C 
corporation in a distribution to which section 355 applies. In 
addition, the Treasury Department and IRS request comments concerning 
whether there are any situations other than those identified in these 
proposed regulations in which adjustments to NUBIG should be less than 
the built-in gain or the built-in loss in the redeemed or canceled 
stock as of the beginning of the recognition period.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
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 regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Therefore, a Regulatory Flexibility Analysis is not required. 
Pursuant to section 7805(f) of the Code, these proposed regulations 
will be submitted to the Chief Counsel for Advocacy of the Small 
Business Administration for comment on their impact on small business.

Public Comment

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

Drafting Information

    The principal author of these regulations is Marie Byrne of the 
Office of Associate Chief Counsel (Corporate). Other personnel from 
Treasury and the IRS 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. Section 1.1374-3 is amended by:
    1. Revising paragraph (b).
    2. Adding paragraph (c).
    The revision and addition read as follows:


Sec.  1.1374-3  Net unrealized built-in gain.

* * * * *
    (b) Adjustment to net unrealized built-in gain--(1) In general. If 
section 1374(d)(8) applies to an S corporation's acquisition of assets, 
some or all of the stock of the corporation from which such assets were 
acquired was taken into account in the computation of the net 
unrealized built-in gain for a pool of assets of the S corporation, and 
some or all of such stock is redeemed or canceled in such transaction, 
then, subject to the limitations of paragraph (b)(2) of this section, 
such net unrealized built-gain is adjusted to eliminate any effect any 
built-in gain or built-in loss in the redeemed or canceled stock (other 
than stock with respect to which a loss under section 165 is claimed) 
had on the initial computation of net unrealized built-in gain for that 
pool of assets. For purposes of this paragraph, stock described in 
section 1374(d)(6) shall be treated as taken into account in the 
computation of the net unrealized built-in gain for a pool of assets of 
the S corporation.
    (2) Limitations on adjustment--(i) Recognized built-in gain or 
loss. Net unrealized built-in gain for a pool of assets of the S 
corporation is only adjusted under paragraph (b)(1) of this section to 
reflect built-in gain or built-in loss in the redeemed or canceled 
stock that has not resulted in recognized built-in gain or recognized 
built-in loss during the recognition period.
    (ii) Anti-duplication rule. Paragraph (b)(1) of this section shall 
not be applied to duplicate an adjustment to the net unrealized built-
in gain for a pool of assets made pursuant to paragraph (b)(1) of this 
section.
    (3) Effect of adjustment. Any adjustment to the net unrealized 
built-in gain made pursuant to this paragraph (b) only affects 
computations of the amount subject to tax under section 1374 for 
taxable years that end on or after the date of the acquisition to which 
section 1374(d)(8) applies.
    (4) Pool of assets. For purposes of this section, a pool of assets 
means--
    (i) The assets held by the corporation on the first day it became 
an S corporation, if the corporation was previously a C corporation; or
    (ii) The assets the S corporation acquired from a C corporation in 
a section 1374(d)(8) transaction.
    (c) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Computation of net unrealized built-in gain. (i)(A) 
X, a calendar year C corporation using the cash method, elects to 
become an S corporation on January 1, 1996. On December 31, 1995, X 
has assets and liabilities as follows:

------------------------------------------------------------------------
                     Assets                           FMV        Basis
------------------------------------------------------------------------
Factory.........................................    $500,000    $900,000
Accounts Receivable.............................     300,000           0
Goodwill........................................     250,000           0
                                                 -------------
    Total.......................................   1,050,000     900,000
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------------------------------------------------------------------------
                         Liabilities                            Amount
------------------------------------------------------------------------
Mortgage....................................................    $200,000
Accounts Payable............................................     100,000
                                                             -----------
    Total...................................................     300,000
------------------------------------------------------------------------

    (B) Further, X must include a total of $60,000 in taxable income 
in 1996, 1997, and 1998 under section 481(a).
    (ii) If, on December 31, 1995, X sold all its assets to a third 
party that assumed all its liabilities, X's amount realized would be 
$1,050,000 ($750,000 cash received + $300,000 liabilities assumed = 
$1,050,000). Thus, X's net unrealized built-in gain is determined as 
follows:


[[Page 35547]]


Amount realized: $1,050,000
Deduction allowed: (100,000)
Basis of X's assets: (900,000)
Section 481 adjustments: 60,000
Net unrealized built-in gain: 110,000

