[Federal Register Volume 71, Number 164 (Thursday, August 24, 2006)]
[Proposed Rules]
[Pages 50007-50009]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-14004]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-158677-05]
RIN 1545-BF24


Effect of Election on Corporation

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Proposed regulations and notice of public hearing.

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SUMMARY: These proposed regulations clarify that if a bank is an S 
corporation within the meaning of section 1361(a)(1), its status as an 
S corporation does not affect the applicability of the special rules 
for banks under the Internal Revenue Code.

DATES: Written or electronic comments and requests for a public hearing 
must be received by November 22, 2006.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-158677-05), Room 
5203, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington DC 20044. Alternatively, taxpayers may submit comments 
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-158677-05). If a public hearing is requested, the public hearing 
will be held in the Auditorium, New Carrollton Federal Building, 5000 
Ellin Road, Lanham, MD.

[[Page 50008]]


FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Laura Fields at (202) 622-3050; concerning submissions and requests for 
a hearing, [email protected], (202) 622-7180 (not 
toll free numbers).

SUPPLEMENTARY INFORMATION:

Background

    Section 1361(b)(2) describes corporations that are ineligible to be 
S corporations (ineligible corporations). Until 1996, section 
1361(b)(2)(A) treated as ineligible corporations financial institutions 
to which section 585 applied (without regard to section 585(c)), which 
included primarily all banks within the meaning of section 581 (section 
581 banks). In 1996, Congress revised section 1361(b)(2)(A) to allow 
certain banks to be S corporations. Under current section 
1361(b)(2)(A), a section 581 bank is eligible to be an S corporation 
only if it does not use the reserve method of accounting for bad debts 
described in section 585, which is otherwise available to certain 
banks.
    The proposed regulations address issues regarding the application, 
to S corporation banks, of the special rules applicable to banks under 
the Internal Revenue Code (Code) (the special bank rules).
    First, questions have arisen regarding whether certain language in 
section 1363(b), enacted in 1982, may prevent S corporation banks from 
being subject to the special bank rules. Subject to certain exceptions, 
the general rule of section 1363(b) requires that ``[t]he taxable 
income of an S corporation shall be computed in the same manner as in 
the case of an individual * * *.'' The special bank rules, however, 
apply only to corporations, because section 581 banks must be 
corporations for Federal tax purposes.
    Second, questions have also arisen regarding the impact of section 
1363(b)(4), which also pre-dates the 1996 legislation allowing banks to 
be S corporations. Section 1363(b)(4) applies section 291 to certain S 
corporations even if they would not otherwise be subject to it. 
Specifically, section 1363(b)(4) provides, ``Section 291 shall apply if 
the S corporation (or any predecessor) was a C corporation for any of 
the 3 immediately preceding taxable years.'' Section 291(a)(3) and 
(e)(1)(B) is a special bank rule that reduces by 20 percent the amount 
allowable as a deduction with respect to the portion of a bank's 
interest expense that is allocable to qualified tax-exempt obligations 
as defined in section 265(b)(3)(B). This portion of a bank's interest 
expense is the amount that bears the same ratio to the taxpayer's 
interest expense as the taxpayer's average adjusted bases of those tax-
exempt obligations bears to the taxpayer's average adjusted bases of 
all its assets.

Explanation of Provisions

    The proposed regulations clarify that neither the general rule of 
section 1363(b), nor paragraph (4) of that section, prevents the 
special bank rules from applying to banks that are S corporations. When 
Congress allowed banks to become S corporations, it did not intend to 
deny them the benefits, or shield them from the burdens, ordinarily 
applicable to banks. This is reflected in the existing regulations 
under section 1361. See Sec.  1.1361-4(a)(3) (``If an S corporation is 
a bank, or if an S corporation makes a valid QSub 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 * * * (except as other published guidance may 
apply section 265(b) and section 291(a)(3) and (e)(1)(B) not only to 
the bank parent or bank subsidiary but also to any QSub * * *).'').
    The only special bank rule that Congress made inapplicable to S 
corporation banks was the section 585 reserve method for bad debts. The 
restriction in section 1361(b)(2)(A) regarding use of that method would 
be superfluous if the special bank rules were rendered inapplicable by 
section 1363(b). The section 585 reserve method is available only to 
banks, and those banks must be corporations. In amending section 
1361(b)(2)(A), therefore, Congress did not expect the pre-existing 
general rule of section 1363(b) to prevent the special bank rules from 
applying to S corporation banks. The section 585 reserve method is a 
special bank rule, and it would have been unnecessary for Congress to 
make that rule inapplicable to S corporation banks if the special bank 
rules did not apply to them generally because of section 1363(b).
    Section 1363(b)(4) historically subjected certain nonbank S 
corporations to section 291 if the S corporation (or any predecessor) 
was a C corporation for any of the 3 immediately preceding taxable 
years, even if section 291 would not otherwise apply. Section 
1363(b)(4) does not provide that section 291 shall not apply in any 
other circumstance. When Congress enacted section 1363(b)(4) in 1984, 
banks could not yet be S corporations, and thus section 1363(b)(4) had 
no applicability to section 291(a)(3) and (e)(1)(B) (which applies only 
to banks). After the 1996 amendments to subchapter S, the general rule 
of section 1363(b) does not prevent the special bank rules from 
applying to S corporations. Thus, if section 291(a)(3) and (e)(1)(B) 
applies to an S corporation bank in the absence of section 1363(b)(4), 
section 1363(b)(4) does not affect the continuing application to that 
bank of section 291(a)(3) and (e)(1)(B).

