Reg-251698-96

Drafting Information
The principal author of these regulations is Robin Ehrenberg, Office of Associate Chief Counsel (Employee Benefits
and Exempt Organizations). However,
other personnel from the IRS and Treasury Department participated in their development.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.513–7 is added to
read as follows:
§ 1.513-7 Travel and tour activities of tax
exempt organizations.
(a) Travel tour activities that constitute
a trade or business, as defined in § 1.5131(b), and that are not substantially related
to the purposes for which exemption has
been granted to the organization constitute an unrelated trade or business with
respect to that organization. Whether
travel tour activities conducted by an organization are substantially related to the
organization’s exempt purpose is determined by looking at all relevant facts and
circumstances. Section 513(c) and
§ 1.513–1(b) also apply to travel tour activity. Application of the rules of section
513(c) and § 1.513–1(b) may result in different treatment for individual tours within
an organization’s travel tour program.
(b) Examples. The provisions of this
section are illustrated by the following examples:
Example 1. O, a university alumni association, is
exempt from federal income tax under section
501(a) as an educational organization described in
section 501(c)(3). As part of its activities, O operates a travel tour program. The program is open to
all current members of O and their guests. O works
with travel agencies to schedule approximately 10
tours annually to various destinations around the
world. Members of O pay $X to the organizing
travel agency to participate in a tour. The travel
agency pays O a per person fee for each participant.
Although the literature advertising the tours encourages O’s members to continue their lifelong learning
by joining the tours, and a faculty member of O’s related university is invited to join the tour as a guest
of the alumni association, none of the tours includes
any scheduled instruction or curriculum related to
the destinations being visited. By arranging to make

May 18, 1998

travel tours available to its members, O is not contributing importantly to the accomplishment of its
educational purpose. Rather, O’s program is designed to generate revenues for O by regularly offering its members travel services. Accordingly, O’s
tour program is an unrelated trade or business within
the meaning of section 513(a) of the Code.
Example 2. N is an organization formed for the
purpose of educating individuals about the geography and culture of the United States. It is exempt
from federal income tax under section 501(a) as an
educational and cultural organization described in
section 501(c)(3). N engages in a number of activities to accomplish its purposes, including offering
courses and publishing periodicals and books. As
one of its activities, N conducts study tours to national parks and other locations within the United
States. The study tours are conducted by teachers
and other education professionals. The tours are
open to all who agree to participate in the required
study program. The study program consists of community college level courses related to the location
being visited by the tour. While the students are on
the tour, five or six hours per day are devoted to organized study, preparation of reports, lectures, instruction and recitation by the students. Each tour
group brings along a library of material related to
the subject being studied on the tour. Examinations
are given at the end of each tour and N’s state board
of education awards academic credit for tour participation. Because the tours offered by N include a
substantial amount of required study, lectures, report
preparation, examinations and qualify for academic
credit, the tours clearly further N’s educational purpose. Accordingly, N’s tour program is not an unrelated trade or business within the meaning of section
513(a) of the Code.
Example 3. R is a section 501(c)(4) social welfare organization devoted to advocacy on a particular issue. On a regular basis throughout the year, R
organizes a travel tour for its members to Washington, D.C.. The tours are priced to produce a profit
for R. While in Washington, the members follow a
schedule according to which they spend substantially all of their time over several days attending
meetings with legislators and government officials
and receiving briefings on policy developments related to the issue that is R’s focus. Bringing members to Washington to participate in advocacy on
behalf of the organization and learn about developments relating to the organization’s principal focus
is substantially related to R’s social welfare purpose.
Therefore, R’s operation of the travel tours does not
constitute an unrelated trade or business.
Example 4. S is a membership organization
formed to foster cultural unity and to educate X
Americans about X, their country of origin. It is exempt from federal income tax under section 501(a)
and is described in section 501(c)(3) as an educational and cultural organization. Membership in S is
open to all Americans interested in the X heritage.
As part of its activities, S sponsors a program of
travel tours to X. All of S’s tours are priced to produce a profit for S. The tours are divided into two
categories. Category A tours are trips to X that are
designed to immerse participants in the X history,
culture and language. The itinerary is designed to
have participants spend substantially all of their time
while in X receiving instruction on the X language,
history and cultural heritage. Destinations are se-

14

lected because of their historical or cultural significance or because of instructional resources they
offer. Category B tours are also trips to X, but rather
than offering scheduled instruction, participants are
given the option of taking guided tours of various X
locations included in their itinerary. Other than the
optional guided tours, Category B tours offer no instruction or curriculum. Even if participants take all
of the tours offered, they have a substantial amount
of time free to pursue their own interests once in X.
Destinations of principally recreational interest,
rather than historical or cultural interest, are regularly included on Category B tour itineraries. Based
on the facts and circumstances, sponsoring Category
A tours is an activity substantially related to S’s exempt purposes, and does not constitute an unrelated
trade or business with respect to S. However, sponsoring Category B tours does not contribute importantly to S’s accomplishment of its exempt purposes
and is designed to generate a profit for S. Therefore,
sponsoring the Category B tours constitutes an unrelated trade or business with respect to S.

Michael P. Dolan,
Deputy Commissioner of
Internal Revenue.
(Filed by the Office of the Federal Register on April
20, 1998, 2:48 p.m., and published in the issue of the
Federal Register for April 23, 1998, 63 F.R. 20156)

Notice of Proposed Rulemaking
S Corporation Subsidiaries
REG–251698–96
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking.
SUMMARY: This document contains
proposed regulations relating to the treatment of corporate subsidiaries of S corporations. The proposed regulations interpret the rules added to the Internal
Revenue Code by section 1308 of the
Small Business Job Protection Act of
1996. The proposed regulations affect S
corporations and their subsidiaries.
DATES: Written comments must be received by July 21, 1998.
ADDRESSES: Send submissions to
CC:DOM:CORP:R (REG–251698–96),
room 5228, Internal Revenue Service,
POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be
hand delivered between the hours of 8
a.m. and 5 p.m. to: CC:DOM:CORP:R
(REG–251698–96), Courier’s Desk, In-

1998–20 I.R.B.

ternal Revenue Service, 1111 Constitution
Avenue, NW, Washington, DC. Alternatively, taxpayers may submit comments
electronically via the Internet by selecting
the “Tax Regs” option on the IRS Home
Page, or by submitting comments directly
to the IRS Internet site at http://www.irs.
ustreas.gov/prod/tax_regs/comments.html.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations,
Deanna L. Walton, (202) 622-3050 (Subchapter S) or Lee A. Dean, (202) 6227540 (Subchapter C); concerning submissions, Michael Slaughter, (202) 622-7190
(not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained
in this notice of proposed rulemaking
have been submitted to the Office of
Management and Budget for review in
accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)).
Comments on the collections of information should be sent to the Office of
Management and Budget, Attn: Desk
Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503, with
copies to the Internal Revenue Service,
Attn: IRS Reports Clearance Officer,
T:FP, Washington, DC 20224. Comments
on the collections of information should
be received by June 22, 1998. Comments
are specifically requested concerning:
Whether the proposed collections of information are necessary for the proper performance of the functions of the Internal
Revenue Service, including whether the
collections will have a practical utility;
The accuracy of the estimated burden
associated with the proposed collections
of information (see below);
How the quality, utility, and clarity of
the information to be collected may be enhanced;
How the burden of complying with the
proposed collections of information may
be minimized, including through the application of automated collection techniques or other forms of information technology; and
Estimates of capital or start-up costs and
costs of operation, maintenance, and purchase of services to provide information.