    Example 2. Adjustment to net unrealized built-in gain for built-
in gain in eliminated C corporation stock. (i) X, a calendar year C 
corporation, elects to become an S corporation effective January 1, 
2005. On that date, X's assets (the first pool of assets) have a net 
unrealized built-in gain of $15,000. Among the assets in the first 
pool of assets is all of the outstanding stock of Y, a C 
corporation, with a fair market value of $33,000 and an adjusted 
basis of $18,000. On March 1, 2009, X sells an asset that it owned 
on January 1, 2005, and as a result has $10,000 of recognized built-
in gain. X has had no other recognized built-in gain or built-in 
loss. X's taxable income limitation for 2009 is $50,000. Effective 
June 1, 2009, X elects under section 1362 to treat Y as a qualified 
subchapter S subsidiary (QSub). The election is treated as a 
transfer of Y's assets to X in a liquidation to which sections 332 
and 337(a) apply.
    (ii) Under paragraph (b) of this section, the net unrealized 
built in-gain of the first pool of assets is adjusted to account for 
the elimination of the Y stock in the liquidation. The net 
unrealized built-in gain of the first pool of assets, therefore, is 
decreased by $15,000, the amount by which the fair market value of 
the Y stock exceeded its adjusted basis as of January 1, 2005. 
Accordingly, for taxable years ending after June 1, 2009, the net 
unrealized built-in gain of the first pool of assets is $0.
    (iii) Under Sec.  1.1374-2(a), X's net recognized built-in gain 
for any taxable year equals the least of X's pre-limitation amount, 
taxable income limitation, and net unrealized built-in gain 
limitation. In 2009, X's pre-limitation amount is $10,000, X's 
taxable income limitation is $50,000, and X's net unrealized built-
in gain limitation is $0. Because the net unrealized built-in gain 
of the first pool of assets has been adjusted to $0, despite the 
$10,000 of recognized built-in gain in 2009, X has $0 net recognized 
built-in gain for the taxable year ending on December 31, 2009.
    Example 3. Adjustment to net unrealized built-in gain for built-
in loss in eliminated C corporation stock. (i) X, a calendar year C 
corporation, elects to become an S corporation effective January 1, 
2005. On that date, X's assets (the first pool of assets) have a net 
unrealized built-in gain of negative $5,000. Among the assets in the 
first pool of assets is 10 percent of the outstanding stock of Y, a 
C corporation, with a fair market value of $18,000 and an adjusted 
basis of $33,000. On March 1, 2009, X sells an asset that it owned 
on January 1, 2005, resulting in $8,000 of recognized built-in gain. 
X has had no other recognized built-in gains or built-in losses. X's 
taxable income limitation for 2009 is $50,000. On June 1, 2009, Y 
transfers its assets to X in a reorganization under section 
368(a)(1)(C).
    (ii) Under paragraph (b) of this section, the net unrealized 
built in-gain of the first pool of assets is adjusted to account for 
the elimination of the Y stock in the reorganization. The net 
unrealized built-in gain of the first pool of assets, therefore, is 
increased by $15,000, the amount by which the adjusted basis of the 
Y stock exceeded its fair market value as of January 1, 2005. 
Accordingly, for taxable years ending after June 1, 2009, the net 
unrealized built-in gain of the first pool of assets is $10,000.
    (iii) Under Sec.  1.1374-2(a), X's net recognized built-in gain 
for any taxable year equals the least of X's pre-limitation amount, 
taxable income limitation, and net unrealized built-in gain 
limitation. In 2009, X's pre-limitation amount is $8,000 and X's 
taxable income limitation is $50,000. The net unrealized built-in 
gain of the first pool of assets has been adjusted to $10,000, so 
X's net unrealized built-in gain limitation is $10,000. X, 
therefore, has $8,000 net recognized built-in gain for the taxable 
year ending on December 31, 2009. X's net unrealized built-in gain 
limitation for 2010 is $2,000.
    Example 4. Adjustment to net unrealized built-in gain in case of 
prior gain recognition. (i) X, a calendar year C corporation, elects 
to become an S corporation effective January 1, 2005. On that date, 
X's assets (the first pool of assets) have a net unrealized built-in 
gain of $30,000. Among the assets in the first pool of assets is all 
of the outstanding stock of Y, a C corporation, with a fair market 
value of $45,000 and an adjusted basis of $10,000. Y has no current 
or accumulated earnings and profits. On April 1, 2007, Y distributes 
$18,000 to X, $8,000 of which is treated as gain to X from the sale 
or exchange of property under section 301(c)(3). That $8,000 is 
recognized built-in gain to X under section 1374(d)(3), and results 
in $8,000 of net recognized built-in gain to X for 2007. X's net 
unrealized built-in gain limitation for 2008 is $22,000. On June 1, 
2009, Y transfers its assets to X in a liquidation to which sections 
332 and 337(a) apply.
    (ii) Under paragraph (b) of this section, the net unrealized 
built in-gain of the first pool of assets is adjusted to account for 
the elimination of the Y stock in the liquidation. The net 
unrealized built-in gain of that pool of assets, however, can only 
be adjusted to reflect the amount of built-in gain that was inherent 
in the Y stock on January 1, 2005 that has not resulted in 
recognized built-in gain during the recognition period. In this 
case, therefore, the net unrealized built-in gain of the first pool 
of assets cannot be reduced by more than $27,000 ($35,000, the 
amount by which the fair market value of the Y stock exceeded its 
adjusted basis as of January 1, 2005, minus $8,000, the recognized 
built-in gain with respect to the stock during the recognition 
period). Accordingly, for taxable years ending after June 1, 2009, 
the net unrealized built-in gain of the first pool of assets is 
$3,000. The net unrealized built-in gain limitation for 2009 is $0.

    Par. 3. Paragraph (a) of Sec.  1.1374-10 is revised to read as 
follows:


Sec.  1.1374-10  Effective date and additional rules.

    (a) In general. Sections 1.1374-1 through 1.1374-9, other than 
Sec.  1.1374-3(b) and (c) Examples 2 through 4, apply for taxable years 
ending on or after December 27, 1994, but only in cases where the S 
corporation's return for the taxable year is filed pursuant to an S 
election or a section 1374(d)(8) transaction occurring on or after 
December 27, 1994. Section 1.1374-3(b) and (c) Examples 2 through 4 
apply for taxable years beginning after the date these regulations are 
published as final regulations in the Federal Register.
* * * * *

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 04-14391 Filed 6-24-04; 8:45 am]
BILLING CODE 4830-01-P