Td 8852

Section 1288.—Treatment of
Original Issue Discounts on TaxExempt Obligations

SUPPLEMENTARY INFORMATION:

Explanation of Revisions and
Summary of Comments

Paperwork Reduction Act

The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month
of January 2000. See Rev. Rul. 2000–1, page 250.

The collection of information contained in these final regulations has been
reviewed and approved by the Office of
Management and Budget in accordance
with the Paperwork Reduction Act of
1995 (44 U.S.C. 3507) under control
number 1545-1613. Responses to this
collection of information are mandatory.
An agency may not conduct or sponsor,
and a person is not required to respond to,
a collection of information unless the collection of information displays a valid
control number.
The burden for this requirement is reflected in the burden of Form 1040, “U.S.
Individual Income Tax Return”, and Form
1120S, “U.S. Income Tax Return for an S
corporation”.
Suggestions for reducing this burden
should be sent to the Internal Revenue
Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224,
and to the Office of Management and
Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.
Books or records relating to this collection of information must be retained as
long as their contents may become material in the administration of any internal
revenue law. Generally, tax returns and
tax return information are confidential, as
required by 26 U.S.C. 6103.

1. Aggregation of deductions from an S
corporation with deductions from other
sources.
The proposed regulations provide that a
shareholder of an S corporation must aggregate its separate deductions and exclusions with the shareholder’s pro rata share
of the S corporation’s separately stated
deductions or exclusions in determining
the allowable amount of any deduction or
exclusion that is subject to a limitation in
the Code.
The proposed regulations provide an
example of this rule for property expensed under section 179. A commentator suggested that the example implies
that a shareholder must expense its pro
rata share of section 179 expense from the
S corporation before it can expense any
separately acquired property.
The example is intended to illustrate
that a shareholder may expense only up to
the amount allowable under section 179
in any given year regardless of whether
the property is owned individually or
through an S corporation. The example is
not intended to imply that a shareholder
must elect to expense property held in an
S corporation before it can expense any
separately acquired property. However,
once an S corporation elects to expense
property under section 179, a shareholder
will generally elect to expense personal
property only to the extent the shareholder’s pro rata share of the corporation’s section 179 expense does not exceed the shareholder ’s individual
limitation under section 179(b). Accordingly, no modifications have been made
to the example in the final regulations.
The commentator also requested that
the final regulations provide additional
examples that illustrate the aggregation of
the shareholder’s pro rata share of deductions and exclusions from an S corporation with deductions and exclusions from
other sources and the operation of any
limitations on those aggregated deductions and exclusions. Specifically, the
commentator requested that the final regulations include an example in which the
shareholder’s aggregate section 179 expenses from several passthrough sources
exceeds the maximum section 179 expense allowable. The allocation of the
section 179 expense among the various

Section 1366.—Pass-Thru of
Items to Shareholders
26 CFR 1.1366–1: Shareholder’s share of items of
an S corporation.

T.D. 8852
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Passthrough of Items of an S
Corporation to its Shareholders
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains final
regulations relating to the passthrough of
items of an S corporation to its shareholders,
the adjustments to the basis of stock of the
shareholders, and the treatment of distributions by an S corporation. Changes to the
applicable law were made by the Subchapter
S Revision Act of 1982, the Tax Reform Act
of 1984, the Tax Reform Act of 1986, the
Technical and Miscellaneous Revenue Act
of 1988, and the Small Business Job Protection Act of 1996. These regulations provide
the public with guidance needed to comply
with the applicable law and will affect S corporations and their shareholders.
DATES: Effective Date: These regulations are effective August 18, 1998.
Applicability Dates: For dates of applicability, see §1.1366-5, §1.1367-3,
and §1.1368-4, plus Transition Rule and
Effective Date under
SUPPLEMENTARY INFORMATION.
FOR FURTHER INFORMATION
CONTACT: Concerning the regulations
under section 1366, Martin Schäffer,
Deane M. Burke, or David Shulman
(202) 622-3070; concerning the regulations under sections 1367 and 1368,
Brenda Stewart, (202) 622-3120.

2000–2 I.R.B.

Background
This document amends 26 CFR part 1 to
provide additional rules under sections 1366,
1367, and 1368 relating to the passthrough
of items of an S corporation to its shareholders, the adjustments to the basis of stock of
the shareholders, and the treatment of distributions by an S corporation.
On August 18, 1998, the IRS published
in the Federal Register (63 FR 44181), a
notice of proposed rulemaking (REG209446-82) regarding sections 1366,
1367, and 1368. Comments responding
to the proposed regulations were received. The public hearing was canceled
because there were no requests to speak.
After considering the comments received,
the proposed regulations are adopted as
amended by this Treasury decision.

253

January 10, 2000

sources is more appropriately addressed
in the regulations under section 179 and is
beyond the scope of these regulations.
Accordingly, the final regulations do not
adopt this comment.
2. Recharacterization of gains and losses
at the shareholder level.
Generally, the items of an S corporation that are passed through, and reported
by, a shareholder are characterized at the
corporate level in the same manner that
partnership items are characterized at the
partnership level.
However, the proposed regulations also
contain exceptions to this general rule for
contributions of either noncapital gain
property or capital loss property if an S
corporation is formed or availed of by any
shareholder or shareholders for a principal purpose of selling or exchanging the
property that in the hands of the shareholder or shareholders would have produced a different character of gain or loss.
The character of the gain or loss will be
the same as it would have been if the
property were in the hands of the shareholder or shareholders at the time of the
sale or exchange.
Commentators suggested that, in the
absence of a statutory provision like section 724 in the partnership context, the
IRS lacked the authority to recharacterize
gain or loss at the shareholder level.
Thus, the commentators asserted that the
final regulations should not adopt the
recharacterization rules.
Alternatively, the commentators suggested limiting the recharacterization rule
to sales or exchanges occurring within a
specified time period.
Unlike the partnership rules, the
recharacterization rules in the proposed
regulations are limited to transactions in
which an S corporation is used for a principal purpose of changing the character of
the gain or loss of contributed property.
These rules are reasonable approaches to
remedying any improper attempts to utilize section 1366(b) to avoid tax. The
length of time between the contribution of
the property to the S corporation and the S
corporation’s sale or exchange of the
property will be a factor considered in
evaluating whether the S corporation was
availed of for a principal purpose of
changing the character of the gain or loss.
However, the final regulations do not
adopt any particular time period. Thus,

January 10, 2000

the final regulations retain the recharacterization rules as proposed.
3. Gross income reporting requirement.
Section 1366(c), like section 702(c) in
the partnership context, provides for the
passthrough of gross income to a shareholder for federal income tax purposes.
Thus, where it is necessary to determine
the amount or character of the gross income of a shareholder, the proposed regulations provide that a shareholder’s gross
income includes the shareholder’s pro
rata share of the gross income of the S
corporation. This amount is the amount
of gross income of the corporation used to
derive the shareholder’s pro rata share of
S corporation taxable income or loss.
A commentator suggested that the rule
in the proposed regulations attempts to
narrow the disclosure exception under
section 6501(e) by applying a pro rata
concept with respect to a shareholder’s
gross income. The commentator recommended that the final regulations not
adopt the gross income reporting rules or,
alternatively, provide a de minimis exception to the rule for certain shareholders
who own minority interests in an S corporation.
The rule in the proposed regulations
parallels the rules for determining the
amount of gross income reported by a
partner in a partnership. See section
702(c); §1.702-1(c)(2). Accordingly,
the final regulations do not adopt this
suggestion.
4. Carryover of disallowed losses under
section 1366(d).
Section 1366(d) provides that a shareholder’s disallowed losses and deductions
for any taxable year shall be treated as incurred by the corporation in the succeeding taxable year with respect to that shareholder. The proposed regulations provide
that a shareholder’s losses and deductions
disallowed under section 1366(d) are personal to the shareholder and cannot in any
manner be transferred to another person.
A commentator requested that the final
regulations provide an exception to this
rule for transferees that have an identity
of investment interest or common basis
with the transferor, such as when stock is
transferred incident to divorce under section 1041.
Under section 1366(d), the carryover of
disallowed losses and deductions is with
respect to the shareholder whose invest-