1998–20 I.R.B.

The collections of information in these
proposed regulations are in §§1.1361–
3(a)(1), 1.1361–3(b)(1), 1.1361–5(a)(2),
and 1.1362–8. The collections of information are required to determine the manner in which a corporate subsidiary of an
S corporation will be treated under the Internal Revenue Code.
These collections of information are required to obtain a benefit. The likely respondents and/or recordkeepers are small
businesses or organizations, businesses or
other for-profit institutions, and farms.
Estimated total annual reporting/recordkeeping burden: 10,110 hours
Estimated average annual burden per respondent/recordkeeper: 57 minutes
Estimated number of respondents/recordkeepers: 10,660
Estimated annual frequency of responses:
On occasion
An agency may not conduct or sponsor,
and a person is not required to respond to,
a collection of information unless it displays a valid control number assigned by
the Office of Management and Budget.
Books or records relating to a collection of information must be retained as
long as their contents may become material in the administration of any internal
revenue law. Generally, tax returns and
tax return information are confidential, as
required by 26 U.S.C. 6103.
Background
This document contains proposed
amendments to the Income Tax Regulations (26 CFR Part 1) relating to S corporations and their subsidiaries under sections 1361 and 1362 of the Internal
Revenue Code (Code). Section 1308 of
the Small Business Job Protection Act of
1996, Public Law 104–188, 110 Stat.
1755 (the Act), modified section 1361 of
the Code to permit an S corporation (1) to
own 80 percent or more of the stock of a
C corporation, and (2) to elect to treat a
wholly owned subsidiary as a qualified
subchapter S subsidiary (QSSS). In Notice 97–4 (1997–2 I.R.B. 24), the IRS announced its intention to issue regulations
under section 1308 of the Act and requested comments on certain issues. Section 1601 of the Taxpayer Relief Act of
1997, Public Law 105–34, 111 Stat. 788
(the 1997 Act), made a technical correction to section 1361 to provide regulatory

15

authority regarding the consequences of
an election to be a QSSS.
Explanation of Provisions
Overview
Prior law prohibited an S corporation
from owning 80 percent or more of the
stock of another corporation. The Act repealed section 1362(b)(2)(A) of the Internal Revenue Code (Code), thereby allowing an S corporation to own 80 percent or
more of the stock of a C corporation. The
Act also added section 1504(b)(8) to the
Code to prevent an S corporation from
joining in the filing of a consolidated return with its affiliated C corporations. A
C corporation subsidiary of an S corporation, however, may file a consolidated return with its affiliated C corporations.
See H.R. Conf. Rep. No. 737, 104th
Cong., 2d Sess. 224 (1996).
New section 1361(b)(3)(B) defines the
term qualified subchapter S subsidiary as
any domestic corporation that is not an ineligible corporation if, (1) an S corporation holds 100 percent of the stock of the
corporation, and (2) that S corporation
elects to treat the subsidiary as a QSSS.
Except as otherwise provided in regulations, a corporation for which a QSSS
election is made is not treated as a separate corporation, and all assets, liabilities,
and items of income, deduction, and
credit of the QSSS are treated as assets, liabilities, and items of income, deduction,
and credit of the parent S corporation.
The legislative history accompanying section 1361(b)(3) indicates that, when the
parent corporation makes the election, the
subsidiary is deemed to have liquidated
under sections 332 and 337 immediately
before the election is effective. See S.
Rep. No. 281, 104th Cong., 2d Sess. 53
(1996); H.R. Rep. No. 586, 104th Cong.,
2d Sess. 89 (1996). However, the legislative history accompanying the technical
correction made by the 1997 Act indicates
that regulations may provide exceptions
to that general rule. See S. Rep. No. 33,
105th Cong., 1st Sess. 320 (1997).
Section 1361(b)(3)(C) provides that
any QSSS that ceases to meet the requirements of section 1361(b)(3)(B) will be
treated as a new corporation acquiring all
of its assets (and assuming all of its liabilities) immediately before the cessation
from its S corporation parent in exchange

May 18, 1998

for the subsidiary’s stock. Section
1361(b)(3)(D) provides that a QSSS
whose election has terminated (or a successor corporation) may not make an S
election or have a QSSS election made
with respect to it before its fifth taxable
year that begins after the first taxable year
for which the termination is effective, unless the Secretary consents to the election.
Under current and prior law, the S election of a corporation with subchapter C
corporation earnings and profits terminated if that S corporation received passive investment income, including dividends, in excess of 25 percent of gross
receipts for three consecutive years. Section 1362(d)(3)(E) modifies that general
rule by excluding dividends from passive
investment income to the extent that the
dividends are attributable to the active
conduct of a trade or business of a C corporation in which the S corporation has an
80 percent or greater ownership interest.
Neither the Act nor the legislative history
provides rules for determining the attribution of dividends to an active trade or
business.
QSSS Formation
Under the proposed regulations, an S
corporation makes a QSSS election with
respect to an eligible subsidiary by filing
a form to be developed by the IRS prior to
the time these regulations become final.
This proposes to change the temporary
election procedure provided in Notice 97–
4, which provides that a parent S corporation files a completed Form 966, Corporate Dissolution and Liquidation (with
some modifications), to make a QSSS
election. Until these proposed regulations
are finalized, taxpayers should continue
to use the temporary election procedure in
Notice 97–4 to make QSSS elections.
The proposed regulations also provide
that the effective date of a QSSS election
may be up to 2 months and 15 days prior
to the day the QSSS election is made.
This is a slight change from the 75 day
retroactive period provided in Notice 97–
4, but is consistent with the general time
period for making S elections. Unlike the
S election, however, a QSSS election
does not need to be made within 2 months
and 15 days of the beginning of a taxable
year. A similar retroactive period is provided for revocations of QSSS status. In
addition, a taxpayer may choose a

May 18, 1998

prospective effective date for a QSSS
election or revocation, so long as the date
selected is not more than 12 months after
the date the election or revocation is
made.
The proposed regulations provide that,
when an S corporation makes a valid
QSSS election with respect to a subsidiary, the subsidiary is deemed to have
liquidated into the parent. The tax treatment of this liquidation, alone or in the
context of any larger transaction (for example, a transaction that also includes the
acquisition of the subsidiary’s stock), is
generally determined under all relevant
provisions of the Code and general principles of tax law, including the step transaction doctrine. However, a special transition rule applies to certain elections
effective prior to the date that is 60 days
after publication of final regulations in the
Federal Register. The transition rule indicates the recognition of special concerns
that may have arisen as a result of transactions entered into by taxpayers relying on
the legislative history to the Act and without applying the step transaction doctrine
to the acquisition of the subsidiary’s stock
followed by a QSSS election. The IRS requests comments concerning other transactions occurring during the transitional
period for which relief from the effect of
application of the step transaction doctrine
may be warranted.
Special rules may apply when a QSSS
election is made following the transfer of
one S corporation’s stock to another S
corporation. For example, if an S corporation acquires the stock of another S corporation in a transaction in which the acquiring S corporation’s basis in the stock
received is determined by reference to the
transferor’s basis and makes a QSSS election with respect to the other corporation
effective on the day of acquisition, any
losses disallowed under section 1366(d)
with respect to a former shareholder of
the QSSS will be available to that shareholder as a shareholder of the acquiring S
corporation. Furthermore, when stock in
an S corporation is transferred to another
S corporation and a QSSS election is
made with respect to the subsidiary effective on the day of acquisition, the S election of the former corporation terminates
at the same moment as the QSSS election
becomes effective. This rule ensures that
the former S corporation is not treated as