Effective Date

    These regulations are proposed to apply to taxable years of 
corporations beginning on or after August 24, 2006. No inference should 
be drawn from this effective date regarding prior taxable years.

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 has also 
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 regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. 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 its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The Treasury Department and the IRS specifically request 
comments on the clarity of the proposed rules and how they can be made 
easier to understand. All comments will be available for public 
inspection and copying. A public hearing will be scheduled if requested 
in writing by any person that timely submits written comments. 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 proposed regulations is Laura Fields, 
Office of the Associate Chief Counsel (Passthroughs and Special 
Industries), IRS. However, other personnel from the

[[Page 50009]]

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. Paragraph (b) of Sec.  1.1363-1 is amended as follows:
    1. Paragraph (b) is revised.
    2. Paragraph (d) is amended by removing the language ``This section 
applies'' and adding the language ``This section (except for paragraph 
(b)(2) of this section) applies'' in its place.
    3. The paragraph heading for (d) is revised.
    4. A sentence is added at the end of paragraph (d).
    The revision and additions read as follows:


Sec.  1.1363-1  Effect of election on corporation.

* * * * *
    (b) Computation of corporate taxable income--(1) In general. The 
taxable income of an S corporation is computed as described in section 
1363(b).
    (2) Treatment of banks. Section 1363(b) (concerning computation of 
an S corporation's taxable income) does not affect an S corporation's 
status as a bank within the meaning of section 581, and it does not 
prevent the application to such an S corporation bank of any special 
rule applicable to banks under the Internal Revenue Code, such as 
sections 582(c) and 291(a)(3) and (e)(1)(B). See Sec.  1.1361-4(a)(3) 
regarding application under subchapter S of the special rules 
applicable to banks. Further, section 1363(b)(4) causes section 291 to 
apply to an S corporation if the S corporation (or any predecessor) was 
a C corporation for any of the three immediately preceding taxable 
years, but section 1363(b)(4) does not prevent section 291 from 
applying to an S corporation to which section 291 otherwise applies.
    (3) Example. The following example illustrates the application of 
this paragraph (b)(2):

    Example. (i) Facts. X is described in section 581 and is an S 
corporation. Neither X nor any of X's predecessors was a C 
corporation for any of the three immediately preceding taxable 
years. During the current taxable year, X sold debt instrument DI at 
a loss. At the time of the sale, X's holding period in DI was more 
than one year and, but for section 582(c), the loss on the sale of 
DI would be capital. During the same taxable year, X held debt 
instrument QD, which it acquired after August 7, 1986. QD is a 
qualified tax-exempt obligation within the meaning of section 
265(b)(3)(B).
    (ii) X is described in section 581, and section 1363(b) does not 
affect X's status under section 581. Accordingly, X qualifies as a 
bank within the meaning of section 581. Also, section 1363(b) does 
not prevent any special rule applicable to banks under the Internal 
Revenue Code from applying to X. Thus, section 582(c), which is a 
special rule applicable to banks, imposes ordinary character on the 
loss that X recognized from the sale of debt instrument DI.
    (iii) Because QD is a qualified tax-exempt obligation that was 
acquired after August 7, 1986, section 265(b)(3)(A) causes QD to be 
treated for purposes of section 291(e)(1)(B) as having been acquired 
on that date. For that reason, if section 291(e)(1)(B) applies to X, 
a portion of the interest expense that X incurs during the taxable 
year is interest on indebtedness incurred or continued to purchase 
or carry qualified tax-exempt obligations and thus is a financial 
institution preference item. Section 291(a)(3) and (e)(1)(B) is a 
special rule applicable to banks, and thus section 1363(b) does not 
prevent section 291(a)(3) and (e)(1)(B) from applying to X unless 
some other authority prevents that result.
    (iv) Section 1363(b)(4) does not prevent section 291 from 
applying in situations in which section 291 otherwise applies. 
Therefore, section 1363(b)(4) does not prevent section 291(a)(3) and 
(e)(1)(B) from applying to X. It is irrelevant that neither X nor 
any predecessor of X was a C corporation for any of the three 
immediately preceding taxable years. X's status as a bank under 
section 581 causes section 291(a)(3) and (e)(1)(B) to apply.
* * * * *
    (d) Effective dates. * * * Paragraph (b)(2) of this section applies 
to taxable years of corporations beginning on or after August 24, 2006.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. E6-14004 Filed 8-23-06; 8:45 am]
BILLING CODE 4830-01-P