254

ment limited the items of loss or deduction. Thus, the carryover is not available
to a transferee who acquires the stock
whether by sale, death, gift, or otherwise.
Accordingly, the final regulations retain
the rule that disallowed losses and deductions are nontransferable.
The proposed regulations also provide
that if a shareholder transfers all of the
shareholder’s stock in the corporation,
any disallowed loss or deduction is permanently disallowed. A commentator
suggested that the final regulations permit
a former shareholder of an S corporation
who subsequently reacquires stock in the
S corporation to utilize the losses and deductions previously disallowed to the
shareholder.
Losses and deductions that are disallowed in any taxable year carry over
under section 1366(d) to the succeeding
taxable year of the corporation with respect to a particular shareholder. If a
shareholder completely terminates its interest in the corporation, the shareholder
will not be a shareholder in the succeeding taxable year of the corporation and the
disallowed losses would not carry over.
There is no statutory authority for the carryover of disallowed items if a shareholder is not a shareholder in the year succeeding the disallowance. The disallowed
items of loss and deduction are amounts
that exceed the shareholder’s economic
investment in the corporation. Once the
shareholder terminates its interest in the
corporation, it is not necessary to preserve
the shareholder’s position in the corporation. Thus, the final regulations do not
adopt this commentator’s suggestion.
5. Basis in S corporation stock received
as a gift.
Section 1366(d)(1) limits the amount of
corporate losses and deductions that can
pass through to, and be deducted by, a
shareholder to the shareholder’s adjusted
basis in the corporation’s stock and debt
of the corporation to the shareholder.
The proposed regulations provide that,
for purposes of section 1366(d)(1), a
shareholder’s basis in stock acquired by
gift is the basis of the stock used for purposes of determining loss under section
1015. Thus, if the fair market value of the
stock exceeds the donor’s adjusted basis
on the date of the gift, for purposes of section 1366(d)(1), the adjusted basis of the
stock in the hands of the donee is its ad-

2000–2 I.R.B.

justed basis in the hands of the donor.
However, if the donor’s adjusted basis in
the stock exceeds the stock’s fair market
value on the date of the gift, for purposes
of section 1366(d)(1), the adjusted basis
of the stock in the hands of the donee is
the stock’s fair market value on the date
of the gift.
One commentator argued that the
basis for determining loss under section
1015 is applicable only on the disposition of the gifted asset. The basis for determining loss in section 1015 generally
does not affect the basis for depreciation
or the deductibility of net expenses arising out of the use or operation of the
gifted asset.
The proposed regulations, however,
apply the loss basis rule in section 1015
not for purposes of determining the depreciable basis of a gifted asset, but
rather for purposes of determining the
amount of passthrough losses and deductions (including depreciation deductions and operating losses) that are allowable to a shareholder under section
1366. The donee of loss stock cannot
dispose of the stock and recognize the
loss inherent in the stock on the date of
gift. If the donee could use the donor’s
basis to take depreciation deductions
and operating losses of the S corporation, the donee in effect would realize
the benefit of the loss inherent in the
stock.
Another commentator agreed that the
basis for determining loss in section
1015 ought to be the basis of gifted
stock for purposes of section 1366.
Thus, the final regulations continue to
provide that for purposes of section
1366, the basis of stock acquired by gift
is the basis for determining loss under
section 1015.
6. Allocation of disallowed losses in certain corporate separations.
The proposed regulations provide
rules for the carryover of disallowed
losses and deductions in the case of certain corporate reorganizations. In the
case of an S corporation that transfers a
part of its assets constituting an active
trade or business to another corporation
in a transaction to which section
368(a)(1)(D) applies, and immediately
thereafter the stock and securities of the
controlled corporation are distributed in
a distribution or exchange to which sec-

2000–2 I.R.B.

tion 355 (or so much of section 356 as
relates to section 355) applies, any disallowed loss or deduction with respect to a
shareholder of the distributing corporation immediately before the transaction
is allocated between the distributing corporation and the controlled corporation
with respect to the shareholder. The
proposed regulations provide that the
amount of disallowed loss or deduction
allocated to the distributing (or controlled) corporation with respect to the
shareholder 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 distributing
(or controlled) corporation bears to the
total value of the shareholder’s stock in
the distributing and controlled corporations, in each case as determined immediately after the distribution.
A commentator suggested that the
term value as used in the proposed regulations is ambiguous and that the final
regulations should specifically state
“fair market value.” The commentator
also recommended that because the
computation of fair market value introduces a host of valuation issues into the
transaction, the final regulations should
permit an allocation of disallowed losses
and deductions based on the relative adjusted bases of the assets of the distributing and controlled corporations. Finally, the commentator requested that
the final regulations allow S corporations to allocate disallowed losses and
deductions to the controlled or distributing corporation based upon the source of
those losses and deductions. The final
regulations permit shareholders to allocate disallowed losses and deductions
according to any reasonable method, including a method based on the relative
fair market value of the shareholder’s
stock in the distributing and controlled
corporations immediately after the distribution, a method based on the relative
adjusted bases of the assets in the distributing and controlled corporations
immediately after the distribution, or, in
the case of losses and deductions clearly
attributable to either the distributing or
controlled corporation, a method that allocates such losses and deductions accordingly.
7. Allocation of tax on passive investment income under section 1366(f)(3).

255

Section 1366(f)(3) provides that if
any tax is imposed under section 1375
for a taxable year, each item of passive
investment income is reduced by an
amount which bears the same ratio to
the amount of the tax as the amount of
the item bears to the total passive investment income for the taxable year.
A commentator requested guidance in
the final regulations on whether the allocation of any tax imposed under section
1375 is made based on the total gross or
total net passive investment income.
Under section 1375, the amount of excess passive investment income is allocated to the items of passive investment
income based on the net passive investment income of the corporation. The allocation of the tax imposed on the excess passive investment income should
be similarly allocated. Accordingly, the
final regulations clarify that the allocation of any tax under section 1375 is
based on the total net passive investment
income for the taxable year.
8. Accrual of charitable contribution deductions under section 170(a)(2).
The proposed regulations under section 1366 provide that each shareholder
must take into account the shareholder’s
pro rata share of any charitable contributions paid by the corporation during the
corporation’s taxable year. A commentator requested that the final regulations
clarify that separately stated items include charitable contributions paid or
deemed to be paid. The commentator
suggested that an accrual basis S corporation may elect under section 170(a)(2)
to treat charitable contributions as paid
in the year prior to the year in which the
charitable contribution is actually paid.
Under section 1363(b), S corporations
generally compute their taxable income
in the same manner as in the case of an
individual. However, S corporations are
not permitted to take charitable contribution deductions by virtue of the cross
reference in section 1363(b)(2) to section 703(a)(2). Instead, the deductions
for charitable contributions pass through
to the shareholders of the S corporation.
Individuals cannot make the election
under section 170(a)(2). Treasury and
the Service believe that an S corporation
also cannot make the election under section 170(a)(2). Accordingly, the final
regulations do not adopt this suggestion.

January 10, 2000

9. Treatment of section 108 income
The regulations enumerate items of
income (including tax-exempt income),
loss, deduction, or credit of an S corporation that must be taken into account
separately by each shareholder pursuant
to section 1366(a)(1)(A). “Tax-exempt
income” does not include income from
discharge of indebtedness excluded
from income under section 108 because
such income is not permanently excludible from income in all circumstances in
which section 108 applies. One commentator objected to this treatment of
section 108 income, arguing that such
income is tax-exempt and that application of section 108 at the S corporation
level pursuant to section 108(d)(7)(A)
does not preclude the pass-through of
section 108 income. Another commentator, however, agreed with the approach
taken by the regulations.
Treasury and the Service continue to
believe that the absence of a stock basis
increase for income of an S corporation
excluded under section 108(a) is consistent with the legislative history of section 108 and the specific rules that apply
to the discharge of indebtedness income
of S corporations. Accordingly, the
treatment of section 108 income is unchanged in the final regulations.
10. Adjustment to Basis of Stock
Section 1367(a) and §1.1367-1 of the
proposed regulations prescribe the order
of adjustments required by subchapter S
to the basis of a shareholder’s stock in
an S corporation and the manner in
which those adjustments are made.
A commentator suggested that the
final regulations should provide that life
insurance premiums on policies owned
by the S corporation do not affect either
a shareholder’s basis in stock/debt or the
corporation’s accumulated adjustments
account (AAA). The commentator further suggested that §1.1367-1(c)(2) (relating to noncapital, nondeductible expenses) be amended to make special
provision for accounts receivable when
debt is restored.
Because these comments relate to
provisions in §1.1367-1 that were not
affected by the amendments contained
in the proposed regulations, the comments are not reflected in the final regulations.
11. Adjustments Required Before Deter-

January 10, 2000

mining Tax Effect of Distribution.
Section 1.1368-2 of the proposed regulations provides rules for determining
the source of a distribution made by an S
corporation with respect to its stock and
the tax effect of the distribution to the
shareholders for taxable years of the
corporation beginning on or after August 18, 1998.
One commentator interpreted
§1.1368-2(a)(5) of the proposed regulations, which prescribes the order in
which adjustments are made to the AAA
for purposes of determining the source
of a distribution, as providing that the
AAA is adjusted in the same order as the
adjustments to the basis of a share of
stock under §1.1367-1 of the proposed
regulations. The commentator stated
that although the Small Business Job
Protection Act of 1996 (1996 Act)
changed the order of the adjustments to
the basis of a share of stock, the 1996
Act did not change the order of the adjustments to the AAA except in situations involving a net negative adjustment (where the reductions in the
account for the taxable year exceed the
increases for the taxable year). When a
net negative adjustment occurs, the
AAA is adjusted to take into account
distributions before the AAA is adjusted
to take into account any net negative adjustment.
Consistent with the comment received, the final regulations make clear
that except in situations involving a net
negative adjustment, the order of adjustments to the AAA is not changed. Examples are added to the final regulations to
illustrate the effect of the 1996 Act on
the AAA ordering rules.
12. Transition Rule and Effective Date
sections 1367 and 1368.
Sections 1.1367-3 and 1.1368-4 of the
proposed regulations provide that the
amendments to the final regulations
under section 1367 and 1368 apply only
to taxable years of the corporation beginning on or after August 18, 1998.
Commentators suggested that because
the amendments to sections 1367 and
1368 under the 1996 Act are effective
for taxable years beginning after December 31, 1996, the final regulations
should be effective, at least on an elective basis, for the period beginning from
the effective date of the 1996 Act and