16

a C corporation for any period solely because of the transfer.
Generally, the proposed regulations
treat the liquidation as occurring at the
close of the day before the QSSS election
is effective. Under this rule, if a parent
corporation makes an S election effective
on the same date as a QSSS election with
respect to a subsidiary, the deemed liquidation occurs at a time when the parent
corporation is still a C corporation. A
QSSS election satisfies the requirement of
adopting a plan of liquidation under section 332.
Following the deemed liquidation, the
QSSS is not treated as a separate corporation (except as otherwise provided in the
regulations), and all assets, liabilities, and
items of income, deduction, and credit are
treated as those of the S corporation. Accordingly, all such items must be reported
on the S corporation’s return required to
be filed under section 6037. A special
rule applies for the calculation of these
items where either an S corporation or its
QSSS is a bank (as defined in section
581). This special rule was first announced in Notice 97–5 (1997–2 I.R.B.
25). Until these proposed regulations are
finalized, taxpayers should continue to
follow Notice 97–5.
QSSS Termination
The QSSS status of a corporation continues until it terminates. The regulations
specify the date of termination for specific terminating events. Section 1361(b)(3)(D) provides that, if a QSSS election
terminates, the corporation is treated as a
new corporation acquiring all of its assets
(and assuming all of its liabilities) from
the S corporation in exchange for stock of
the new corporation immediately before
the termination. The tax treatment of this
transaction or of a larger transaction that
includes this transaction will be determined under the Code and general principles of tax law, including the step transaction doctrine. Examples are provided to
illustrate situations in which the formation of the new corporation will qualify as
a nonrecognition transaction under section 351. The proposed regulations also
provide that, under certain circumstances,
relief may be available under the standards established under section 1362(f)
for the inadvertent termination of an S
election.

1998–20 I.R.B.

Section 1361(b)(3)(D) provides that a
corporation whose QSSS election has terminated (or a successor corporation) may
not make an S election or have a QSSS
election made with respect to it for five
taxable years following the termination
without the consent of the Secretary. The
proposed regulations provide that, without requesting the Secretary’s consent, a
corporation may make an election to be
treated as an S corporation or may have a
QSSS election made with respect to it before the expiration of the five-year period
under certain circumstances. Consent is
not required if an otherwise valid S election or QSSS election is made for the former QSSS (or its successor corporation)
effective immediately following the disposition of its stock. Thus, the proposed
regulations allow corporations to move
freely between QSSS and S corporation
status, provided there is no intervening
period for which the corporation is treated
as a C corporation.
C Corporation Subsidiaries
The proposed regulations also provide
rules relating to certain C corporation
subsidiaries held by S corporations.
Under section 1362(d)(3)(E), dividends
received by an S corporation from a C
corporation in which the S corporation
has an 80 percent or greater ownership
interest are not treated as passive investment income for purposes of sections
1362 and 1375 to the extent the dividends
are attributable to the earnings and profits
of the C corporation derived from the active conduct of a trade or business. The
proposed regulations provide guidance
for attributing dividends to the active
conduct of a trade or business. Special
rules apply to dividends distributed by
the common parent of a consolidated
group.
Under the proposed regulations, earnings and profits of a C corporation derived from the active conduct of a trade or
business are the earnings and profits of
the corporation derived from activities
that would not produce passive investment income under section 1362(d)(3) if
the C corporation were an S corporation.
The proposed regulations provide a safe
harbor under which the corporation may
determine the amount of the active earnings and profits by comparing the corporation’s gross receipts derived from non-

1998–20 I.R.B.

passive investment income-producing activities with the corporation’s total gross
receipts in the year the earnings and profits are produced. If less than 10 percent
of the C corporation’s earnings and profits
for a taxable year are derived from activities that would produce passive investment income, all earnings and profits produced by the corporation during the
taxable year are considered active earnings and profits.
The proposed regulations also provide
that a C corporation may treat all earnings
and profits accumulated by the corporation prior to the time an S corporation
held stock meeting the requirements of
section 1504(a)(2) as active earnings and
profits in the same proportion as the C
corporation’s active earnings and profits
for the three taxable years ending prior to
the time when the S corporation acquired
80 percent of the C corporation bear to the
C corporation’s total earnings and profits
for those three taxable years. Provisions
also address the allocation of distributions
from current or accumulated earnings and
profits.
Proposed Effective Date
The regulations are proposed to be effective on the date that final regulations
are published in the Federal Register.
However, the IRS is considering whether
certain provisions should be made
retroactive. The IRS requests comments
concerning whether certain provisions
should be made effective for taxable years
beginning on or after January 1, 1997.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a significant regulatory action as defined in EO
12866. Therefore, a regulatory assessment is not required. Pursuant to section
7805(f) of the Internal Revenue Code,
this notice of proposed rulemaking will
be submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its impact on
small business. It is hereby certified that
the collections of information contained
in these regulations will not have a significant economic impact on a substantial
number of small businesses. This certification is based on the fact that the economic burden imposed on taxpayers by

17

the collections of information and recordkeeping requirements of these regulations is insignificant. For example, the
estimated average annual burden per respondent is less than one hour. Furthermore, most taxpayers will only have to
respond to the requests for information
contained in §§1.1361–3(b)(1) and
1.1361–5(a)(2) one time in the life of the
corporation. Therefore, a Regulatory
Flexibility Analysis under the Regulatory
Flexibility Act (5 U.S.C. chapter 6) is not
required.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consideration will be given to any written comments (preferably a signed original and
eight (8) copies) that are timely submitted to the IRS. All comments will be
available for public inspection and
copying.
A public hearing will be scheduled in
the Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.
The IRS recognizes that persons outside
the Washington, DC, area also may wish
to testify at the public hearing through
teleconferencing. Requests to include
teleconferencing sites must be received
by June 22, 1998. If the IRS receives
sufficient indications of interest to warrant teleconferencing to a particular city,
and if the IRS has teleconferencing facilities available in that city on the date the
public hearing is to be scheduled, the IRS
will try to accommodate the requests.
The IRS will publish the time and date
of the public hearing and the locations of
any teleconferencing sites in an announcement in the Federal Register.
Drafting Information
The principal authors of these proposed
regulations are Deanna L. Walton, Office
of the Assistant Chief Counsel (Passthroughs and Special Industries); and Lee
A. Dean, Office of the Assistant Chief
Counsel (Corporate). However, other
personnel from the IRS and Treasury Department participated in their development.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:

May 18, 1998

PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Amend §1.1361–0 as follows:
1. Revise the introductory text.
2. Remove the entry for §1.1361–
1(d)(3).
3. Add entries for §§1.1361–2,
1.1361–3, 1.1361–4, 1.1361–5, and
1.1361–6.
The revisions and additions read as follows:
§1.1361–0 Table of contents.
This section lists captions contained in
§§1.1361–1, 1.1361–2, 1.1361–3,
1.1361–4, 1.1361–5, and 1.1361–6.
*

*

*

*

*

§1.1361–2 Definitions relating to S
corporation subsidiaries.
(a) In general.
(b) Stock treated as held by S corporation.
(c) Examples.
§1.1361–3 QSSS election.
(a)
(1)
(2)
(3)
(4)
(5)
(b)
(1)
(2)
(3)

Time and manner of making election.
In general.
Time of making election.
Effective date of election.
Example.
Extension of time for making a QSSS
election.
Revocation of QSSS election.
Manner of revoking QSSS election.
Effective date of revocation.
Revocation after termination.

§1.1361–4 Effect of QSSS election.
(a)
(1)
(2)
(3)
(i)
(ii)
(4)
(5)
(i)
(ii)
(b)
(1)
(2)
(3)

Separate existence ignored.
In general.
Liquidation of subsidiary.
Treatment of banks.
In general.
Examples.
Treatment of stock of QSSS.
Transitional relief.
General rule.
Examples.
Timing of the liquidation.
In general.
Acquisitions.
Coordination with section 338 election.

May 18, 1998

(c) Carryover of disallowed losses and
deductions.
(d) Examples.
§1.1361–5 Termination of QSSS election.
(a) In general.
(1) Effective date.
(2) Information to be provided upon termination of QSSS election by failure
to qualify as a QSSS.
(3) Examples.
(b) Effect of termination of QSSS election.
(1) Formation of new corporation.
(2) Carryover of disallowed losses and
deductions.
(3) Examples.
(c) Inadvertent terminations.
(d) Election after QSSS termination.
(1) In general.
(2) Exception.
(3) Examples.
§1.1361–6 Effective date.
Par. 3. Amend §1.1361–1 as follows:
1. Revise paragraph (b)(1)(i).
2. Remove paragraph (d)(1)(i).
3. Redesignate paragraphs (d)(1)(ii),
(d)(1)(iii), (d)(1)(iv), and (d)(1)(v) as
paragraphs (d)(1)(i), (d)(1)(ii), (d)(1)(iii),
and (d)(1)(iv), respectively.
4. Revise newly designated paragraph
(d)(1)(i).
5. Remove paragraph (d)(3).
6. Revise the first sentence of paragraph (e)(1).
The revisions read as follows:
§1.1361–1 S corporation defined.
*

*

*

*

*

(b) * * *
(1) * * *
(i) More than 75 shareholders (35 for
taxable years beginning before January 1,
1997);
* * * * *
(d) * * *
(1) * * *
(i) For taxable years beginning on or
after January 1, 1997, a financial institution that uses the reserve method of accounting for bad debts described in section 585 (for taxable years beginning
prior to January 1, 1997, a financial institution to which section 585 applies (or
would apply but for section 585(c)) or to
which section 593 applies);
*

*

*

18

*

*

(e) * * *
(1) General rule. A corporation does
not qualify as a small business corporation if it has more than 75 shareholders
(35 for taxable years beginning prior to
January 1, 1997). * * *
*

*

*

*

*

Par. 4. Add §§ 1.1361–2, 1.1361–3,
1.1361–4, 1.1361–5, and 1.1361–6 to
read as follows:
§1.1361–2 Definitions relating to S
corporation subsidiaries.
(a) In general. The term qualified subchapter S subsidiary (QSSS) means any
domestic corporation that is not an ineligible corporation (as defined in section
1361(b)(2) and the regulations thereunder), if—
(1) 100 percent of the stock of such
corporation is held by an S corporation;
and
(2) The S corporation properly elects
to treat the subsidiary as a QSSS under
§1.1361–3.
(b) Stock treated as held by S corporation. For purposes of satisfying the 100
percent stock ownership requirement in
section 1361(b)(3)(B)(i) and paragraph
(a)(1) of this section, stock of a corporation is treated as held by an S corporation
if the S corporation is the owner of that
stock for federal income tax purposes.
(c) Examples. The following examples
illustrate the application of this section:
Example 1. X, an S corporation, owns 100 percent of Y, a corporation for which a valid QSSS election is in effect for the taxable year. Y owns 100 percent of Z, a corporation otherwise eligible for QSSS
status. X may elect to treat Z as a QSSS under section 1361(b)(3)(B)(ii).
Example 2. Assume the same facts as in Example
1, except that Y is a business entity that is disregarded as an entity separate from its owner under
§301.7701–2(c)(2) of this chapter. X may elect to
treat Z as a QSSS.
Example 3. Assume the same facts as in Example
1, except that Y owns 50 percent of Z, and X owns
the other 50 percent. X may elect to treat Z as a
QSSS.
Example 4. Assume the same facts as in Example
1, except that Y is a C corporation. Although Y is a
domestic corporation that is otherwise eligible to be
a QSSS, no QSSS election has been made for Y.
Thus, X is not treated as holding the stock of Z.
Consequently, X may not elect to treat Z as a QSSS.

§1.1361–3 QSSS election.
(a) Time and manner of making election—(1) In general. Except as provided

1998–20 I.R.B.

in section 1361(b)(3)(D) and §1.1361–
5(d) (five-year prohibition on re-election), an S corporation may elect to treat
an eligible subsidiary as a QSSS by filing
a completed form to be prescribed by the
Internal Revenue Service. The election
form must be signed by a person authorized to sign the S corporation’s return required to be filed under section 6037 and
must be submitted to the service center
where the subsidiary filed its most recent
tax return (if applicable). If an S corporation forms a subsidiary and makes a valid
QSSS election (effective upon the date of
the subsidiary’s formation) for the subsidiary, the election should be submitted
to the service center where the S corporation filed its most recent return.
(2) Time of making election. A QSSS
election may be made by the S corporation parent at any time during the taxable
year.
(3) Effective date of election. A QSSS
election will be effective on the date specified on the election form or on the date
the election form is filed if no date is
specified. The effective date specified on
the form can not be more than 2 months
and 15 days prior to the date of filing and
can not be more than 12 months after the
date of filing. For this purpose, the definition of the term “month” found in
§1.1362–6(a)(2)(ii)(C) applies. If an
election form specifies an effective date
more than 2 months and 15 days prior to
the date on which the election form is
filed, it will be effective 2 months and 15
days prior to the date it is filed. If an election form specifies an effective date more
than 12 months after the date on which
the election is filed, it will be effective 12
months after the date it is filed. The corporation for which the QSSS election is
made must meet all the requirements of
section 1361(b)(3)(B) at the time the election is made and for all periods for which
the election is to be effective.
(4) Example. The following example
illustrates the application of paragraph
(a)(3) of this section:
Example. X has been a calendar year S corporation engaged in a trade or business for several years.
X acquires the stock of Y, a calendar year C corporation, on April 1, 1998. On August 10, 1998, X
makes an election to treat Y as a QSSS. Unless otherwise specified on the election form, the election
will be effective as of August 10, 1998. If specified
on the election form, the election may be effective
on some other date that is not more than 2 months

1998–20 I.R.B.

and 15 days prior to August 10, 1998, and not more
than 12 months after August 10, 1998.