256

ending on the effective date of the final
regulations.
Sections 1.1367-3 and 1.1368-4 of the
final regulations reflect this comment
and provide that for taxable years beginning on or after January 1, 1997, and before August 18, 1998, the adjustments to
the basis of a shareholder’s stock and
the treatment of distributions by an S
corporation, respectively, must be determined in a reasonable manner, taking
into account the statute and the legislative history. Return positions consistent
with the final regulations will be considered reasonable.
Special Analyses
It has been determined that this Treasury decision 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. It is hereby certified that the collection of information in these regulations
will not have a significant economic impact on a substantial number of small entities. This certification is based upon the
fact that these regulations do not impose a
collection of information that is not already required by the underlying statute
or the current regulations and reflected in
the appropriate forms. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter
6) is not required. Pursuant to section
7805(f) of the Internal Revenue Code, the
notice of proposed rulemaking preceding
these regulations was submitted to the
Chief Counsel for Advocacy of the Small
Business Administration for comment on
its impact on small business.
Drafting Information
The principal authors of these final
regulations are Terri A. Belanger, Deane
M. Burke, and Brenda Stewart of the
Office of Chief Counsel (Passthroughs
and Special Industries), Internal Revenue Service. However, other personnel
from the IRS and Treasury Department
participated in their development.
*****

2000–2 I.R.B.

Adoption of Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 602
are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Sections 1.1366-0 and 1.1366-1
are added, §1.1366-2 is revised, and
§§1.1366-3 through 1.1366-5 are added to
read as follows:
§1.1366-0 Table of contents.
The following table of contents is provided to facilitate the use of §§1.1366-1
through 1.1366-5:
§1.1366-1 Shareholder’s share of items
of an S corporation.
(a) Determination of shareholder’s tax liability.
(1) In general.
(2) Separately stated items of income,
loss, deduction, or credit.
(3) Nonseparately computed income or
loss.
(4) Separate activities requirement.
(5) Aggregation of deductions or exclusions for purposes of limitations.
(b) Character of items constituting pro
rata share.
(1) In general.
(2) Exception for contribution of noncapital gain property.
(3) Exception for contribution of capital
loss property.
(c) Gross income of a shareholder.
(1) In general.
(2) Gross income for substantial omission of items.
(d) Shareholders holding stock subject to
community property laws.
(e) Net operating loss deduction of shareholder of S corporation.
(f) Cross-reference.
§1.1366-2 Limitations on deduction of
passthrough items of an S corporation to
its shareholders.
(a) In general.
(1) Limitation on losses and deductions.
(2) Carryover of disallowance.
(3) Basis limitation amount.
(i) Stock portion.
(ii) Indebtedness portion.
(4) Limitation on losses and deductions

2000–2 I.R.B.

allocated to each item.
(5) Nontransferability of losses and deductions.
(6) Basis of stock acquired by gift.
(b) Special rules for carryover of disallowed losses and deductions to post-termination transition period described in
section 1377(b).
(1) In general.
(2) Limitation on losses and deductions.
(3) Limitation on losses and deductions
allocated to each item.
(4) Adjustment to the basis of stock.
(c) Carryover of disallowed losses and
deductions in the case of liquidations, reorganizations, and divisions.
(1) Liquidations and reorganizations.
(2) Corporate separations to which section 368(a)(1)(D) applies.
§1.1366-3 Treatment of family groups.
(a) In general.
(b) Examples.
§1.1366-4 Special rules limiting the
passthrough of certain items of an S corporation to its shareholders.
(a) Passthrough inapplicable to section
34 credit.
(b) Reduction in passthrough for tax imposed on built-in gains.
(c) Reduction in passthrough for tax imposed on excess net passive income.
§1.1366-5 Effective date. §1.1366-1
Shareholder’s share of items of an S corporation.
(a) Determination of shareholder’s tax
liability—(1) In general. An S corporation must report, and a shareholder is required to take into account in the shareholder’s return, the shareholder’s pro rata
share, whether or not distributed, of the S
corporation’s items of income, loss, deduction, or credit described in paragraphs
(a)(2), (3), and (4) of this section. A
shareholder’s pro rata share is determined
in accordance with the provisions of section 1377(a) and the regulations thereunder. The shareholder takes these items
into account in determining the shareholder’s taxable income and tax liability
for the shareholder’s taxable year with or
within which the taxable year of the corporation ends. If the shareholder dies (or
if the shareholder is an estate or trust and
the estate or trust terminates) before the

257

end of the taxable year of the corporation,
the shareholder’s pro rata share of these
items is taken into account on the shareholder’s final return. For the limitation
on allowance of a shareholder’s pro rata
share of S corporation losses or deductions, see section 1366(d) and §1.1366-2.
(2) Separately stated items of income,
loss, deduction, or credit. Each shareholder must take into account separately
the shareholder’s pro rata share of any
item of income (including tax-exempt income), loss, deduction, or credit of the S
corporation that if separately taken into
account by any shareholder could affect
the shareholder’s tax liability for that taxable year differently than if the shareholder did not take the item into account
separately. The separately stated items of
the S corporation include, but are not limited to, the following items—
(i) The corporation’s combined net
amount of gains and losses from sales or
exchanges of capital assets grouped by
applicable holding periods, by applicable
rate of tax under section 1(h), and by any
other classification that may be relevant
in determining the shareholder’s tax liability;
(ii) The corporation’s combined net
amount of gains and losses from sales or
exchanges of property described in section 1231 (relating to property used in the
trade or business and involuntary conversions), grouped by applicable holding periods, by applicable rate of tax under section 1(h), and by any other classification
that may be relevant in determining the
shareholder’s tax liability;
(iii) Charitable contributions, grouped
by the percentage limitations of section
170(b), paid by the corporation within the
taxable year of the corporation;
(iv) The taxes described in section 901
that have been paid (or accrued) by the
corporation to foreign countries or to possessions of the United States;
(v) Each of the corporation’s separate
items involved in the determination of
credits against tax allowable under part
IV of subchapter A (section 21 and following) of the Internal Revenue Code,
except for any credit allowed under section 34 (relating to certain uses of gasoline and special fuels);
(vi) Each of the corporation’s separate
items of gains and losses from wagering
transactions (section 165(d)); soil and

January 10, 2000

water conservation expenditures (section 175); deduction under an election to
expense certain depreciable business expenses (section 179); medical, dental,
etc., expenses (section 213); the additional itemized deductions for individuals provided in part VII of subchapter B
(section 212 and following) of the Internal Revenue Code; and any other itemized deductions for which the limitations on itemized deductions under
sections 67 or 68 applies;
(vii) Any of the corporation’s items of
portfolio income or loss, and expenses related thereto, as defined in the regulations
under section 469;
(viii) The corporation’s tax-exempt income. For purposes of subchapter S, taxexempt income is income that is permanently excludible from gross income in all
circumstances in which the applicable
provision of the Internal Revenue Code
applies. For example, income that is excludible from gross income under section
101 (certain death benefits) or section 103
(interest on state and local bonds) is taxexempt income, while income that is excludible from gross income under section
108 (income from discharge of indebtedness) or section 109 (improvements by
lessee on lessor’s property) is not tax-exempt income;
(ix) The corporation’s adjustments described in sections 56 and 58, and items
of tax preference described in section 57;
and
(x) Any item identified in guidance (including forms and instructions) issued by
the Commissioner as an item required to
be separately stated under this paragraph
(a)(2).
(3) Nonseparately computed income or
loss. Each shareholder must take into account separately the shareholder’s pro
rata share of the nonseparately computed
income or loss of the S corporation. For
this purpose, nonseparately computed income or loss means the corporation’s
gross income less the deductions allowed
to the corporation under chapter 1 of the
Internal Revenue Code, determined by
excluding any item requiring separate
computation under paragraph (a)(2) of
this section.
(4) Separate activities requirement. An
S corporation must report, and each
shareholder must take into account in the
shareholder’s return, the shareholder’s

January 10, 2000

pro rata share of an S corporation’s items
of income, loss, deduction, or credit described in paragraphs (a)(2) and (3) of this
section for each of the corporation’s activities as defined in section 469 and the regulations thereunder.
(5) Aggregation of deductions or exclusions for purposes of limitations—(i) In
general. A shareholder aggregates the
shareholder’s separate deductions or exclusions with the shareholder’s pro rata
share of the S corporation’s separately
stated deductions or exclusions in determining the amount of any deduction or
exclusion allowable to the shareholder
under subtitle A of the Internal Revenue
Code as to which a limitation is imposed.
(ii) Example. The provisions of paragraph (a)(5)(i) of this section are illustrated by the following example:
Example. In 1999, Corporation M, a calendar
year S corporation, purchases and places in service
section 179 property costing $10,000. Corporation
M elects to expense the entire cost of the property.
Shareholder A owns 50 percent of the stock of Corporation M. Shareholder A’s pro rata share of this
item after Corporation M applies the section 179(b)
limitations is $5,000. Because the aggregate amount
of Shareholder A’s pro rata share and separately acquired section 179 expense may not exceed $19,000
(the aggregate maximum cost that may be taken into
account under section 179(a) for the applicable taxable year), Shareholder A may elect to expense up to
$14,000 of separately acquired section 179 property
that is purchased and placed in service in 1999, subject to the limitations of section 179(b).