(5) Extension of time for making a
QSSS election. An extension of time to
make a QSSS election may be available
under the procedures applicable under
§§301.9100–1 and 301.9100–3 of this
chapter.
(b) Revocation of QSSS election—(1)
Manner of revoking QSSS election. An S
corporation may revoke a QSSS election
under section 1361 by filing a statement
with the service center where the S corporation’s most recent tax return was properly filed. The revocation statement must
include the names, addresses, and taxpayer identification numbers of both the
parent S corporation and the QSSS. The
statement must be signed by a person authorized to sign the S corporation’s return
required to be filed under section 6037.
(2) Effective date of revocation. The
revocation of a QSSS election is effective
on the date specified on the revocation
statement or on the date the revocation
statement is filed if no date is specified.
The effective date specified on the revocation statement can not be more than 2
months and 15 days prior to the date on
which the revocation statement is filed
and can not be more than 12 months after
the date on which the revocation statement is filed. If a revocation statement
specifies an effective date more than 2
months and 15 days prior to the date on
which the statement is filed, it will be effective 2 months and 15 days prior to the
date it is filed. If a revocation statement
specifies an effective date more than 12
months after the date on which the statement is filed, it will be effective 12
months after the date it is filed.
(3) Revocation after termination. A revocation may not be made after the occurrence of an event that renders the subsidiary ineligible for QSSS status under
section 1361(b)(3)(B).
§1.1361–4 Effect of QSSS election.
(a) Separate existence ignored—(1) In
general. Except as otherwise provided in
paragraph (a)(3) of this section, for federal tax purposes—
(i) A corporation which is a QSSS shall
not be treated as a separate corporation;
and
(ii) All assets, liabilities, and items of
income, deduction, and credit of a QSSS

19

shall be treated as assets, liabilities, and
items of income, deduction, and credit of
the S corporation.
(2) Liquidation of subsidiary. If an S
corporation makes a valid QSSS election
with respect to a subsidiary, the subsidiary is deemed to have liquidated into
the S corporation. Except as provided in
paragraph (a)(5) of this section, the tax
treatment of the liquidation or of a larger
transaction that includes the liquidation
will be determined under the Internal
Revenue Code and general principles of
tax law, including the step transaction
doctrine. Thus, for example, if an S corporation forms a subsidiary and makes a
valid QSSS election (effective upon the
date of the subsidiary’s formation) for the
subsidiary, there will be no deemed liquidation of the new subsidiary. Instead, the
corporation will be deemed to be a QSSS
from its inception. For purposes of section 332, the making of a QSSS election
satisfies the requirement of adopting a
plan of liquidation.
(3) Treatment of banks—(i) In general.
If an S corporation is a bank, or if an S
corporation makes a valid QSSS election
for a subsidiary that is a bank, any special
rules applicable to banks under the Internal Revenue Code continue to apply separately to the bank parent or bank subsidiary as if the deemed liquidation of any
QSSS under paragraph (a)(2) of this section had not occurred. For any QSSS that
is a bank, however, all assets, liabilities,
and items of income, deduction, and credit
of the QSSS, as determined in accordance
with the special bank rules, are treated as
assets, liabilities, and items of income, deduction, and credit of the S corporation.
For purposes of this paragraph (a)(3)(i),
the term “bank” has the same meaning as
in section 581.
(ii) Examples. The following examples illustrate the application of this paragraph (a)(3):
Example 1. X, an S corporation, is a bank as defined in section 581. X owns 100 percent of Y and Z,
corporations for which valid QSSS elections are in
effect. Y is a bank as defined in section 581, and Z is
not a financial institution. Pursuant to paragraph
(a)(3)(i) of this section, any special rules applicable
to banks under the Internal Revenue Code continue
to apply separately to X and Y and do not apply to Z.
Thus, for example, section 265(b), which provides
special rules for interest expense deductions of
banks, applies separately to X and Y. That is, X and
Y each must make a separate determination under
section 265(b) of interest expense allocable to tax-

May 18, 1998

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

(4) Treatment of stock of QSSS. Except for purposes of section 1361(b)(3)(B)(i) and §1.1361–2(a)(1), the stock
of a QSSS shall be disregarded for all federal tax purposes.
(5) Transitional relief—(i) General
rule. If an S corporation and another corporation (the related corporation) are persons specified in section 267(b) prior to
an acquisition by the S corporation of
some or all of the stock of the related corporation followed by a QSSS election for
the related corporation, the step transaction doctrine will not apply to determine
the tax consequences of the acquisition.
This paragraph (a)(5) shall apply to QSSS
elections effective prior to the date that is
60 days after publication of final regulations in the Federal Register.
(ii) Examples. The following examples illustrate the application of this paragraph (a)(5):
Example 1. Individual A owns 100 percent of the
stock of X, an S corporation. X owns 79 percent of
the stock of Y, a solvent corporation, and A owns the
remaining 21 percent. On May 4, 1998, A contributes its Y stock to X in exchange for X stock. X
makes a QSSS election with respect to Y effective
immediately following the transfer. The liquidation
described in paragraph (a)(2) of this section is respected as an independent step separate from the
stock acquisition, and the tax consequences of the
liquidation are determined under sections 332 and
337. The contribution by A of the Y stock qualifies
under section 351, and no gain or loss is recognized
by A, X, or Y.
Example 2. Individual A owns 100 percent of the
stock of two solvent S corporations, X and Y. On
May 4, 1998, A contributes the stock of Y to X. X
makes a QSSS election with respect to Y immediately following the transfer. The liquidation described in paragraph (a)(2) of this section is respected as an independent step separate from the
stock acquisition, and the tax consequences of the

May 18, 1998

liquidation are determined under sections 332 and
337. The contribution by A of the Y stock to X qualifies under section 351, and no gain or loss is recognized by A, X, or Y. Y is not treated as a C corporation for any period solely because of the transfer of
its stock to X, an ineligible shareholder. See
§1.1362–2(b)(4).