(b) Character of items constituting pro
rata share—(1) In general. Except as
provided in paragraph (b)(2) or (3) of this
section, the character of any item of income, loss, deduction, or credit described
in section 1366(a)(1)(A) or (B) and paragraph (a) of this section is determined for
the S corporation and retains that character in the hands of the shareholder. For
example, if an S corporation has capital
gain on the sale or exchange of a capital
asset, a shareholder’s pro rata share of
that gain will also be characterized as a
capital gain regardless of whether the
shareholder is otherwise a dealer in that
type of property. Similarly, if an S corporation engages in an activity that is not for
profit (as defined in section 183), a shareholder’s pro rata share of the S corporation’s deductions will be characterized as
not for profit. Also, if an S corporation
makes a charitable contribution to an or-

258

ganization qualifying under section
170(b)(1)(A), a shareholder’s pro rata
share of the S corporation’s charitable
contribution will be characterized as
made to an organization qualifying under
section 170(b)(1)(A).
(2) Exception for contribution of noncapital gain property. If an S corporation
is formed or availed of by any shareholder
or group of shareholders for a principal
purpose of selling or exchanging contributed property that in the hands of the
shareholder or shareholders would not
have produced capital gain if sold or exchanged by the shareholder or shareholders, then the gain on the sale or exchange
of the property recognized by the corporation is not treated as a capital gain.
(3) Exception for contribution of capital loss property. If an S corporation is
formed or availed of by any shareholder
or group of shareholders for a principal
purpose of selling or exchanging contributed property that in the hands of the
shareholder or shareholders would have
produced capital loss if sold or exchanged by the shareholder or shareholders, then the loss on the sale or exchange of the property recognized by
the corporation is treated as a capital
loss to the extent that, immediately before the contribution, the adjusted basis
of the property in the hands of the shareholder or shareholders exceeded the fair
market value of the property.
(c) Gross income of a shareholder—(1)
In general. Where it is necessary to determine the amount or character of the
gross income of a shareholder, the shareholder’s gross income includes the shareholder’s pro rata share of the gross income of the S corporation. The
shareholder’s pro rata share of the gross
income of the S corporation is the amount
of gross income of the corporation used in
deriving the shareholder’s pro rata share
of S corporation taxable income or loss
(including items described in section
1366(a)(1)(A) or (B) and paragraph (a) of
this section). For example, a shareholder
is required to include the shareholder’s
pro rata share of S corporation gross income in computing the shareholder’s
gross income for the purposes of determining the necessity of filing a return
(section 6012(a)) and the shareholder’s
gross income derived from farming (sections 175 and 6654(i)).

2000–2 I.R.B.

(2) Gross income for substantial omission of items—(i) In general. For purposes of determining the applicability of
the 6- year period of limitation on assessment and collection provided in section
6501(e) (relating to omission of more
than 25 percent of gross income), a shareholder’s gross income includes the shareholder’s pro rata share of S corporation
gross income (as described in section
6501(e)(1)(A)(i)). In this respect, the
amount of S corporation gross income
used in deriving the shareholder’s pro rata
share of any item of S corporation income, loss, deduction, or credit (as included or disclosed in the shareholder’s
return) is considered as an amount of
gross income stated in the shareholder’s
return for purposes of section 6501(e).
(ii) Example. The following example
illustrates the provisions of paragraph
(c)(2)(i) of this section:
Example. Shareholder A, an individual, owns 25
percent of the stock of Corporation N, an S corporation that has $10,000 gross income and $2,000 taxable
income. A reports only $300 as A’s pro rata share of
N’s taxable income. A should have reported $500 as
A’s pro rata share of taxable income, derived from A’s
pro rata share, $2,500, of N’s gross income. Because
A’s return included only $300 without a disclosure
meeting the requirements of section 6501(e)(1)(A)(ii)
describing the difference of $200, A is regarded as
having reported on the return only $1,500 ($300/$500
of $2,500) as gross income from N.

(d) Shareholders holding stock subject
to community property laws. If a shareholder holds S corporation stock that is
community property, then the shareholder’s pro rata share of any item or
items listed in paragraphs (a)(2), (3), and
(4) of this section with respect to that
stock is reported by the husband and wife
in accordance with community property
rules.
(e) Net operating loss deduction of
shareholder of S corporation. For purposes of determining a net operating loss
deduction under section 172, a shareholder of an S corporation must take into
account the shareholder’s pro rata share
of items of income, loss, deduction, or
credit of the corporation. See section
1366(b) and paragraph (b) of this section
for rules on determining the character of
the items. In determining under section
172(d)(4) the nonbusiness deductions allowable to a shareholder of an S corporation (arising from both corporation

2000–2 I.R.B.

sources and any other sources), the shareholder separately takes into account the
shareholder’s pro rata share of the deductions of the corporation that are not attributable to a trade or business and combines
this amount with the shareholder’s nonbusiness deductions from any other
sources. The shareholder also separately
takes into account the shareholder’s pro
rata share of the gross income of the corporation not derived from a trade or business and combines this amount with the
shareholder’s nonbusiness income from
all other sources. See section 172 and the
regulations thereunder.
(f) Cross-reference. For rules relating
to the consistent tax treatment of subchapter S items, see section 6037(c).
§1.1366-2 Limitations on deduction of
passthrough items of an S corporation to
its shareholders.
(a) In general—(1) Limitation on
losses and deductions. The aggregate
amount of losses and deductions taken
into account by a shareholder under
§1.1366-1(a)(2), (3), and (4) for any taxable year of an S corporation cannot exceed the sum of—
(i) The adjusted basis of the shareholder’s stock in the corporation (as determined under paragraph (a)(3)(i) of this
section); and
(ii) The adjusted basis of any indebtedness of the corporation to the shareholder
(as determined under paragraph (a)(3)(ii)
of this section).
(2) Carryover of disallowance. A
shareholder’s aggregate amount of losses
and deductions for a taxable year in excess of the sum of the adjusted basis of
the shareholder’s stock in an S corporation and of any indebtedness of the S corporation to the shareholder is not allowed
for the taxable year. However, any disallowed loss or deduction retains its character and is treated as incurred by the corporation in the corporation’s first succeeding
taxable year, and subsequent taxable
years, with respect to the shareholder. For
rules on determining the adjusted bases of
stock of an S corporation and indebtedness of the corporation to the shareholder,
see paragraphs (a)(3)(i) and (ii) of this
section.
(3) Basis limitation amount—(i)
Stock portion. A shareholder generally
determines the adjusted basis of stock for
purposes of paragraphs (a)(1)(i) and (2) of

259

this section (limiting losses and deductions) by taking into account only increases in basis under section 1367(a)(1)
for the taxable year and decreases in basis
under section 1367(a)(2)(A), (D) and (E)
(relating to distributions, noncapital,
nondeductible expenses, and certain oil
and gas depletion deductions) for the taxable year. In so determining this loss limitation amount, the shareholder disregards
decreases in basis under section
1367(a)(2)(B) and (C) (for losses and deductions, including losses and deductions
previously disallowed) for the taxable
year. However, if the shareholder has in
effect for the taxable year an election
under §1.1367-1(g) to decrease basis by
items of loss and deduction prior to decreasing basis by noncapital, nondeductible expenses and certain oil and gas
depletion deductions, the shareholder also
disregards decreases in basis under section 1367(a)(2)(D) and (E). This basis
limitation amount for stock is determined
at the time prescribed under §1.13671(d)(1) for adjustments to the basis of
stock.
(ii) Indebtedness portion. A shareholder determines the shareholder’s adjusted basis in indebtedness of the corporation for purposes of paragraphs
(a)(1)(ii) and (2) of this section (limiting
losses and deductions) without regard to
any adjustment under section
1367(b)(2)(A) for the taxable year. This
basis limitation amount for indebtedness
is determined at the time prescribed under
§1.1367-2(d)(1) for adjustments to the
basis of indebtedness.
(4) Limitation on losses and deductions
allocated to each item. If a shareholder’s
pro rata share of the aggregate amount of
losses and deductions specified in
§1.1366-1(a)(2), (3), and (4) exceeds the
sum of the adjusted basis of the shareholder’s stock in the corporation (determined in accordance with paragraph
(a)(3)(i) of this section) and the adjusted
basis of any indebtedness of the corporation to the shareholder (determined in accordance with paragraph (a)(3)(ii) of this
section), then the limitation on losses and
deductions under section 1366(d)(1) must
be allocated among the shareholder’s pro
rata share of each loss or deduction. The
amount of the limitation allocated to any
loss or deduction is an amount that bears
the same ratio to the amount of the limita-

January 10, 2000

tion as the loss or deduction bears to the
total of the losses and deductions. For
this purpose, the total of losses and deductions for the taxable year is the sum of
the shareholder’s pro rata share of losses
and deductions for the taxable year, and
the losses and deductions disallowed and
carried forward from prior years pursuant
to section 1366(d)(2).
(5) Nontransferability of losses and deductions. Any loss or deduction disallowed under paragraph (a)(1) of this section is personal to the shareholder and
cannot in any manner be transferred to another person. If a shareholder transfers
some but not all of the shareholder’s stock
in the corporation, the amount of any disallowed loss or deduction under this section is not reduced and the transferee does
not acquire any portion of the disallowed
loss or deduction. If a shareholder transfers all of the shareholder’s stock in the
corporation, any disallowed loss or deduction is permanently disallowed.
(6) Basis of stock acquired by gift. For
purposes of section 1366(d)(1)(A) and
paragraphs (a)(1)(i) and (2) of this section, the basis of stock in a corporation
acquired by gift is the basis of the stock
that is used for purposes of determining
loss under section 1015(a).
(b) Special rules for carryover of disallowed losses and deductions to post-termination transition period described in
section 1377(b)—(1) In general. If, for
the last taxable year of a corporation for
which it was an S corporation, a loss or
deduction was disallowed to a shareholder by reason of the limitation in paragraph (a) of this section, the loss or deduction is treated under section
1366(d)(3) as incurred by that shareholder
on the last day of any post-termination
transition period (within the meaning of
section 1377(b)).
(2) Limitation on losses and deductions. The aggregate amount of losses
and deductions taken into account by a
shareholder under paragraph (b)(1) of this
section cannot exceed the adjusted basis
of the shareholder’s stock in the corporation determined at the close of the last day
of the post-termination transition period.
For this purpose, the adjusted basis of a
shareholder’s stock in the corporation is
determined at the close of the last day of
the post-termination transition period
without regard to any reduction required

January 10, 2000

under paragraph (b)(4) of this section. If
a shareholder disposes of a share of stock
prior to the close of the last day of the
post-termination transition period, the adjusted basis of that share is its basis as of
the close of the day of disposition. Any
losses and deductions in excess of a
shareholder’s adjusted stock basis are permanently disallowed. For purposes of
section 1366(d)(3)(B) and this paragraph
(b)(2), the basis of stock in a corporation
acquired by gift is the basis of the stock
that is used for purposes of determining
loss under section 1015(a).
(3) Limitation on losses and deductions
allocated to each item. If the aggregate
amount of losses and deductions treated
as incurred by the shareholder under paragraph (b)(1) of this section exceeds the
adjusted basis of the shareholder’s stock
determined under paragraph (b)(2) of this
section, the limitation on losses and deductions under section 1366(d)(3)(B)
must be allocated among each loss or deduction. The amount of the limitation allocated to each loss or deduction is an
amount that bears the same ratio to the
amount of the limitation as the amount of
each loss or deduction bears to the total of
all the losses and deductions.
(4) Adjustment to the basis of stock.
The shareholder’s basis in the stock of the
corporation is reduced by the amount allowed as a deduction by reason of this
paragraph (b). For rules regarding adjustments to the basis of a shareholder’s stock
in an S corporation, see §1.1367-1.
(c) Carryover of disallowed losses and
deductions in the case of liquidations, reorganizations, and divisions—(1) Liquidations and reorganizations. If a corporation acquires the assets of an S
corporation in a transaction to which section 381(a) applies, any loss or deduction
disallowed under paragraph (a) of this
section with respect to a shareholder of
the distributor or transferor S corporation
is available to that shareholder as a shareholder of the acquiring corporation.
Thus, where the acquiring corporation is
an S corporation, a loss or deduction of a
shareholder of the distributor or transferor
S corporation disallowed prior to or during the taxable year of the transaction is
treated as incurred by the acquiring S corporation with respect to that shareholder
if the shareholder is a shareholder of the
acquiring S corporation after the transac-

260

tion. Where the acquiring corporation is a
C corporation, a post-termination transition period arises the day after the last day
that an S corporation was in existence and
the rules provided in paragraph (b) of this
section apply with respect to any shareholder of the acquired S corporation that
is also a shareholder of the acquiring C
corporation after the transaction. See the
special rules under section 1377 for the
availability of the post-termination transition period if the acquiring corporation is
a C corporation.
(2) Corporate separations to which
section 368(a)(1)(D) applies. If an S corporation transfers a portion of its assets
constituting an active trade or business to
another corporation in a transaction to
which section 368(a)(1)(D) applies, and
immediately thereafter the stock and securities of the controlled corporation are
distributed in a distribution or exchange
to which section 355 (or so much of section 356 as relates to section 355) applies,
any loss or deduction disallowed under
paragraph (a) of this section with respect
to a shareholder of the distributing S corporation immediately before the transaction is allocated between the distributing
corporation and the controlled corporation with respect to the shareholder. Such
allocation shall be made according to any
reasonable method, including a method
based on the relative fair market value of
the shareholder’s stock in the distributing
and controlled corporations immediately
after the distribution, a method based on
the relative adjusted basis of the assets in
the distributing and controlled corporations immediately after the distribution,
or, in the case of losses and deductions
clearly attributable to either the distributing or controlled corporation, any method
that allocates such losses and deductions
accordingly.
§1.1366-3 Treatment of family groups.
(a) In general. Under section 1366(e),
if an individual, who is a member of the
family of one or more shareholders of an
S corporation, renders services for, or furnishes capital to, the corporation without
receiving reasonable compensation, the
Commissioner shall prescribe adjustments to those items taken into account
by the individual and the shareholders as
may be necessary to reflect the value of
the services rendered or capital furnished.
For these purposes, in determining the

2000–2 I.R.B.

reasonable value for services rendered, or
capital furnished, to the corporation, consideration will be given to all the facts and
circumstances, including the amount that
ordinarily would be paid in order to obtain comparable services or capital from a
person (other than a member of the family) who is not a shareholder in the corporation. In addition, for purposes of section 1366(e), if a member of the family of
one or more shareholders of the S corporation holds an interest in a passthrough
entity (e.g., a partnership, S corporation,
trust, or estate), that performs services for,
or furnishes capital to, the S corporation
without receiving reasonable compensation, the Commissioner shall prescribe
adjustments to the passthrough entity and
the corporation as may be necessary to reflect the value of the services rendered or
capital furnished. For purposes of section
1366(e), the term family of any shareholder includes only the shareholder’s
spouse, ancestors, lineal descendants, and
any trust for the primary benefit of any of
these persons.
(b) Examples. The provisions of this
section may be illustrated by the following examples:
Example 1. The stock of an S corporation is
owned 50 percent by F and 50 percent by T, the
minor son of F. For the taxable year, the corporation
has items of taxable income equal to $70,000. Compensation of $10,000 is paid by the corporation to F
for services rendered during the taxable year, and no
compensation is paid to T, who rendered no services.
Based on all the relevant facts and circumstances,
reasonable compensation for the services rendered
by F would be $30,000. In the discretion of the Internal Revenue Service, up to an additional $20,000
of the $70,000 of the corporation’s taxable income,
for tax purposes, may be allocated to F as compensation for services rendered. If the Internal Revenue
Service allocates $20,000 of the corporation’s taxable income to F as compensation for services, taxable income of the corporation would be reduced by
$20,000 to $50,000, of which F and T each would be
allocated $25,000. F would have $30,000 of total
compensation paid by the corporation for services
rendered.
Example 2. The stock of an S corporation is
owned by A and B. For the taxable year, the corporation has paid compensation to a partnership that
rendered services to the corporation during the taxable year. The spouse of A is a partner in that partnership. Consequently, if based on all the relevant
facts and circumstances the partnership did not receive reasonable compensation for the services ren-

2000–2 I.R.B.

dered to the corporation, the Internal Revenue Service, in its discretion, may make adjustments to
those items taken into account by the partnership
and the corporation as may be necessary to reflect
the value of the services rendered.