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

20

(S2) in a transaction in which the basis of
the S2 stock is determined in whole or in
part by reference to the transferor’s basis,
and S1 makes a QSSS election with respect to S2 effective on the day of the acquisition, any loss or deduction disallowed under section 1366(d) with respect
to a former shareholder of S2 is available
to that shareholder as a shareholder of S1.
Thus, a loss or deduction of a shareholder
of S2 disallowed prior to or during the
taxable year of the transaction is treated
as incurred by S1 with respect to that
shareholder if the shareholder is a shareholder of S1 after the transaction.
(d) Examples. The following examples illustrate the application of this section:
Example 1. X, an S corporation, owns 100 percent of the stock of Y, a C corporation. On June 2,
1998, X makes a valid QSSS election for Y, effective
June 2, 1998. Assume that, under general principles
of tax law, including the step transaction doctrine,
X’s acquisition of the Y stock and the subsequent
QSSS election would not be treated as related. The
liquidation described in paragraph (a)(2) of this section occurs at the close of the day on June 1, 1998,
the day before the QSSS election is effective, and
the plan of liquidation is considered adopted on that
date. Y’s taxable year and separate existence for federal tax purposes end at the close of June 1, 1998.
Example 2. X, a C corporation, owns 100 percent
of the stock of Y, another C corporation. On December 31, 1998, X makes an election under section
1362 to be treated as an S corporation and a valid
QSSS election for Y, both effective January 1, 1999.
Assume that, under general principles of tax law, including the step transaction doctrine, X’s acquisition
of the Y stock and the subsequent QSSS election
would not be treated as related. The liquidation described in paragraph (a)(2) of this section occurs at
the close of December 31, 1998, the day before the
QSSS election is effective. The QSSS election for Y
is effective on the same day that X’s S election is effective, and the deemed liquidation is treated as occurring before the S election is effective, when X is
still a C corporation. Y’s taxable year ends at the
close of December 31, 1998. See §1.381(b)–1.
Example 3. On June 1, 1998, X, an S corporation, acquires 100 percent of the stock of Y, an existing S corporation, for cash in a transaction meeting
the requirements of a qualified stock purchase
(QSP) under section 338. X immediately makes a
QSSS election for Y effective June 2, 1998, and also
makes a joint election under section 338(h)(10) with
the shareholder of Y. Under section 338(a) and
§1.338(h)(10)–1, Y is treated as having sold all of its
assets at the close of the acquisition date, June 1,
1998. Y is treated as a new corporation which purchased all of those assets as of the beginning of June
2, 1998, the day after the acquisition date. Section
338(a)(2). The QSSS election is effective on June 2,
1998, and the liquidation under paragraph (a)(2) of
this section occurs immediately after the deemed
asset purchase by the new corporation.

1998–20 I.R.B.

Example 4. X, an S corporation, owns 100 percent of Y, a corporation for which a QSSS election is
in effect. On May 12, 1998, a date on which the
QSSS election is in effect, X issues Y a $10,000 note
under state law that matures in ten years with a market rate of interest. Y is not treated as a separate corporation, and X’s issuance of the note to Y on May
12, 1998, is disregarded for federal tax purposes.
Example 5. X, an S corporation, owns 100 percent of the stock of Y, a C corporation. At a time
when Y is indebted to X in an amount which exceeds
the fair market value of Y’s assets, X makes a QSSS
election effective on the date it is filed with respect
to Y. The liquidation described in paragraph (a)(2)
of this section does not qualify under sections 332
and 337 and, thus, Y recognizes gain or loss on the
assets distributed, subject to the limitations of section 267.

§1.1361-5 Termination of QSSS election.
(a) In general—(1) Effective date.
The termination of a QSSS election is effective —
(i) On the effective date contained in
the revocation statement if a QSSS election is revoked under §1.1361–3(b);
(ii) At the close of the last day of the
parent’s last taxable year as an S corporation if the parent’s S election terminates
under §1.1362–2; or
(iii) At the close of the day on which
an event (other than an event described in
paragraph (a)(1)(ii) of this section) occurs
that renders the subsidiary ineligible for
QSSS status under section 1361(b)(3)(B).
(2) Information to be provided upon
termination of QSSS election by failure to
qualify as a QSSS. If a QSSS election terminates because an event renders the subsidiary ineligible for QSSS status, the S
corporation must attach to its return for
the taxable year in which the termination
occurs a notification that a QSSS election
has terminated, the date of the termination, and the names, addresses, and employer identification numbers of both the
parent corporation and the QSSS.
(3) Examples. The following examples illustrate the application of this paragraph (a):
Example 1. Termination because parent’s S election terminates. X, an S corporation, owns 100 percent of Y. A QSSS election is in effect with respect
to Y for 1998. Effective on January 1, 1999, X revokes its S election. Because X is no longer an S
corporation, Y no longer qualifies as a QSSS at the
close of December 31, 1998.
Example 2. Termination due to transfer of QSSS
stock. X, an S corporation, owns 100 percent of Y.
A QSSS election is in effect with respect to Y for
1998. On December 10, 1998, X sells one share of Y
stock to A, an individual. Because X no longer owns

1998–20 I.R.B.

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

(b) Effect of termination of QSSS election—(1) Formation of new corporation.
If a QSSS election terminates under paragraph (a) of this section, the former QSSS
is treated as a new corporation acquiring
all of its assets (and assuming all of its liabilities) immediately before the termination from the S corporation parent in exchange for stock of the new corporation.
The tax treatment of this transaction or of
a larger transaction that includes this
transaction will be determined under the
Internal Revenue Code and general principles of tax law, including the step transaction doctrine.
(2) Carryover of disallowed losses and
deductions. If a QSSS terminates because
the S corporation distributes the QSSS
stock to some or all of the S corporation’s
shareholders in a transaction to which
section 368(a)(1)(D) applies by reason of
section 355 (or so much of section 356 as
relates to section 355), any loss or deduction disallowed under section 1366(d)
with respect to a shareholder of the S corporation immediately before the distribution is allocated between the S corporation and the former QSSS with respect to
the shareholder. The amount of the disallowed loss or deduction allocated to the S
corporation is an amount that bears the
same ratio to each item of disallowed loss
or deduction as the value of the shareholder’s stock in the S corporation bears
to the total value of the shareholder’s
stock in both the S corporation and the
former QSSS, in each case as determined
immediately after the distribution.
(3) Examples. The following examples illustrate the application of this paragraph (b):
Example 1. X, an S corporation, owns 100 percent of the stock of Y, a corporation for which a

21

QSSS election is in effect. X sells 21 percent of the
Y stock to Z, an unrelated corporation, for cash,
thereby terminating the QSSS election. Y is treated
as a new corporation acquiring all of its assets (and
assuming all of its liabilities) in exchange for Y
stock immediately before the termination from the S
corporation. The deemed exchange by X of assets
for Y stock does not qualify under section 351 because X is not in control of Y within the meaning of
section 368(c) immediately after the transfer as a result of the sale of stock to Z. Therefore, X must recognize gain, if any, on the assets transferred to Y in
exchange for its stock. X’s losses, if any, on the assets transferred are subject to the limitations of section 267.
Example 2. Assume the same facts as in Example
1, except that, instead of purchasing Y stock, Z contributes to Y an operating asset in exchange for 21
percent of the Y stock. Y is treated as a new corporation acquiring all of its assets (and assuming all of
its liabilities) in exchange for Y stock immediately
before the termination. Because X and Z are cotransferors that control the transferee immediately
after the transfer, the transaction qualifies under section 351.
Example 3. X, an S corporation, owns 100 percent of the stock of Y, a corporation for which a
QSSS election is in effect. X distributes all of the Y
stock pro rata to its shareholders, and the distribution terminates the QSSS election. The transaction
can qualify as a distribution to which sections
368(a)(1)(D) and 355 apply if the transaction otherwise satisfies the requirements of those sections.
Example 4. X, an S corporation, owns 100 percent of the stock of Y, a corporation for which a
QSSS election is in effect. X subsequently revokes
the QSSS election. Y is treated as a new corporation
acquiring all of its assets (and assuming all of its liabilities) immediately before the revocation from its
S corporation parent in a deemed exchange for Y
stock. On a subsequent date, X sells 21 percent of
the stock of Y to Z, an unrelated corporation, for
cash. Assume that under general principles of tax
law including the step transaction doctrine, the sale
is not taken into account in determining whether X is
in control of Y immediately after the deemed exchange of assets for stock. The deemed exchange by
X of assets for Y stock and the deemed assumption
by Y of its liabilities qualify under section 351 because, for purposes of that section, X is in control of
Y within the meaning of section 368(c) immediately
after the transfer.