§1.1366-4 Special rules limiting the
passthrough of certain items of an S corporation to its shareholders.
(a) Passthrough inapplicable to section
34 credit. Section 1.1366-1(a) does not
apply to any credit allowable under section 34 (relating to certain uses of gasoline and special fuels).
(b) Reduction in passthrough for tax
imposed on built-in gains. For purposes
of §1.1366-1(a), if for any taxable year of
the S corporation a tax is imposed on the
corporation under section 1374, the
amount of the tax imposed is treated as a
loss sustained by the S corporation during
the taxable year. The character of the
deemed loss is determined by allocating
the loss proportionately among the net
recognized built-in gains giving rise to the
tax and attributing the character of each
net recognized built-in gain to the allocable portion of the loss.
(c) Reduction in passthrough for tax
imposed on excess net passive income.
For purposes of §1.1366-1(a), if for any
taxable year of the S corporation a tax is
imposed on the corporation under section
1375, each item of passive investment income shall be reduced by an amount that
bears the same ratio to the amount of the
tax as the amount of the item bears to the
total net passive investment income for
that taxable year.
§1.1366-5 Effective date.
Sections 1.1366-1 through 1.1366-4
apply to taxable years of an S corporation
beginning on or after August 18, 1998.
Par. 3. Section 1.1367-0 is amended in
the table as follows:
1. The entries for §1.1367-1(e) through
(g) are revised.
2. The entries for §1.1367-1(h)
through (j) are added.
The additions and revisions read as follows:
§1.1367-0 Table of contents.
*****
§1.1367-1 Adjustments to basis of shareholder’s stock in an S corporation.
*****
(e) Ordering rules for taxable years beginning before January 1, 1997.
(f) Ordering rules for taxable years begin-

261

ning on or after
August 18, 1998.
(g) Elective ordering rule.
(h) Examples.
(i) [Reserved]
(j) Adjustments for items of income in respect of a decedent.
*****
Par. 4. Section 1.1367-1 is amended as
follows:
1. The paragraph heading and introductory text of paragraph (e) are revised.
2. Paragraphs (f) and (g) are redesignated as paragraphs (g) and (h), respectively.
3. New paragraph (f) is added.
4. The first and second sentences of
newly designated paragraph (g) are revised.
5. Newly designated paragraph (h) is
amended as follows:
a. The heading for Example 1 is revised.
b. Example 2 and Example 3 are redesignated as Example 3 and Example 4, respectively.
c. New Example 2 is added.
d. The heading of newly designated
Example 4 is revised.
e. Example 5 is added.
6. Paragraph (i) is added and reserved
and paragraph (j) is added.
The additions and revisions read as follows:
§1.1367-1 Adjustments to basis of shareholder’s stock in an S corporation.
*****
(e) Ordering rules for taxable years beginning before January 1, 1997. For any
taxable year of a corporation beginning
before January 1, 1997, except as provided in paragraph (g) of this section, the
adjustments required by section 1367(a)
are made in the following order—
*****
(f) Ordering rules for taxable years beginning on or after August 18, 1998. For
any taxable year of a corporation beginning on or after August 18, 1998, except
as provided in paragraph (g) of this section, the adjustments required by section
1367(a) are made in the following
order—
(1) Any increase in basis attributable to
the income items described in section
1367(a)(1)(A) and (B), and the excess of
the deductions for depletion described in
section 1367(a)(1)(C);

January 10, 2000

(2) Any decrease in basis attributable to
a distribution by the corporation described in section 1367(a)(2)(A);
(3) Any decrease in basis attributable
to noncapital, nondeductible expenses described in section 1367(a)(2)(D), and the
oil and gas depletion deduction described
in section 1367(a)(2)(E); and
(4) Any decrease in basis attributable to
items of loss or deduction described in
section 1367(a)(2)(B) and (C).
(g) Elective ordering rule. A shareholder may elect to decrease basis under
paragraph (e)(3) or (f)(4) of this section,
whichever applies, prior to decreasing
basis under paragraph (e)(2) or (f)(3) of
this section, whichever applies. If a
shareholder makes this election, any
amount described in paragraph (e)(2) or
(f)(3) of this section, whichever applies,
that is in excess of the shareholder’s basis
in stock and indebtedness is treated,
solely for purposes of this section, as an
amount described in paragraph (e)(2) or
(f)(3) of this section, whichever applies,
in the succeeding taxable year. * * *
(h) * * *
Example 1. Adjustments to basis of stock for taxable years beginning before January 1, 1997. * * *
Example 2. Adjustments to basis of stock for taxable years beginning on or after August 18, 1998. (i)
On December 31, 2001, A owns a block of 50 shares
of stock with an adjusted basis per share of $6 in
Corporation S. On December 31, 2001, A purchases
for $400 an additional block of 50 shares of stock
with an adjusted basis of $8 per share. Thus, A
holds 100 shares of stock for each day of the 2002
taxable year. For S’s 2002 taxable year, A’s pro rata
share of the amount of items described in section
1367(a)(1)(A) (relating to increases in basis of
stock) is $300, A’s pro rata share of the amount of
the items described in section 1367(a)(2)(B) (relating to decreases in basis of stock attributable to
items of loss and deduction) is $300, and A’s pro rata
share of the amount of the items described in section
1367(a)(2)(D) (relating to decreases in basis of stock
attributable to noncapital, nondeductible expenses)
is $200. S makes a distribution to A in the amount
of $100 during 2002.
(ii) Pursuant to the ordering rules of paragraph (f)
of this section, A first increases the basis of each
share of stock by $3 ($300/100 shares) and then decreases the basis of each share by $1 ($100/100
shares) for the distribution. A next decreases the
basis of each share by $2 ($200/100 shares) for the
noncapital, nondeductible expenses and then decreases the basis of each share by $3 ($300/100
shares) for the items of loss. Thus, on January 1,

January 10, 2000

2003, A has a basis of $3 per share in the original
block of 50 shares ($6 + $3 - $1 - $2 - $3) and a
basis of $5 per share in the second block of 100
shares ($8 + $3 - $1 - $2 - $3).

*****
Example 4. Effects of section 1377(a)(2) election
and distribution on basis of stock for taxable years
beginning before January 1, 1997. * * *
Example 5. Effects of section 1377(a)(2) election
and distribution on basis of stock for taxable years
beginning on or after August 18, 1998. (i) The facts
are the same as in Example 4, except that all of the
events occur in 2001 rather than in 1994 and except
as follows: On June 30, 2001, B sells 25 shares of
her stock for $5,000 to D and 25 shares back to Corporation S for $5,000. Under section 1377(a)(2)(B)
and §1.1377-1(b)(2), B and C are affected shareholders because B has transferred shares to Corporation S. Pursuant to section 1377(a)(2)(A) and
§1.1377-1(b)(1), B and C, the affected shareholders,
and Corporation S agree to treat the taxable year
2001 as if it consisted of two separate taxable years
for all affected shareholders for the purposes set
forth in §1.1377-1(b)(3)(i).
(ii) On June 30, 2001, B and C, pursuant to the
ordering rules of paragraph (f)(1) of this section, increase the basis of each share by $60 ($6,000/100
shares) for the nonseparately computed income.
Then B and C reduce the basis of each share by $120
($12,000/100 shares) for the distribution. Finally, B
and C decrease the basis of each share by $40
($4,000/100 shares) for the separately stated deduction item.
(iii) The basis of the stock of B is reduced from
$120 to $20 per share ($120 + $60 - $120 - $40).
Prior to accounting for the separately stated deduction item, the basis of the stock of C is reduced from
$80 to $20 ($80 + $60 - $120). Finally, because the
period from January 1 through June 30, 2001 is
treated under §1.1377-1(b)(3)(i) as a separate taxable year for purposes of making adjustments to the
basis of stock, under section 1366(d) and §1.13662(a)(2), C may deduct only $20 per share of the remaining $40 of the separately stated deduction item,
and the basis of the stock of C is reduced from $20
per share to $0 per share. Under section 1366 and
§1.1366-2(a)(2), C’s remaining separately stated deduction item of $20 per share is treated as having
been incurred in the first succeeding taxable year of
Corporation S, which, for this purpose, begins on
July 1, 2001.

(i) [Reserved]
(j) Adjustments for items of income in
respect of a decedent. The basis determined under section 1014 of any stock in
an S corporation is reduced by the portion
of the value of the stock that is attributable to items constituting income in re-

262

spect of a decedent. For the determination of items realized by an S corporation
constituting income in respect of a decedent, see sections 1367(b)(4)(A) and 691
and applicable regulations thereunder.
For the determination of the allowance of
a deduction for the amount of estate tax
attributable to income in respect of a
decedent, see section 691(c) and applicable regulations thereunder.
Par. 5. §1.1367-3 is revised to read as
follows:
§1.1367-3 Effective date and transition
rule.
Except for §1.1367-1(f), (h) Example 2
and Example 5, and (j), §§1.1367-1 and
1.1367-2 apply to taxable years of the
corporation beginning on or after January
1, 1994. Section 1.1367-1(f), (h) Example 2 and Example 5, and (j) apply only to
taxable years of the corporation beginning
on or after August 18, 1998. For taxable
years beginning before January 1, 1994,
and taxable years beginning on or after
January 1, 1997, and before August 18,
1998, the basis of a shareholder’s stock
must be determined in a reasonable manner, taking into account the statute and
legislative history. Except for §1.13671(f), (h) Example 2 and Example 5, and
(j), return positions consistent with
§§1.1367-1 and 1.1367-2 are reasonable
for taxable years beginning before January 1, 1994. Return positions consistent
with §1.1367-1(f), (h) Example 2 and Example 5, and (j) are reasonable for taxable
years beginning on or after January 1,
1997, and before August 18, 1998.
Par. 6. Section 1.1368-0 is amended in
the table as follows:
1. The entry for §1.1368-1(e) is revised and entries for §1.1368-1(e)(1) and
(2) are added.
2. The entry for §1.1368-2(a)(4) is revised.
3. An entry for §1.1368-2(a)(5) is
added.
4. The entry for §1.1368-2(d) is revised.
The additions and revisions read as follows:
§1.1368-0 Table of contents.
*****
§1.1368-1 Distributions by S corporations.
*****
(e) Certain adjustments taken into account.

2000–2 I.R.B.

(1) Taxable years beginning before January 1, 1997.
(2) Taxable years beginning on or after
August 18, 1998.
*****
§1.1368-2 Accumulated adjustments account (AAA).
(a) * * *
(4) Ordering rules for the AAA for taxable
years beginning before January 1, 1997.
(5) Ordering rules for the AAA for taxable
years beginning on or after August 18,
1998.
*****
(d) Adjustment in the case of redemptions, liquidations, reorganizations, and
divisions.
*****
Par. 7. Section 1.1368-1 is amended by
revising paragraphs (d)(1) and (e) to read
as follows:
§1.1368-1 Distributions by S corporations.
*****
(d) S corporation with earnings and
profits—(1) General treatment of distribution. Except as provided in paragraph
(d)(2) of this section, a distribution made
with respect to its stock by an S corporation that has accumulated earnings and
profits as of the end of the taxable year of
the S corporation in which the distribution
is made is treated in the manner provided
in section 1368(c). See section 316 and
§1.316-2 for provisions relating to the allocation of earnings and profits among
distributions.
*****
(e) Certain adjustments taken into account—(1) Taxable years beginning before January 1, 1997. For any taxable
year of the corporation beginning before
January 1, 1997, paragraphs (c) and (d) of
this section are applied only after taking
into account—
(i) The adjustments to the basis of the
shares of a shareholder’s stock described
in section 1367 (without regard to section
1367(a)(2)(A) (relating to decreases attributable to distributions not includible in
income)) for the S corporation’s taxable
year; and
(ii) The adjustments to the AAA required by section 1368(e)(1)(A) (but
without regard to the adjustments for distributions under §1.1368-2(a)(3)(iii)) for
the S corporation’s taxable year.
(2) Taxable years beginning on or after

2000–2 I.R.B.

August 18, 1998. For any taxable year of
the corporation beginning on or after August 18, 1998, paragraphs (c) and (d) of
this section are applied only after taking
into account—
(i) The adjustments to the basis of the
shares of a shareholder’s stock described
in section 1367(a)(1) (relating to increases in basis of stock) for the S corporation’s taxable year; and
(ii) The adjustments to the AAA required by section 1368(e)(1)(A) (but
without regard to the adjustments for distributions under §1.1368-2(a)(3)(iii)) for
the S corporation’s taxable year. Any net
negative adjustment (as defined in section
1368(e)(1)(C)(ii)) for the taxable year
shall not be taken into account.
*****
Par. 8. Section 1.1368-2 is amended as
follows:
1. Paragraphs (a)(1) and (a)(3)(ii), and
the paragraph heading and introductory
text of paragraph (a)(4) are revised.
2. Paragraph (a)(5) is added.
3. The paragraph heading for paragraph (d) is revised.
The additions and revisions read as follows:
§1.1368-2 Accumulated adjustments account (AAA).
(a)
Accumulated
adjustments
account—(1) In general. The accumulated adjustments account is an account of
the S corporation and is not apportioned
among shareholders. The AAA is relevant for all taxable years beginning on or
after January 1, 1983, for which the corporation is an S corporation. On the first
day of the first year for which the corporation is an S corporation, the balance of
the AAA is zero. The AAA is increased in
the manner provided in paragraph (a)(2)
of this section and is decreased in the
manner provided in paragraph (a)(3) of
this section. For the adjustments to the
AAA in the case of redemptions, liquidations, reorganizations, and corporate separations, see paragraph (d) of this section.
*****
(3) * * *
(ii) Extent of allowable reduction. The
AAA may be decreased under paragraph
(a)(3)(i) of this section below zero. The
AAA is decreased by noncapital, nondeductible expenses under paragraph
(a)(3)(i)(C) of this section even though a
portion of the noncapital, nondeductible

263

expenses is not taken into account by a
shareholder under §1.1367-1(g) (relating
to the elective ordering rule). The AAA is
also decreased by the entire amount of
any loss or deduction even though a portion of the loss or deduction is not taken
into account by a shareholder under section 1366(d)(1) or is otherwise not currently deductible under the Internal Revenue Code. However, in any subsequent
taxable year in which the loss, deduction,
or noncapital, nondeductible expense is
treated as incurred by the corporation
with respect to the shareholder under section 1366(d)(2) or §1.1367-1(g) (or in
which the loss or deduction is otherwise
allowed to the shareholder), no further adjustment is made to the AAA.
*****
(4) Ordering rules for the AAA for taxable years beginning before January 1,
1997. For any taxable year beginning before January 1, 1997, the adjustments to
the AAA are made in the following
order—
*****
(5) Ordering rules for the AAA for taxable years beginning on or after August
18, 1998. For any taxable year of the S
corporation beginning on or after August
18, 1998, the adjustments to the AAA are
made in the following order—
(i) The AAA is increased under paragraph (a)(2) of this section before it is decreased under paragraph (a)(3)(i) of this
section for the taxable year;
(ii) The AAA is decreased under paragraph (a)(3)(i) of this section (without
taking into account any net negative adjustment (as defined in section
1368(e)(1)(C)(ii)) before it is decreased
under paragraph (a)(3)(iii) of this section;
(iii) The AAA is decreased (but not
below zero) by any portion of an ordinary
distribution to which section 1368(b) or
(c)(1) applies;
(iv) The AAA is decreased by any net
negative adjustment (as defined in section
1368(e)(1)(C)(ii)); and
(v) The AAA is adjusted (whether negative or positive) for redemption distributions under paragraph (d)(1) of this section.
*****
(d) Adjustment in the case of redemptions, liquidations, reorganizations, and
divisions * * *
*****

January 10, 2000

Par. 9. Section 1368-3 is amended as
follows:
1. The heading for Example 1 is revised.
2. Example 3 through Example 6 are redesignated as Example 6 through Example 9, respectively.
3. Example 2 is redesignated as Example 3.
4. The heading for newly redesignated
Example 3 is revised.
5. New Example 2, Example 4, and Example 5 are added.
The revisions and additions read as follows:
§1.1368-3 Examples.
*****
Example 1. Distributions by S corporations
without C corporation earnings and profits for taxable years beginning before January 1, 1997. * * *
Example 2. Distributions by S corporations
without earnings and profits for taxable years beginning on or after August 18, 1998. (i) Corporation S,
an S corporation, has no earnings and profits as of
January 1, 2001, the first day of its 2001 taxable
year. S’s sole shareholder, A, holds 10 shares of S
stock with a basis of $1 per share as of that date. On
March 1, 2001, S makes a distribution of $38 to A.
The balance in Corporation S’s AAA is $100. For
S’s 2001 taxable year, A’s pro rata share of the
amount of the items described in section 1367(a)(1)
(relating to increases in basis of stock) is $50. A’s
pro rata share of the amount of the items described
in sections 1367(a)(2)(B) through (D) (relating to
decreases in basis of stock for items other than distributions) is $26, $20 of which is attributable to
items described in section 1367(a)(2)(B) and (C)
and $6 of which is attributable to items described in
section 1367(a)(2)(D) (relating to decreases in basis
attributable to noncapital, nondeductible expenses).
(ii) Under section 1368(d)(1) and §1.13681(e)(1) and (2), the adjustments to the basis of A’s
stock in S described in sections 1367(a)(1) are made
before the distribution rules of section 1368 are applied. Thus, A’s basis per share in the stock is $6.00
($1 + [$50/10]) before taking into account the distribution. Under section 1367(a)(2)(A), the basis of
A’s stock is decreased by distributions to A that are
not includible in A’s income. Under §1.13671(c)(3), the amount of the distribution that is attributable to each share of A’s stock is $3.80 ($38 distribution/10 shares). Thus, A’s basis per share in the
stock is $2.20 ($6.00 - $3.80), after taking into account the distribution. Under section 1367(a)(2)(D),
the basis of each share of A’s stock in S after taking
into account the distribution, $2.20, is decreased by
$.60 ($6 noncapital, nondeductible expenses/10).
Thus, A’s basis per share after taking into account