(c) Inadvertent terminations. Relief
from the consequences of an inadvertent
termination of a QSSS election may be
available under the standards established
by the Commissioner for the inadvertent
termination of an S election under
§1.1362–4.
(d) Election after QSSS termination—
(1) In general. Absent the Commissioner’s consent, and except as provided
in paragraph (d)(2) of this section, a corporation whose QSSS election has terminated under paragraph (a) of this section
(or a successor corporation as defined in

May 18, 1998

§1.1362–5(b)) may not make an S election under section 1362 or have a QSSS
election under section 1361(b)(3)(B)(ii)
made with respect to it for five taxable
years (as described in section 1361(b)(3)(D)). The Commissioner may permit
an S election by the corporation or a new
QSSS election with respect to the corporation before the 5-year period expires.
The corporation requesting consent to
make the election has the burden of establishing that, under the relevant facts and
circumstances, the Commissioner should
consent to a new election.
(2) Exception. If a corporation’s QSSS
election terminates by reason of a disposition of the corporation’s stock, the corporation may, without requesting the Commissioner’s consent, make an S election
or have a QSSS election made with respect to it before the expiration of the
five-year period described in section
1361(b)(3)(D) and paragraph (d)(1) of
this section, provided that —
(i) Immediately following the disposition of its stock, the corporation (or its
successor corporation) is otherwise eligible to make an S election or have a QSSS
election made for it; and
(ii) The relevant election is made effective immediately following the disposition of the stock of the corporation.
(3) Examples. The following examples illustrate the application of this paragraph (d):
Example 1. Termination upon distribution of
QSSS stock to shareholders of parent. X, an S corporation, owns Y, a QSSS. X distributes all of its Y
stock to X’s shareholders. The distribution terminates the QSSS election because Y no longer satisfies the requirements of a QSSS. Assuming Y is otherwise eligible to be treated as an S corporation, Y’s
shareholders may elect to treat Y as an S corporation
effective on the date of the stock distribution without
requesting the Commissioner’s consent.
Example 2. Sale of 100 percent of QSSS stock.
X, an S corporation, owns Y, a QSSS. X sells 100
percent of the stock of Y to Z, an unrelated S corporation. Z may elect to treat Y as a QSSS effective on
the date of purchase without requesting the Commissioner’s consent.

§1.1361–6 Effective date.
Except as provided in §1.1361–4(a)(5)(i), the provisions of §§1.1361–2
through 1.1361–5 apply to taxable years
beginning on or after the date that final
regulations are published in the Federal
Register.
Par. 5. Amend §1.1362–0 as follows:

May 18, 1998

1. Add an entry for §1.1362–2(b)(4).
2. Add entries for §1.1362–8.
The additions read as follows:
§1.1362–0 Table of contents.
*

*

*

*

*

§1.13622 Termination of election.
*

*

*

*

*

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

*

*

*

*

§1.1362–8 Dividends received from
affiliated subsidiaries.
(a) In general.
(b) Determination of active or passive
earnings and profits.
(1) In general.
(2) Lower tier subsidiaries.
(3) De minimis exception.
(4) Special rules for earnings and profits
accumulated by a C corporation prior
to 80 percent acquisition.
(5) Gross receipts safe harbor.
(c) Allocating distributions to active or
passive earnings and profits.
(1) Distributions from current earnings
and profits.
(2) Distributions from accumulated earnings and profits.
(3) Adjustments to active earnings and
profits.
(4) Special rules for consolidated groups.
(d) Examples.
(e) Effective date.
Par. 6. Amend §1.1362–2 as follows:
1. Amend paragraph (b)(1) by adding a
sentence to the end of the paragraph.
2. Add paragraph (b)(4).
3. Amend paragraph (c)(5)(ii)(C) by
adding a sentence to the end of the paragraph.
The additions read as follows:
§1.1362–2 Termination of election.
*

*

*

*

*

(b) * * *
(1) * * * See paragraph (b)(4) of this
section for a special rule applying to the
termination of an S election caused by the
transfer of the corporation’s stock to another S corporation.
*

*

*

22

*

*

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

*

*

*

*

Par. 7. Add §1.1362–8 to read as follows:
§1.1362–8 Dividends received from
affiliated subsidiaries.
(a) In general. For purposes of section
1362(d)(3), if an S corporation holds
stock in a C corporation meeting the requirements of section 1504(a)(2), the
term “passive investment income” does
not include dividends from the C corporation to the extent those dividends are attributable to the earnings and profits of
the C corporation derived from the active
conduct of a trade or business (“active
earnings and profits”). For purposes of
applying section 1362(d)(3), earnings and
profits of a C corporation are active earnings and profits to the extent that the earnings and profits are derived from activities that would not produce passive
investment income (as defined in section
1362(d)(3)) if the C corporation were an S
corporation.
(b) Determination of active or passive
earnings and profits—(1) In general. An
S corporation may use any reasonable
method to determine the amount of dividends that are not treated as passive in-

1998–20 I.R.B.

vestment income under section 1362(d)(3)(E). Paragraph (b)(5) of this section
describes a method of determining the
amount of dividends that are not treated
as passive investment income under section 1362(d)(3)(E) that is deemed to be
reasonable under all circumstances.
(2) Lower tier subsidiaries. If a C corporation subsidiary (upper tier corporation) holds stock in another C corporation
(lower tier subsidiary) meeting the requirements of section 1504(a)(2), the
upper tier corporation’s gross receipts attributable to a dividend from the lower
tier subsidiary are considered to be derived from the active conduct of a trade or
business to the extent the lower tier subsidiary’s earnings and profits are attributable to the active conduct of a trade or
business by the subsidiary under paragraph (b)(1), (b)(3), (b)(4), or (b)(5) of
this section. For purposes of this section,
distributions by the lower tier subsidiary
will be considered attributable to active
earnings and profits according to the rule
in paragraph (c) of this section. This
paragraph (b)(2) does not apply to any
member of a consolidated group (as defined in §1.1502–1(h)).
(3) De minimis exception. If less than
10 percent of a C corporation’s earnings
and profits for a taxable year are derived
from activities that would produce passive investment income if the C corporation were an S corporation, all earnings
and profits produced by the corporation
during that taxable year are considered
active earnings and profits.
(4) Special rules for earnings and
profits accumulated by a C corporation
prior to 80 percent acquisition. A C corporation may treat all earnings and profits
accumulated by the corporation in all taxable years ending before the S corporation
held stock meeting the requirements of
section 1504(a)(2) as active earnings and
profits in the same proportion as the C
corporation’s active earnings and profits
for the three taxable years ending prior to
the time when the S corporation acquired
80 percent of the C corporation bears to
the C corporation’s total earnings and
profits for those three taxable years.
(5) Gross receipts safe harbor. A corporation may treat its earnings and profits
for a year as active earnings and profits in
the same proportion as the corporation’s
gross receipts (as defined in §1.1362–

1998–20 I.R.B.