January 10, 2000

the nondeductible, noncapital expenses is $1.60.
Under section 1367(a)(2)(B) and (C), A’s basis per
share is further decreased by $2 ($20 items described in section 1367(a)(2)(B) and (C)/10 shares).
However, basis may not be reduced below zero.
Therefore, the basis of each share of A’s stock is reduced to zero. As of January 1, 2002, A has a basis
of $0 in his shares of S stock. Pursuant to section
1366(d)(2), the $.40 of loss in excess of A’s basis in
each of his shares of S stock is treated as incurred by
the corporation in the succeeding taxable year with
respect to A.
Example 3. Distributions by S corporations with
C corporation earnings and profits for taxable years
beginning before January 1, 1997. * * *
Example 4. Distributions by S corporations with
earnings and profits and no net negative adjustment
for taxable years beginning on or after August 18,
1998. (i) Corporation S, an S corporation, has accumulated earnings and profits of $1,000 and a balance
in the AAA of $2,000 on January 1, 2001. S’s sole
shareholder B holds 100 shares of stock with a basis
of $20 per share as of January 1, 2001. On April 1,
2001, S makes a distribution of $1,500 to B. B’s pro
rata share of the income earned by S during 2001 is
$2,000 and B’s pro rata share of S’s losses is $1,500.
For the taxable year ending December 31, 2001, S
does not have a net negative adjustment as defined
in section 1368(e)(1)(C). S does not make the election under section 1368(e)(3) and §1.1368-1(f)(2) to
distribute its earnings and profits before its AAA.
(ii) The AAA is increased from $2,000 to $4,000
for the $2,000 of income earned during the 2001 taxable year. The AAA is decreased from $4,000 to
$2,500 for the $1,500 of losses. The AAA is decreased from $2,500 to $1,000 for the portion of the
distribution ($1,500) to B that does not exceed the
AAA.
(iii) As of December 31, 2001, B’s basis in his
stock is $10 ($20 + $20 ($2,000 income/100 shares)
- $15 ($1,500 distribution/100 shares) - $15 ($1,500
loss/100 shares).
Example 5. Distributions by S corporations with
earnings and profits and net negative adjustment for
taxable years beginning on or after August 18, 1998.
(i) Corporation S, an S corporation, has accumulated
earnings and profits of $1,000 and a balance in the
AAA of $2,000 on January 1, 2001. S’s sole shareholder B holds 100 shares of stock with a basis of
$20 per share as of January 1, 2001. On April 1,
2001, S makes a distribution of $2,000 to B. B’s pro
rata share of the income earned by S during 2001 is
$2,000 and B’s pro rata share of S’s losses is $3,500.
For the taxable year ending December 31, 2001, S
has a net negative adjustment as defined in section
1368(e)(1)(C). S does not make the election under
section 1368(e)(3) and §1.1368-1(f)(2) to distribute
its earnings and profits before its AAA.

264

(ii) The AAA is increased from $2,000 to $4,000
for the $2,000 of income earned during the 2001 taxable
year.
Because
under
section
1368(e)(1)(C)(ii)and §1.1368-2(a)(ii), the net negative adjustment is not taken into account, the AAA is
decreased from $4,000 to $2,000 for the portion of
the losses ($2,000) that does not exceed the income
earned during the 2001 taxable year. The AAA is reduced from $2,000 to zero for the portion of the distribution to B ($2,000) that does not exceed the
AAA. The AAA is decreased from zero to a negative
$1,500 for the portion of the $3,500 of loss that exceeds the $2,000 of income earned during the 2001
taxable year.
(iii) Under §1.1367-1(c)(1), the basis of a shareholder’s share in an S corporation stock may not be
reduced below zero. Accordingly, as of December
31, 2001, B’s basis per share in his stock is zero ($20
+ $20 income - $20 distribution - $35 loss). Pursuant to section 1366(d)(2), the $15 of loss in excess
of B’s basis in each of his shares of S stock is treated
as incurred by the corporation in the succeeding taxable year with respect to B.

*****
Par. 10. §1.1368-4 is revised to read as
follows:
§1.1368-4 Effective date and transition
rule.
Except for §§1.1368-1(e)(2), 1.13682(a)(5), and 1.1368-3 Example 2, Example 4, and Example 5, §§1.1368-1,
1.1368-2, and 1.1368-3 apply to taxable
years of the corporation beginning on or
after January 1, 1994. Section 1.13681(e)(2), §1.1368-2(a)(5), and §1.1368-3
Example 2, Example 4, and Example 5
apply only to taxable years of the corporation beginning on or after August 18,
1998. For taxable years beginning before
January 1, 1994, and taxable years beginning on or after January 1, 1997, and before August 18, 1998, the treatment of
distributions by an S corporation to its
shareholders must be determined in a reasonable manner, taking into account the
statute and legislative history. Except
with regard to the deemed dividend rule
under §1.1368-1(f)(3), §1.1368-1(e)(2),
§1.1368-2(a)(5), and §1.1368-3 Example
2, Example 4, and Example 5, return positions consistent with §§1.1368-1, 1.13682, and 1.1368-3 are reasonable for taxable
years beginning before January 1, 1994.
Return positions consistent with
§§1.1368-1(e)(2), 1.1368-2(a)(5), and
1.1368-3 Example 2, Example 4, and Example 5 are reasonable for taxable years
beginning on or after January 1, 1997, and

2000–2 I.R.B.

before August 18, 1998.
PART 602—OMB CONTROL
NUMBERS UNDER THE
PAPERWORK REDUCTION ACT
Par. 11. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.
Par. 12. In §602.101, paragraph (b) is

amended by adding the entry for 1.1366-1
to the table as follows:
§602.101 OMB Control numbers.
*****
(b) * * *
Robert E. Wenzel,
Deputy Commissioner of
Internal Revenue.

Jonathan Talisman,
Acting Assistant Secretary
of the Treasury.
(Filed by the office of the Federal Register on December 21, 1999, 8:45 a.m., and published in the
issue of the Federal Register for December 22, 1999,
64 F.R. 71641)

Approved December 13, 1999.

CFR part or section where
identified and described

Current OMB
control No.

*****
1.1366-1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1545-1613
*****

Section 1397E.—Credit to
Holders of Qualified Zone
Academy Bonds
What is the 2000 qualified zone academy bond
national limitation for each State, the District of Columbia, and the possessions of the United States?
See Rev. Proc. 2000–10, page 287.

Section 6038.—Information
Reporting With Respect to
Certain Foreign Corporations and
Partnerships
26 CFR 1.6038–2: Information returns required of
United States persons with respect to annual
accounting periods of certain foreign corporations
beginning after December 31, 1962.

T.D. 8850
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Information Reporting With
Respect to Certain Foreign
Partnerships and Certain
Foreign Corporations
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.

2000–2 I.R.B.

SUMMARY: This document contains
final regulations under section 6038 of
the Internal Revenue Code relating to
information reporting requirements for
United States persons owning interests
in controlled foreign partnerships
(CFPs). This document also contains
amendments to the final regulations
under section 6038 relating to the reporting requirements of U.S. shareholders of certain foreign corporations and
amendments to the final regulations
under section 6038B relating to the reporting requirements with respect to
transfers of property to foreign partnerships and to foreign corporations.
DATES: Effective Dates: These regulations are effective December 29, 1999,
except that §1.6038B-2(a)(5) is effective
January 1, 2000.
Applicability Dates: For dates of applicability, see §§1.6038-2(l), 1.6038-3(l),
and 1.6038B-2(c)(4) and (j)(3).
FOR FURTHER INFORMATION CONTACT: Eliana Dolgoff, (202) 622-3860
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in these final regulations have been
reviewed and approved by the Office of
Management and Budget in accordance

265

with the Paperwork Reduction Act of
1995 (44 U.S.C. 3507(d)) under control
numbers 1545-1615, 1545-1617, and
1545-1317. Responses to these collections of information are mandatory.
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.
The burden of complying with the collection of information required to be reported on Form 8865 is reflected in the
burden for Form 8865.
The burden of complying with the collection of information required to be reported on Form 5471 is reflected in the
burden for Form 5471.
The burden of complying with the collection of information required to be reported on Form 926 is reflected in the
burden for Form 926.
The estimated annual burden per respondent of complying with the collection of information in §1.6038-3(c)(1)(ii)(B) and
(2)(ii)(B) varies from .5 hours to 1.5 hours,
depending on individual circumstances,
with an estimated average of 1 hour.
Comments concerning the accuracy of
this burden estimate and suggestions for
reducing this burden should be sent to the
Internal Revenue Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 20224, and to the Office of

January 10, 2000