2(c)(4)) derived from activities that would
not produce passive investment income
(if the C corporation were an S corporation), including those that do not produce
passive investment income under paragraphs (b)(2) through (b)(4) of this section, bear to the corporation’s total gross
receipts for the year in which the earnings
and profits are produced.
(c) Allocating distributions to active or
passive earnings and profits—(1) Distributions from current earnings and profits.
Dividends distributed by a C corporation
from current earnings and profits are attributable to active earnings and profits in
the same proportion as current active
earnings and profits bear to total current
earnings and profits of the C corporation.
(2) Distributions from accumulated
earnings and profits. Dividends distributed by a C corporation out of accumulated earnings and profits for a taxable
year are attributable to active earnings
and profits in the same proportion as accumulated active earnings and profits for
that taxable year bear to total accumulated
earnings and profits for that taxable year
immediately prior to the distribution.
(3) Adjustments to active earnings and
profits. For purposes of applying paragraph (c)(1) or (c)(2) of this section to a
distribution, the active earnings and profits of a corporation shall be reduced by the
amount of any prior distribution properly
treated as attributable to active earnings
and profits from the same taxable year.
(4) Special rules for consolidated
groups. For purposes of applying section
1362(d)(3) and this section to dividends
received by an S corporation from the
common parent of a consolidated group
(as defined in §1.1502–1(h)), the following rules apply—
(i) The current earnings and profits, accumulated earnings and profits, and active earnings and profits of the common
parent shall be determined under the principles of §1.1502–33 (relating to earnings
and profits of any member of a consolidated group owning stock of another
member); and
(ii) The gross receipts of the common
parent shall be the sum of the gross receipts of each member of the consolidated
group (including the common parent), adjusted to eliminate gross receipts from intercompany transactions (as defined in
§1.1502-13(b)(1)(i)).

23

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

(e) Effective date. This section applies
to dividends received in taxable years beginning on or after the date that final regulations are published in the Federal
Register.
§1.1368–0 [Amended]
Par. 8. Amend §1.1368–0 in the entry
for §1.1368–2(d)(2) by revising “Reorganizations” to read “Liquidations and reorganizations”.
§1.1368–2 [Amended]
Par. 9. Amend §1.1368–2 in paragraph
(d)(2) by revising “Reorganizations” to
read “Liquidations and reorganizations”
in the heading and by revising “section
381(a)(2)” to read “section 381(a)” in the
first sentence.
Par. 10. Amend §1.1374–8 by adding
two sentences to the end of paragraph (b)
to read as follows:
§1.1374–8 Section 1374(d)(8)
transactions.
*

*

*

*

*

May 18, 1998

(b) Separate determination of tax. * *
* If a C corporation elects to be treated
as an S corporation, and also makes a
QSSS election under section 1361(b)(3)
(effective on the same date as the S election) with respect to a subsidiary, the assets held by the QSSS at the time of the
QSSS election will be treated as assets
held by the parent when it became an S
corporation. The preceding sentence applies to QSSS elections made after the
date final regulations are published in
the Federal Register.
*

*

*

*

*

Michael P. Dolan,
Deputy Commissioner of
Internal Revenue.
(Filed by the Office of the Federal Register on
April 21, 1998, 8:45 a.m., and published in the
issue of the Federal Register for April 22, 1998, 63
F.R. 19864)

Change From Dollar
Approximate Separate
Transaction Method of
Accounting (DASTM) to the
Profit and Loss Method of
Accounting/Change From the
Profit and Loss Method to
DASTM; Correction to T.D.
8765
Announcement 98–39
SUMMARY: This announcement contains corrections to final regulations
(T.D. 8765 [1998–16 I.R.B. 11] 63 F.R.
10772), relating to adjustments required
when a qualified business unit (QBU)
that used the profit and loss method of
accounting (P&L) in a post-1986 year
begins to use the dollar approximate separate transaction method of accounting
(DASTM) and adjustments required
when a QBU that used DASTM begins
using P&L.
DATES: This correction is effective
April 6, 1998.
FOR FURTHER INFORMATION CONTACT: Howard Wiener of the Office of
Chief Counsel (International), (202)
622-3870 (not a toll-free number).

May 18, 1998

SUPPLEMENTARY INFORMATION:
Background
The final regulations that are the subject of these corrections are under section 985 of the Internal Revenue Code.
Need for Correction
As published, the final regulations
(T.D. 8765) contain errors which may
prove to be misleading and are in need of
clarification.
Correction of Publication
Accordingly, the publication of the
final regulations (TD 8765), which was
the subject of FR Doc. 98-5470, is corrected as follows:
§1.985–1 [Corrected]
1. On page 10774, column 2,
§1.985–1 (b)(2)(ii)(C) is corrected as
follows:
1. The paragraph heading for paragraph (b)(2)(ii)(C)(1) is added.
2. A new paragraph (b)(2)(ii)(C)(2) is
added.
The corrections read as follows:
§1.985–1 Functional currency.
*

*

*

*

*

(b) * * *
(2) * * *
(ii) * * *
(C) * * * (1) In general. * * *
(2) Effective date. This paragraph
(b)(2)(ii)(C) applies to taxable years beginning after April 6, 1998. However, a
taxpayer may choose to apply this paragraph to all open years after December
31, 1986, provided each person, and
each QBU branch of a person, that is related (within the meaning of
§1.985–2(d)(3)) also applies to this paragraph (b)(2)(ii)(C).
§1.985–7 [Corrected]
2. On page 10775, column 2,
§1.985–7 (b)(3), in the last three lines,
the language “had translated its assets
and liabilities under §1.985–3 during the
look-back period.” is corrected to read
“had translated its assets and liabilities
acquired and incurred during the lookback period under §1.985–3.”.
4. On page 10776, column 2,

24

§1.985–7 (c)(5), line 17, the language
“of change.) For purposes of section
960,” is corrected to read “of change).
For purposes of section 960,”.
5. On page 10776, column 2,
§1.985–7 (c)(5), the last line, the language “section.)” is corrected to read
“section).”.
6. On page 10776, column 3,
§1.985–7 (d)(5), the last two lines, the
language “assets and liabilities under
§1.985–3 during the look- back period.”
is corrected to read “assets and liabilities
acquired and incurred during the lookback period under §1.985–3.”.
Cynthia E. Grigsby,
Chief, Regulations Unit,
Assistant Chief Counsel (Corporate).

Allocation and Sourcing of
Income and Deductions Among
Taxpayers Engaged in a Global
Dealing Operation; Correction
Announcement 98–40
SUMMARY: This announcement contains corrections, including a change to
the date of the public hearing, to the notice of proposed rulemaking (REG–
208299–90 [1998–16 I.R.B. 26] 63 F.R.
11177). The notice of proposed rulemaking relates to the allocation among
controlled taxpayers and sourcing of income, deductions, gains and losses from
a global dealing operation; rules applying these allocation and sourcing rules to
foreign currency transactions and to foreign corporations engaged in a U.S. trade
or business; and rules concerning the
mark-to-market treatment resulting from
hedging activities of a global dealing operation.
DATES: The public hearing originally
scheduled for July 9, 1998 has been
rescheduled for July 14, 1998.
ADDRESS: The public hearing will be
held in room 2615, Internal Revenue
Building, 1111 Constitution Avenue,
NW, Washington, DC 20224.
FOR FURTHER INFORMATION CONTACT: Ginny Chung, (202) 622-3870
(not a toll-free number).

1998–20 I.R.B.